QUALIFICATION PROGRAMME

Professional Module 14
nal Taxation
4

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 TAXATION

MODULE 14
TAXATION
Qualification Programme

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 First edition 2021

ISBN 9781119485636

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potential source of further information does not mean that the publisher and authors endorse the information or
services the organization, website, or product may provide or recommendations it may make. This work is sold with the
understanding that the publisher is not engaged in rendering professional services. The advice and strategies contained
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2021

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 T a b l e of C onte nts

TABLE OF CONTENTS

Module 14: Taxation

Director’s Message v

Introductionvi

HKICPA Proficiency Levels and Taxonomy vii

Learning Outcomes x

Study Text Key Features xxiv

Tax Tables xxv

PART A TAX SYSTEM AND ADMINISTRATION IN HONG KONG 1

CHAPTER 1: Key Aspects of the Tax System in Hong Kong 3

CHAPTER 2: Administration of the Tax System in Hong Kong 43

PART B TAX RULES, PRINCIPLES AND CALCULATIONS

OF TAX LIABILITIES FOR PROPERTY TAX,
SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT
AND STAMP DUTY IN HONG KONG 119
CHAPTER 3: Profits Tax 121

CHAPTER 4: Salaries Tax 319

CHAPTER 5: Property Tax 505

CHAPTER 6: Personal Assessment 553

CHAPTER 7: Stamp Duty 621

PART C PROFITS TAX RULES, PRINCIPLES AND CALCULATIONS

OF PROFITS TAX LIABILITIES FOR CROSS-BORDER
­TRANSACTIONS 689
CHAPTER 8: Profits Tax Liabilities for Cross-border Transactions 691

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 TAXATION

PART D TAX SYSTEM AND ADMINISTRATION IN

MAINLAND CHINA 729
CHAPTER 9: Tax System and Administration in Mainland China 731

PART E HONG KONG TAX PLANNING IDEAS AND

STRATEGIES TO ENHANCE TAX EFFICIENCY 825
CHAPTER 10: Hong Kong Tax Planning Ideas and Strategies 827

CHAPTER 11: Transfer Pricing 921

Further Reading 961

Glossary of Terms 963

Table of Cases 971

Table of Ordinances 981

Table of Board of Review Decisions 985

Practice Notes and Circulars 987

Index 989

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 D IRE C T O R ’S M ESSA GE

D I R E C T O R ’ S M ESS A G E

Congratulations on choosing the Qualification Programme (‘QP’) of the Hong Kong Institute of
Certified Public Accountants (‘HKICPA’) as your pathway to becoming a CPA! You have joined
thousands of others on this exciting and important journey to develop the knowledge, skills
and perspectives you need to succeed in your career and becoming a valued member of the
Institute.

The world is evolving rapidly, so too is the business environment. The Accounting
profession faces a number of challenges and trends including technological enhancement,
regulatory development, changing societal expectations and more.

Professional accountants are no longer left only to deal with numbers, but also to analyse
and advise. We are also expected to be highly strategic, collaborative, and building trust by
demonstrating relevance and value to many aspects of society.

The QP of the HKICPA aims at qualifying accountants with the agility needed to embrace the
changing environment. You will grow and discover a plethora of relevant competencies through
QP by completing training programmes, passing professional examinations and acquiring
practical experience under an authorised employer or supervisor. In the longer term, we hope
that you will succeed not only in accountancy but also in enhancing your employability and
portability so that you will be able to help business and society move forward.

We are delighted to partner with you on your development journey.

The QP consists of three levels of designations:

• The Associate Level aims to build a solid foundation of technical accounting knowledge.

• The Professional Level aims to deepen your technical capabilities and develop core
enabling competences in the workplace.

• The Capstone integrates your knowledge, skills and experiences to resolve business
problems and emerge as a top tier accounting professional.

We have designed this Learning Pack to provide you with the valuable resources for your
development on attaining your CPA designation under the QP. I trust you will be successful and
enjoy your QP journey!

Should you require any assistance at any time, please feel free to contact us on (852) 2287 7228.

Kit Wong
Director of Education and Training
Hong Kong Institute of Certified Public Accountants

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 TAXATION

INTRODUCTION

Successfully preparing for a career in accounting is a significant undertaking. To better prepare

you for this challenging profession, the HKICPA provides a qualification programme (QP)
comprising three progressive levels: A 10-module Associate Level, a four-module Professional
Level including workshops and a Capstone that includes three-day workshops and a final
examination.

The Professional Level of the QP comprises four modules. Each of these modules involves
approximately 120 hours of self-study and an open-book module examination. There are also a
total of five workshops to be completed for the Professional Level. They include a prerequisite
Introductory Workshop and a one-day workshop for each Professional Module.

• Module 11: Financial Reporting

• Module 12: Business Finance
• Module 13: Business Assurance
• Module 14: Taxation

While each of the Associate Level and Professional Level modules stands on its own, the
modules are also arranged in a series of ‘verticals’ that map to the CPA competence blueprint.
These verticals are designed to develop an area of knowledge, through two or three modules,
from basic understanding to professional excellence.

The Financial Accounting and Reporting vertical runs from Module 1, through Module 6 to
Professional Level Module 11: Financial Reporting. A second vertical, Management Accounting,
runs from Module 2, via Module 7 to Professional Level Module 12: Business Finance. The
third vertical, Audit and Assurance, develops from Module 8 to Professional Level Module 13:
Business Assurance. The fourth vertical, Taxation, takes students from Module 9 to Professional
Level Module 14: Taxation.

Each Professional Level module of the new QP requires students to sit a three-hour
examination. Two exam sittings are held each year in June session and December session.

Please refer to the Student Handbook for the examination structure and the cut-off rule on
the examinable content.

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 H K IC P A P R O F IC IENC Y L EV EL S A ND   T A X ONOM Y

HKICPA PROFICIENCY LEVELS AND TAXONOMY

The proficiency level indicated in the table below reflects the level at which the topics covered
in particular learning outcome is tested. There are three levels of proficiency:

• Level 1 is the foundational level, covering the skills of knowledge and comprehension.

• Level 2 is the intermediate level, covering the skills of application and analysis.

• Level 3 is the advanced level, covering the skills of integration and evaluation.

You are expected to understand which skill is exercised based on the taxonomy verbs with
which it is associated.

Please note that the list of taxonomy verbs below is for reference only and does not
represent an exhaustive list.

LEVEL 1: FOUNDATION
Skill Verb Definition
Knowledge Define Give the accepted meaning of
The remembering of previously Identify List or ascertaining possibilities before
learned material (recall of facts) analysis; Point to the essential part or
parts
List Provide a concise summary of the
relevant points, often in bullet point
format
Outline Give the main facts about something
State Accurately articulate established
principles, concepts, terms etc.
Comprehension Describe Communicate the key features of
Demonstrative understanding something, present a detailed account
of facts and ideas by organising, of something focusing on depth of
comparing, translating, knowledge
interpreting, giving descriptions Explain Make clear the details of something;
and stating main ideas or show how the reason for, or
underlying cause of, or the means by
which something occurs
Illustrate Offer examples, to show how something
happens, that something happens,
or make concrete a concept by giving
examples
Interpret Make clear the meaning of something
and its implications
Summarise Describe something concisely; bring
together the main facts

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 TAXATION

LEVEL 2: INTERMEDIATE
Skill Verb Definition
Application Account for / Demonstrate Give details of accounting entries to
Using new knowledge. Solve be made for in the context of financial
problems to new situations by reporting or justify (if used in a more
applying acquired knowledge, general context); Demonstrate the
facts, techniques and rules in a accounting treatment by using a set of
different way accounts
Apply Demonstrate knowledge, concepts or
techniques; Use established methods /
tools / procedures to resolve relatively
straightforward scenarios or problems
Calculate / Compute Determine by computation or arrive at
by mathematical means or processes
Prepare Follow established procedures /
methods to create a report of financial
information or commentary (e.g. using a
proforma spreadsheet)
Solve To work out to a result or conclusion
Use Apply in a practical way
Analysis Analyse To examine methodically by
Examine and break information separating into parts and studying the
into parts by identifying motives interrelationships in order to discover
or causes. Make inferences essential features
and find evidence to support Compare Critically consider two or more things,
generalisation emphasising their similarities
Contrast Critically consider two or more things,
emphasising their differences
Classify / Categorise Apply concepts to categorise
information or groups into categories
Justify Explain the reason for recommendation
made, or underlying cause of, based
on an analysis of a range of available
options
Prioritise / Determine Determine the order for dealing with
a series of items or tasks according to
their relative importance e.g. Determine
the priorities / determine the level of
importance

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 H K IC P A P R O F IC IENC Y L EV EL S A ND   T A X ONOM Y

LEVEL 3: ADVANCED
Skill Verb Definition
Integration Construct To form an idea, a process, or procedure
Compile information together by bringing together various theoretical
and conceptual elements
in a different way by combining
elements in a new pattern or Design Develop a procedure/process or course
proposing alternative solutions of action based on selection of the
optimum combination from a range of
available options
Develop To bring something into existence that
has not previously existed, or to reshape
something from its initial position into
something more refined; Use judgement
to bring to a more advanced or effective
state or to create a plan
Formulate Devise and put a plan into words
Integrate Combine one aspect of learning with
another to form a holistic understanding of
a process, procedure or course of action
Plan / Propose Formulate a detailed proposal for doing
or achieving something
Produce Draw together similar or disparate items
to form a report containing financial
and/or non-financial information
Evaluation Advise Communicate appropriately the
The ability to judge the value recommended course of action based
of material for a given purpose on an analysis of specific circumstances
in a manner suited to the recipient
Appraise Assess the value or quality of something;
or to assess its performance
Consider Think carefully about something before
making a decision, to look closely or
attentively at something through a
process involving critical thinking
Evaluate Assess and determine the value,
importance or qualities of something,
normally with reference to specific
criteria and draw conclusions
Recommend Select the best course of action or
choice; Advocate a particular outcome or
course of action based on an analysis of
a range of available options

References
Anderson, L. W., Krathwohl, D. R., Airiasian, W., Cruikshank, K. A., Mayer, R. E., & Pintrich, P. R. (2001).
A taxonomy for learning, teaching and assessing: A revision of Bloom’s Taxonomy of educational outcomes:
Complete edition. New York: Longman.
The International Federation of Accountants. (2016). Framework for International Education Standards for
Professional Accountants and Aspiring Professional Accountants. (2015). Retrieved from https://www.ifac.org
The Government of the Hong Kong Special Administrative Region. (2016). Qualification Framework – Generic
Level Descriptors. Retrieved from https://www.hkqf.gov.hk

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 TAXATION

L E A R N I N G O U T C O M ES

Each module includes Principal Learning Outcomes and Supporting Learning Outcomes
arranged along a series of proficiency levels.

Module 14: TAXATION

Syllabus area Weighting (%)

Demonstrate an understanding of the tax system and administration in Hong Kong 5–10
Apply tax rules and principles and calculate tax liabilities for property tax, salaries 50–60
tax, profits tax, personal assessment and stamp duty in Hong Kong
Apply profits tax rules and principles and calculate profits tax liabilities for cross- 5–10
border transactions
Demonstrate an understanding of the tax system and administration in Mainland 5–10
China
Advise on Hong Kong tax planning ideas and strategies to enhance tax efficiency 25–30

The syllabus weighting table indicates the relative weightings of the syllabus areas encompassed
in this module. It serves as a guide to the percentage of study time spent on each syllabus area. In
the long run, the marks allocation in the module examinations would conform to the weightings as
shown above. The exact range of marks allocation in each module examination may deviate from
the weightings for suitably robust questions to be set.

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 L E A R NING O U TCOM ES

Learning Outcomes Proficiency Chapter

Level where
covered
PRINCIPAL LO1: DEMONSTRATE AN UNDERSTANDING OF THE TAX SYSTEM AND ADMINISTRATION
IN HONG KONG
State, describe and apply the following key aspects of the tax system in Hong Kong:
LO1.01: P
 rinciples of taxation 2
1.01.01 Describe the Hong Kong tax system and contrast it with the tax 2 1
systems generally adopted in other parts of the world
1.01.02 Explain and apply the territorial source principle, describe its 2 1
historical background, and contrast the differences between
tax jurisdictions that adopt territorial source principle with
those that adopt residence system
1.01.03 Illustrate the challenges in Hong Kong under the territorial 1 1
source principle amid the worldwide trends such as Base Erosion
and Profit Shifting (‘BEPS’), Foreign Account Tax Compliance Act
(‘FATCA’) and Common Reporting Standard (‘CRS’)
1.01.04 Describe the roles of the taxpayer, the tax advisor and the 1 2
Inland Revenue Department (‘IRD’)
LO1.02: T
 ypes of tax 1
1.02.01 Describe the various types of taxes levied under the Inland 1 1
Revenue Ordinance (‘IRO’) and Stamp Duty Ordinance (‘SDO’)
LO1.03: S
 ources of Hong Kong tax law – statute, case law, Board of 1
Review decisions
1.03.01 Describe the various sources of tax law 1 1
1.03.02 Describe the doctrine of precedent in the context of tax law 1 1
LO1.04: I nterpretation of tax statutes 1
1.04.01 Explain the rules of interpretation of tax law and their 1 1
applications
1.04.02 Explain the purposive interpretation and the significance of the 1 1
Ramsay principle
LO1.05: T
 he Basic Law 1
1.05.01 State the tax relations between the HKSAR and the Mainland 1 1
of China with reference to Departmental Interpretation and
Practice Notes (‘DIPN’) 29
1.05.02 State the major articles of the Basic Law relating to taxation 1 1
1.05.03 State the important principles of DIPN 29 1 1
LO1.06: D
 epartmental Interpretation and Practice Notes and Stamp 1
Office Interpretation and Practice Notes
1.06.01 Describe the status and application of DIPNs and Stamp Office 1 1
Interpretation and Practice Notes (‘SOIPN’)
LO1.07: S
 tructure and administration of the Inland Revenue 1
Department
1.07.01 State the structure of the IRD 1 2
1.07.02 Explain the administration of the IRD 1 2

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Learning Outcomes Proficiency Chapter

Level where
covered
LO1.08: D
 uties and powers of officers of the Inland Revenue 1
Department, and official secrecy
1.08.01 Explain the duties and powers of IRD officers 1 2
1.08.02 Explain the secrecy provisions under the IRO 1 2
LO1.09: O
 bligations and liabilities of a taxpayer, his agent, a trustee 1
or an executor
1.09.01 Explain the obligations and liabilities of a taxpayer, his agent, a 1 2
trustee or an executor under the IRO and the SDO
LO1.10: R
 eturns, offences and penalties 2
1.10.01 Describe the powers of IRD officers to require the furnishing of 1 2
returns, statements and information
1.10.02 Describe the powers of IRD officers to seize books, records and 1 2
documents by way of search warrant
1.10.03 Describe the obligations of a taxpayer in relation to keeping of 1 2
business and rent records
1.10.04 Describe the obligations and rights of an employer under the 1 2
IRO
1.10.05 Describe the tax offences and apply the penalty provisions 2 2
under the IRO
LO1.11: A
 ssessments, additional assessments and provisional 2
assessments
1.11.01 Apply the provisions under the IRO regarding the raising of tax 2 2
assessments
LO1.12: P
 ayment, recovery, holding over and refund of tax 1
1.12.01 Explain the provisions under the IRO regarding payment of tax 1 2
1.12.02 Explain the provisions under the IRO regarding recovery, 1 2
holding over and refund of tax
LO1.13: O
 bjections, appeals and claims 2
1.13.01 Describe and apply the objection and appeal procedures, and 2 2
the requirements to lodge a claim to correct error or omission
in a tax return or statement
1.13.02 Describe and apply the provision under the IRO regarding 2 2
finality of tax assessments
1.13.03 Apply DIPN 6 2 2
LO1.14: B
 oard of Review 1
1.14.01 Describe the role, formation and functions of the Board of 1 2
Review
LO1.15: Board of Inland Revenue 2
1.15.01 Describe the role, formation and functions of the Board of 1 2
Inland Revenue
1.15.02 Describe and apply the Inland Revenue Rules (‘IRR’) 2 2

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Learning Outcomes Proficiency Chapter

Level where
covered
1.15.03 Justify the circumstances under which IRR can be used to 2 2
compute the profits of a Hong Kong branch, and apply the
applicable computation methods
1.15.04 Explain the difference between the permanent establishment 1 2
(‘PE’) definition under the IRR and that under double taxation
agreements/arrangements
LO1.16: Field audit and investigation 2
1.16.01 Describe the essential issues concerning field audit and 1 2
investigation
1.16.02 Describe the efficient ways to lead a tax investigation to an 1 2
early settlement
1.16.03 Explain and apply the settlement methods used by the IRD in 2 2
the quantification process
1.16.04 Describe and apply judicial review cases on the raising of 2 2
assessments and recovery of taxes
1.16.05 Apply DIPN 11 2 2
PRINCIPAL LO2: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES FOR
PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT AND
STAMP DUTY IN HONG KONG
Describe, explain and analyse the following tax issues as they impact
and interact on transactions, individuals and entities:
Property tax
LO2.01: S
 cope of property tax charge 2
2.01.01 Explain the scope of charge of property tax 1 5
2.01.02 Determine whether property letting amounts to a business 2 5
2.01.03 Explain whether the scope should cover properties like 1 5
indefeasible right of use of satellites or undersea cables
2.01.04 Explain the property tax implications for alternative bond 1 5
schemes
2.01.05 Describe and apply the relief and exemptions available under 2 5
property tax
2.01.06 Apply DIPN 14 and 50 2 5
LO2.02: C
 hargeable property and owners of land and/or buildings 2
2.02.01 Explain an owner of a property as defined under the IRO 1 5
2.02.02 Describe the obligations of a property owner under the IRO 1 5
2.02.03 Apply DIPN 14 2 5
Salaries tax
LO2.03: S
 cope of salaries tax charge 2
2.03.01 Explain the scope of charge of salaries tax 1 4
2.03.02 Describe the circumstances under which income from 1 4
employment would cover income other than from employer
2.03.03 Explain when to apply salaries tax and when to apply profits 1 4
tax in special circumstances such as insurance agents
2.03.04 Explain and apply the various exemptions available under 2 4
salaries tax

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Learning Outcomes Proficiency Chapter

Level where
covered
LO2.04: T
 ime basis assessment 2
2.04.01 Analyse circumstances to determine whether time 2 4
apportionment is applicable
2.04.02 Apply DIPN 10 2 4
LO2.05: I ncomes 2
2.05.01 Describe and apply the rules governing the source of income 2 4
from office, employment and pension
2.05.02 Apply DIPN 10 2 4
LO2.06: B
 enefits in kind, housing benefits, share-based benefits and 2
holiday journey benefits
2.06.01 Analyse the taxation of benefits in kind, housing benefits and 2 4
share-based benefits
2.06.02 Analyse the taxation of holiday journey benefits 2 4
2.06.03 Apply DIPN 16, 38 and 41 2 4
LO2.07: L
 ump sum receipts 2
2.07.01 Analyse the taxation of lump sum receipts and retirement 2 4
scheme benefits
2.07.02 Describe and apply the tax treatments of different termination 2 4
payments under case law
2.07.03 Apply DIPN 23 2 4
LO2.08: E
 xpenses and deductions 2
2.08.01 Explain and apply the rules governing the deduction of expenses 2 4
and depreciation allowances available under salaries tax
2.08.02 Explain and apply the rules governing the deduction of 2 4
concessionary deductions
2.08.03 Apply DIPN 9, 23, 35, 36 and 37 2 4
LO2.09: L
 osses 2
2.09.01 Describe the nature of losses 1 4
2.09.02 Explain the treatment of losses and apply loss relief 2 4
LO2.10: P
 ersonal allowances 2
2.10.01 Explain and apply the rules governing the claims for various 2 4
personal allowances
2.10.02 Apply DIPN 18 2 4
LO2.11: S
 eparate taxation on spouses and joint assessment 2
2.11.01 Explain the issues relating to the separate taxation and joint 1 4
assessment of husband and wife
2.11.02 Apply DIPN 18 2 4
Profits tax
LO2.12: S
 cope of profits tax charge 2
2.12.01 Explain the scope of charge of profits tax 1 3

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 L E A R NING O U TCOM ES

Learning Outcomes Proficiency Chapter

Level where
covered
2.12.02 Explain and apply the criteria for determining whether a 2 3
person carries on a trade, profession or business in Hong Kong
2.12.03 Describe the circumstances under which both profits tax and 1 3
salaries tax may not apply
LO2.13: Badges of trade 2
2.13.01 Analyse whether a transaction constitutes an adventure in the 2 3
nature of trade
2.13.02 Apply the badges of trade in the context of tax cases and 2 3
recent Board of Review decisions
LO2.14: Source of profits 2
2.14.01 Apply the principles and rules for determining the sources of 2 3
profits (including the chargeability of e-commerce transactions)
2.14.02 Describe and apply the latest developments in tax cases on 2 3
source issues
2.14.03 Apply DIPN 13, 21 and 39 2 3
LO2.15: Deemed trading receipts 2
2.15.01 Apply the rules governing the taxation of deemed trading 2 3
receipts
2.15.02 Apply DIPN 22 and 49 2 3
LO2.16: Distinction between capital and revenue items 2
2.16.01 Contrast capital and revenue items 2 3
LO2.17: General deductions and specific deductions 2
2.17.01 Apply the rules governing allowable and non-allowable profits 2 3
tax deductions under the IRO
2.17.02 Apply DIPN 3, 5, 12, 13A, 24, 28, 33, 40 and 49 2 3
LO2.18: Cessation and post-cessation receipts and payments 2
2.18.01 Explain and analyse the tax issues in relation to cessation 2 3
2.18.02 Explain the operation of section 15D of the IRO 1 3
LO2.19: Sharkey v Wernher principle 2
2.19.01 Explain and apply the Sharkey v Wernher principle 2 3
LO2.20: Stock borrowing and lending transactions 2
2.20.01 Explain the tax implications for stock borrowing and lending 1 3
transactions
2.20.02 Apply DIPN 26 and 27 2 3
LO2.21: Financial instruments and foreign exchange differences 2
2.21.01 Explain the taxation on financial instruments and taxation of 1 3
foreign exchange differences
2.21.02 Apply DIPN 42 2 3
LO2.22: E
 xemption for funds 2
2.22.01 Explain and apply the exemption for funds 2 3

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Learning Outcomes Proficiency Chapter

Level where
covered
2.22.02 Explain the historical background and rationale for the 1 3
exemption for offshore funds and offshore private equity funds
2.22.03 Explain and apply the deeming provision and the 2 3
ascertainment of the deemed assessable profits
2.22.04 Apply DIPN 43 and 51 2 3
LO2.23: Alternative bond schemes 2
2.23.01 Explain the religious background for alternative bond schemes 1 3
2.23.02 Explain the tax implications for alternative bond schemes 1 3
2.23.03 Apply DIPN 50 2 3
LO2.24: Corporate treasury activities 2
2.24.01 Explain the profits tax concession to qualifying corporate 1 3
treasury centres
2.24.02 Explain the rules governing the deduction of interest payments 1 3
on money borrowed by a corporation carrying on in Hong Kong
an intra-group financing business
2.24.03 Apply DIPN 52 2 3
LO2.25: Regulatory capital securities 2
2.25.01 Explain the profits tax treatments in respect of regulatory 1 3
capital securities issued by banks to comply with Basel III
capital adequacy requirements
2.25.02 Apply DIPN 53 2 3
LO2.26: Aircraft leasing activities 2
2.26.01 Explain the profits tax concession and treatments for qualifying 1 3
aircraft lessors and qualifying aircraft leasing managers
2.26.02 Apply DIPN 54 2 3
LO2.27: Special classes of business 1
2.27.01 Explain the tax rules governing income from aircrafts and 1 3
shipping business
2.27.02 Describe how income from international traffic may be taxed 1 3
under DTAs and Airline and Shipping Income Agreements
2.27.03 Explain the tax rules governing income for different types of 1 3
insurance companies
2.27.04 Describe the two different taxation methods for life insurance 1 3
companies
2.27.05 Explain the tax rules governing income of clubs and 1 3
associations
2.27.06 Explain the differences between clubs and associations with 1 3
reference to tax cases
2.27.07 Explain the tax rules governing the income and expenses of 1 3
financial institutions
2.27.08 Explain the significance of the Sincere Insurance & Investment 1 3
Co Ltd case to financial institutions

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 L E A R NING O U TCOM ES

Learning Outcomes Proficiency Chapter

Level where
covered
LO2.28: Partnerships, joint ventures, and allocation of profit/loss 2
2.28.01 Explain the tax rules governing partnerships and joint ventures 1 3
2.28.02 Apply the rules relating to partnerships and joint ventures in 2 3
evaluating the choice of entity for business purposes and the
tax reporting requirements
LO2.29: Losses 2
2.29.01 Explain the treatment of losses 1 3
2.29.02 Explain and apply the mechanism under which the tax loss of 2 3
a partner under a partnership is offset against the partner’s
other income under personal assessment and vice versa
2.29.03 Apply DIPN 8 2 3
LO2.30: Depreciation allowances: plant and machinery 2
2.30.01 Explain the rules governing the grant of depreciation 1 3
allowances on plant and machinery
2.30.02 Calculate the depreciation allowances on plant and machinery 2 3
2.30.03 Apply DIPN 7 2 3
LO2.31: D
 epreciation allowances: industrial buildings and 2
commercial buildings
2.31.01 Explain the rules governing the grant of industrial building 1 3
allowances and commercial building allowances
2.31.02 Calculate the industrial building allowances and commercial 2 3
building allowances
2.31.03 Apply DIPN 2 2 3
Personal assessment
LO2.32: Election of personal assessment 2
2.32.01 Explain the issues, including eligibility and application 1 6
procedures, relating to personal assessment election
2.32.02 Analyse how a taxpayer can benefit from a personal 2 6
assessment election
2.32.03 Determine the different circumstances under which a personal 2 6
assessment election is not advantageous
2.32.04 Apply DIPN 18 2 6
Stamp duty
LO2.33: Scope of stamp duty charge 1
2.33.01 Explain the relevant heads of stamp duty charge 1 7
LO2.34: Conveyance on sale of immovable property 2
2.34.01 Apply the stamping requirements and practices in relation to a 2 7
conveyance on sale of immovable property in Hong Kong
2.34.02 Apply SOIPN 1, 3, 5, 7 and 8 2 7

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 TAXATION

Learning Outcomes Proficiency Chapter

Level where
covered
LO2.35: Agreement for sale of immovable property 2
2.35.01 Apply the stamping requirements and practices in relation to 2 7
an agreement for sale of immovable property in Hong Kong
2.35.02 Apply SOIPN 1, 3, 5, 7 and 8 2 7
LO2.36: Lease of immovable property 2
2.36.01 Apply the stamping requirements and practices in relation to a 2 7
lease of immovable property in Hong Kong
LO2.37: Hong Kong stock 2
2.37.01 Apply the stamping requirements and practices in relation to 2 7
Hong Kong stock
2.37.02 Contrast Hong Kong stock and non-Hong Kong stock 2 7
LO2.38: Hong Kong bearer instrument, duplicate and counterpart 2
2.38.01 Apply the stamping requirements and practices in relation to 2 7
Hong Kong bearer instrument, duplicate and counterpart
LO2.39: Voluntary disposition inter vivos 2
2.39.01: Explain and apply the stamp duty implications for voluntary 2 7
disposition inter vivos
LO2.40: Alternative bond schemes 2
2.40.01 Explain the stamp duty implications for alternative bond 1 7
schemes
2.40.02 Apply SOIPN 6 2 7
LO2.41: Exemptions and reliefs 2
2.41.01 Explain and apply the exemptions and reliefs available under 2 7
the SDO
2.41.02 Describe and apply the Arrowtown case and explain its 2 7
significance
2.41.03 Apply SOIPN 2 and 6 2 7
LO2.42: Adjudication, assessment and administration 1
2.42.01 Describe the administration issues concerning stamp duty 1 7
2.42.02 Explain the adjudication and appeal procedures for stamp duty 1 7
assessment
2.42.03 Describe stamp duty offences and penalty provisions under the 1 7
SDO
2.42.04 Describe the recovery of outstanding stamp duty and penalty 1 7
Calculate the following tax liabilities for transactions, individuals
and entities:
Property tax
LO2.43: Ascertainment of property tax liability 2
2.43.01 Calculate the assessable value of a property 2 5

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 L E A R NING O U TCOM ES

Learning Outcomes Proficiency Chapter

Level where
covered
2.43.02 Calculate the allowable deductions 2 5
2.43.03 Calculate the net assessable value and the property tax 2 5
payable, including provisional property tax
2.43.04 Apply DIPN 4 and 14 2 5
Salaries tax
LO2.44: Ascertainment of salaries tax liability 2
2.44.01 Calculate the assessable income from an office, employment 2 4
and pension, including using time apportionment method
2.44.02 Calculate the allowable outgoings and expenses, depreciation 2 4
allowances, losses brought forward, concessionary deductions
and personal allowances
2.44.03 Calculate the net assessable income 2 4
2.44.04 Calculate the net chargeable income 2 4
2.44.05 Calculate the salaries tax payable including provisional salaries 2 4
tax under separate taxation and joint assessment
Profits tax
LO2.45: Ascertainment of profits tax liability 2
2.45.01 Determine the basis period for calculating assessable 2 3
profits for the years in which a trade, profession or business
commenced, ceased or there is a change in accounting date
2.45.02 Calculate the assessable profits from a trade, profession or 2 3
business chargeable to profits tax
2.45.03 Calculate the tax adjustments, the depreciation allowances on 2 3
plant and machinery, the industrial building allowances and
commercial building allowances
2.45.04 Calculate the net assessable profits or adjusted losses 2 3
2.45.05 Calculate the profits tax payable, including provisional profits 2 3
tax
2.45.06 Interpret the relevance of accounting policies in the context of 1 3
tax computations
2.45.07 Apply DIPN 1, 20, 34 and 40 2 3
Personal assessment
LO2.46: Ascertainment of tax liability under personal assessment 2
2.46.01 Calculate total income and tax payable under personal 2 6
assessment for individual and spouses
Stamp duty
LO2.47: Ascertainment of stamp duty liability 2
2.47.01 Calculate the stamp duty payable under the relevant heads of 2 7
stamp duty charge

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 TAXATION

Learning Outcomes Proficiency Chapter

Level where
covered
PRINCIPAL LO3: APPLY PROFITS TAX RULES AND PRINCIPLES AND CALCULATE PROFITS TAX
LIABILITIES FOR CROSS-BORDER TRANSACTIONS
LO3.01: E
 xplain and analyse the tax implications and calculate the tax 2
liabilities for cross-border transactions
3.01.01 Analyse the relevant issues in relation to residents and non- 2 8
residents
3.01.02 Compare and contrast the tax treatments for residents and 2 8
non-residents
3.01.03 Explain the methods used by the IRD in assessing a non- 1 8
resident person to tax in Hong Kong
3.01.04 Explain what is meant by an agent of a non-resident person 1 8
3.01.05 Calculate the amount of tax which is to be withheld by a Hong 2 8
Kong resident from payments made to non-residents
3.01.06 Apply DIPN 17 and 30 2 8
PRINCIPAL LO4: DEMONSTRATE AN UNDERSTANDING OF THE TAX SYSTEM AND ADMINISTRATION
IN MAINLAND CHINA
LO4.01: D
 escribe and apply the key aspects of the tax system in 2
Mainland China
4.01.01 Describe and apply the key aspects of China tax system 2 9
4.01.02 Illustrate the turnover tax regimes including value added tax 2 9
and consumption tax, and analyse the related tax implications
for transactions in Mainland China
4.01.03 Illustrate the regime of individual income tax and analyse the 2 9
related tax implications for individuals
4.01.04 Illustrate the regime of corporate income tax and analyse the 2 9
related tax implications for entities
Principal LO5: Advise on Hong Kong tax planning ideas and strategies
to enhance tax efficiency
LO5.01: E
 xplain, apply and consider the anti-avoidance provisions 3
in the IRO
5.01.01 Explain and apply the general and specific anti-avoidance 2 10
provisions under the IRO
5.01.02 Describe the tax implications and development of tax 1 10
avoidance cases
5.01.03 Consider and evaluate the tax implications of business 3 10
transactions from anti-avoidance perspective
5.01.04 Apply DIPN 15 2 10
LO5.02: Explain and apply the Ramsay principle 2
5.02.01 Explain and apply the Ramsay principle 2 10
5.02.02 Apply DIPN 15 2 10
LO5.03: Explain and apply the provisions on offences and penalties 2
5.03.01 Explain the exposure to penalty action due to tax avoidance 1 10
5.03.02 Apply DIPN 15 2 10

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 L E A R NING O U TCOM ES

Learning Outcomes Proficiency Chapter

Level where
covered
LO5.04: Explain and apply the advance ruling system 2
5.04.01 Explain the application of the advance ruling system 1 10
5.04.02 Apply DIPN 31 2 10
LO5.05: Advise on Hong Kong tax planning opportunities 3
5.05.01 Advise on tax planning opportunities for individuals, 3 10
partnerships, unincorporated businesses, corporations, and
group restructuring
5.05.02 Recommend tax-efficient ways to structure remuneration 3 3, 10
packages and employment arrangements for employees
5.05.03 Advise on tax planning opportunities for individuals under 3 10
contracts of service or contracts for service
5.05.04 Advise on service company ‘Type I’ arrangements 3 10
5.05.05 Advise on service company ‘Type II’ arrangements 3 10
5.05.06 Recommend legitimate strategies to minimise tax exposure or 3 10
defer the tax liability of a group of companies
5.05.07 Advise on stamp duty planning opportunities for individuals or 3 7
corporations
5.05.08 Evaluate the differences between tax implications of an asset 3 10
deal and those of a share deal under a merger and acquisition
("M&A") transaction
5.05.09 Advise on the common tax issues to the buyer and the seller 3 10
for an asset deal or a share deal
5.05.10 Advise how a tax indemnity clause may address the tax 3 10
uncertainties under a M&A transaction
5.05.11 Evaluate alternative business operations and transactions from 3 10
a tax perspective
5.05.12 Illustrate the background of the introduction of BEPS, FATCA 1 10
and CRS
5.05.13 Explain the impacts of BEPS, FATCA and CRS on the entities 1 10
in Hong Kong, and explain the significance in relation to tax
planning
5.05.14 Apply DIPN 24 and 25 2 10
LO5.06: Advise on transfer pricing 3
5.06.01 Advise on transfer pricing arrangement in relation to tax 3 11
planning
5.06.02 Advise on the issues, including advantages and application 3 11
procedures, relating to the advance pricing arrangement
5.06.03 Apply DIPN 45, 46 and 48 2 11
LO5.07: E
 xplain and advise on the use of double taxation agreements/ 3
arrangements (‘DTAs’) for tax planning
5.07.01: List the countries with which the HKSAR has entered into a 1 10
DTA
5.07.02 Explain the various articles and provisions under DTAs 1 10

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 TAXATION

Learning Outcomes Proficiency Chapter

Level where
covered
5.07.03 Explain the relationship between the DTAs and the IRO 1 10
5.07.04 Explain what constitutes a resident in the context of DTAs 1 10
5.07.05 Explain and apply the concept of PE in the context of DTAs 2 10
5.07.06 Explain and apply the concept of business profits in the context 2 10
of DTAs
5.07.07 Explain and demonstrate how DTAs may reduce the tax on 2 10
dividends, interests, royalties and capital gains
5.07.08 Compare the terms royalties and capital gains under DTAs and 2 10
the IRO
5.07.09 Calculate the amount of tax payable and credits under DTAs 2 10
5.07.10 Explain the article concerning the exchange of information 1 10
under DTAs and its significance
5.07.11 Advise on transfer pricing adjustments in the context of DTAs 3 11
5.07.12 Evaluate the tax implications of setting up a holding company, 3 10
a subsidiary or a branch in Hong Kong for international tax
planning considerations
5.07.13 Explain the tax advantages of using a Hong Kong incorporated 1 10
company to facilitate China’s inbound and outbound
investments
5.07.14 Advise on tax planning opportunities under DTAs 3 10
5.07.15 Apply DIPN 44, 45 and 47 2 10
LO5.08: A
 dvise on the professional, ethical and legal considerations in 3
relation to tax compliance engagements and tax planning
5.08.01 Advise on the professional, ethical and legal considerations 3 10
in tax compliance engagements and tax planning regarding
particular business transactions

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 S T U D Y TE X T KE Y FE A T URES

S T U D Y T E X T K E Y FE A T U R ES

Each of the Associate Level and Professional Module texts include a series of pedagogical
features designed to help QP candidates better absorb the material, reach the required
proficiency levels and meet the outlined Learning Outcomes (LOs).

The aim of these features is to help students understand the content while regularly
reinforcing concepts and building the skills necessary to successfully complete each of the
modules and progress through the Associate Level, the Professional Level and the Capstone.

Each chapter includes these features:

• Chapter topic list: A succinct list of the specific topics covered in the chapter.

• Learning outcomes: Outlines the specific knowledge points covered in the chapter and
the specific skills related to each learning outcome (LO) discussed in the chapter.

• Opening case: A case study that aims to relate the material covered in the chapter
to a real-life situation. At times, this opening case may be linked to opening cases in
other chapters.

• Overview: Provides a more detailed preview of the material covered in the chapter.

• Exhibits and charts: Through illustrations and examples, exhibits and charts aim to
convey information in graphic fashion or actual examples of accounting, reporting or
calculations that are likely to be used in actual practice.

• Illustrative examples: Case studies that explore specific issues related to the chapter
topics and further understanding of the LOs.

• Apply and analyse: Exam questions with analysis provided to show how to approach
answering the question and apply what was learned from the concepts presented in
the chapter.

• Ethics in practice: Ethical discussions on issues that may arise during professional practice.

• Key learning point: A concise summary of a salient point that is key to achieving
chapter LOs.

• Knowledge check questions: A set of questions geared at furthering students’

understanding of specific topics, to help them work through problems and meet the
chapter LOs.

• Summary: A list of the concepts and topics covered in the chapter in an easy-to-
review format.

• Mind map: A graphic depiction of the knowledge conveyed in the chapter to facilitate
understanding of the LOs.

• List of formulas: A compilation of the equations introduced in the chapter.

• Exam practice questions: Questions similar to those likely to be featured in the

examination paper required for each QP module.

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 TAXATION

T A X T A B L ES

Tax Reduction
Year of Assessment % of Tax Maximum Per Applicable Tax Types
Reduction Case ($)
2018/19 and 2019/20 100% 20,000 profits tax, salaries tax and tax under
personal assessment
2017/18 75% 30,000 profits tax, salaries tax and tax under
personal assessment
2014/15 to 2016/17 75% 20,000 profits tax, salaries tax and tax under
personal assessment
2013/14 75% 10,000 profits tax, salaries tax and tax under
personal assessment

Profits Tax
Normal Rate – Corporations
Year of Assessment Tax Rate
2008/09 onwards 16.5%
2003/04–2007/08 17.5%

Normal Rate – Unincorporated businesses

Year of Assessment Tax Rate
2008/09 onwards 15%
2003/04–2007/08 16%

Two-Tiered Rate – Corporations

Year of Assessment Tax Rate
2018/19 onwards 8.25% on assessable profits up to HK$2,000,000; and 16.5%
on any part of assessable profits over HK$2,000,000

Two-Tiered Rate – Unincorporated businesses

Year of Assessment Tax Rate
2018/19 onwards 7.5% on assessable profits up to HK$2,000,000; and 15%
on any part of assessable profits over HK$2,000,000

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 T A X T ABL ES

Salaries Tax and Personal Assessment

Calculation of Tax Payable
Year of Assessment
2013/14 to 2016/17 2017/18 2018/19 onwards
First Net Rate Tax Net Rate Tax Net Rate Tax
chargeable chargeable chargeable
income income income
On the first 40,000 2% 800 45,000 2% 900 50,000 2% 1,000
On the next 40,000 7% 2,800 45,000 7% 3,150 50,000 6% 3,000
On the next 40,000 12% 4,800 45,000 12% 5,400 50,000 10% 5,000
On the next – – – – – – 50,000 14% 7,000
Remainder 17% 17% 17%
Standard 15% 15% 15%
rates of tax

Standard Rate

Year of Assessment Tax Rate

2013/14 onwards 15%

Annual Income Levels at Which Salaries Tax Payers Approach

the ­Standard Rate Zone

Year of Assessment
Filing Status 2015/16 2016/17 2017/18 2018/19–2019/20
Single 1,620,000 1,722,000 1,797,000 2,022,000
Married 2,640,000 2,844,000 2,919,000 3,144,000
Married + 1 child 3,490,000 3,694,000 3,769,000 4,164,000
Married + 2 children 4,340,000 4,544,000 4,619,000 5,184,000
Married + 3 children 5,190,000 5,394,000 5,469,000 6,204,000

Including Two Dependent Parents or Grandparents Aged 60 or Above

Year of Assessment
Filing Status 2015/16 2016/17 2017/18 2018/19–2019/20
Single 2,300,000 2,504,000 2,579,000 2,872,000
Married 3,320,000 3,626,000 3,701,000 3,994,000
Married + 1 child 4,170,000 4,476,000 4,551,000 5,014,000
Married + 2 children 5,020,000 5,326,000 5,401,000 6,034,000
Married + 3 children 5,870,000 6,176,000 6,251,000 7,054,000

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 TAXATION

Including Two Dependent Parents or Grandparents Both Aged 60 or Above

and Living With You

Year of Assessment
Filing Status 2015/16 2016/17 2017/18 2018/19–2019/20
Single 2,980,000 3,286,000 3,361,000 3,722,000
Married 4,000,000 4,408,000 4,483,000 4,844,000
Married + 1 child 4,850,000 5,258,000 5,333,000 5,864,000
Married + 2 children 5,700,000 6,108,000 6,183,000 6,884,000
Married + 3 children 6,550,000 6,958,000 7,033,000 7,094,000

Including One Dependent Parent or Grandparent Aged 60 or Above and

Living With You and One Disabled Dependent Brother or Sister

Year of Assessment
Filing Status 2015/16 2016/17 2017/18 2018/19–2019/20
Single 3,141,500 3,345,500 3,535,250 3,828,250
Married 4,161,500 4,467,500 4,657,250 4,950,250
Married + 1 child 5,011,500 5,317,500 5,507,250 5,970,250
Married + 2 children 5,861,500 6,167,500 6,357,250 6,990,250
Married + 3 children 6,711,500 7,017,500 7,207,250 8,010,250

Being a Single Parent

Year of Assessment
Filing Status 2015/16 2016/17 2017/18 2018/19–2019/20
1 child 3,490,000 3,694,000 3,769,000 4,164,000
2 children 4,340,000 4,544,000 4,619,000 5,184,000
3 children 5,190,000 5,394,000 5,469,000 6,204,000

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 T A X T ABL ES

Allowances

Year of Assessment
Allowance 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20
Basic 120,000 120,000 120,000 132,000 132,000 132,000 132,000
Married person’s 240,000 240,000 240,000 264,000 264,000 264,000 264,000
Child 70,000 70,000 100,000 100,000 100,000 120,000 120,000
New born 70,000 70,000 100,000 100,000 100,000 120,000 120,000
Dependent brother/ 33,000 33,000 33,000 33,000 37,500 37,500 37,500
sister (per dependent)
Dependent parent/ 38,000 40,000 40,000 46,000 46,000 50,000 50,000
grandparent (per
dependent age > or = 60)
Dependent parent/ 19,000 20,000 20,000 23,000 23,000 25,000 25,000
grandparent (per
dependent age 55–59)
Additional dependent 38,000 40,000 40,000 46,000 46,000 50,000 50,000
parent/grandparent
(per dependent age
> or = 60)
Additional dependent 19,000 20,000 20,000 23,000 23,000 25,000 25,000
parent/grandparent
(per dependent age
55–59)
Single parent 120,000 120,000 120,000 132,000 132,000 132,000 132,000
Personal disability – – – – – 75,000 75,000
Disabled dependent 66,000 66,000 66,000 66,000 75,000 75,000 75,000
(per dependent)

Deductions (Maximum limit)

Year of Assessment
Deduction 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20
Self-education 80,000 80,000 80,000 80,000 100,000 100,000 100,000
Elderly residential care 76,000 80,000 80,000 92,000 92,000 100,000 100,000
Home loan interest 100,000 100,000 100,000 100,000 100,000 100,000 100,000
Mandatory 15,000 17,500 18,000 18,000 18,000 18,000 18,000
contributions to
recognised retirement
schemes
Approved charitable 35% 35% 35% 35% 35% 35% 35%
donation
Qualifying voluntary N/A N/A N/A N/A N/A N/A 8,000
health insurance
premiums paid (for
each insured person)
Qualifying annuity N/A N/A N/A N/A N/A N/A 60,000
premiums and tax
deductible MPF
voluntary contributions

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 TAXATION

Property Tax
Calculation of Tax Payable

Year of Assessment Tax Rate

2008/09 onwards 15%
2004/05–2007/08 16%
2003/04 15.5%
2002/03 15%

Stamp Duty
Ad Valorem Duty on Sale or Transfer of Immovable Property in Hong Kong

Part 1 of Scale 1 Rates: 15%

Part 2 of Scale 1 Rates:

Amount or value of the consideration Rates

Exceeds Does not exceed
$2,000,000 1.5%
$2,000,000 $2,176,470 $30,000 + 20% of excess over $2,000,000
$2,176,470 $3,000,000 3%
$3,000,000 $3,290,330 $90,000 + 20% of excess over $3,000,000
$3,290,330 $4,000,000 4.5%
$4,000,000 $4,428,580 $180,000 + 20% of excess over $4,000,000
$4,428,580 $6,000,000 6%
$6,000,000 $6,720,000 $360,000 + 20% of excess over $6,000,000
$6,720,000 $20,000,000 7.5%
$20,000,000 $21,739,130 $1,500,000 + 20% of excess over $20,000,000
$21,739,130 8.5%

Scale 2 Rates:

Amount or value of the consideration Rates

Exceeds Does not exceed
$2,000,000 $100
$2,000,000 $2,351,760 $100 +10% of excess over $2,000,000
$2,351,760 $3,000,000 1.5%
$3,000,000 $3,290,320 $45,000 +10% of excess over $3,000,000
$3,290,320 $4,000,000 2.25%
$4,000,000 $4,428,570 $90,000 +10% of excess over $4,000,000
$4,428,570 $6,000,000 3%
$6,000,000 $6,720,000 $180,000 +10% of excess over $6,000,000
$6,720,000 $20,000,000 3.75%
$20,000,000 $21,739,120 $750,000 +10% of excess over $20,000,000
$21,739,120 4.25%

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 T A X T ABL ES

Special Stamp Duty on Sale or Transfer of Residential Property

in Hong Kong

Holding period The property was acquired The property was

on or after 20 November 2010 acquired on or after
and before 27 October 2012 27 October 2012
6 months or less 15% 20%
More than 6 months but for 10% 15%
12 months or less
More than 12 months but for 5% 10%
24 months or less
More than 24 months but for – 10%
12 months or less

Lease of Immovable Property in Hong Kong

Term Rate
Not defined or is uncertain 0.25% of the yearly or average yearly rent*
Exceeds Does not exceed
1 year 0.25% of the total rent payable over the term of the lease*
1 year 3 years 0.5% of the yearly or average yearly rent*
3 years 1% of the yearly or average yearly rent*
Key money, construction fee etc. 4.25% of the consideration if rent is also payable under the lease.
mentioned in the lease Otherwise, same duty as for a sale of immovable property
* The yearly rent/average yearly rent/total rent has to be rounded-up to the nearest $100.

Transfer of Hong Kong Stock

Nature of Document Rate
Contract Note for sale or purchase of 0.1% of the amount of the consideration or of its
Hong Kong stock value on every sold note and every bought note
Transfer operating as a voluntary $5 + 0.2% of the value of the stock to be transferred
disposition inter vivos
Transfer of any other kind $5

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M14_FM.indd 30 2/6/2021 12:35:50 AM
 Part A
Tax System and Administration
in Hong Kong

Chapter 1 Key Aspects of the Tax System in Hong Kong

Chapter 2 Administration of the Tax System in Hong Kong

M14_c01.indd 1 29-01-2021 12:18:31

M14_c01.indd 2 29-01-2021 12:18:31
 1
Key Aspects of the Tax
System in Hong Kong

CHAPTER TOPIC LIST

1.1 Principles of Taxation 1.3 Types of Taxes

1.1.1 Scope and Purpose 1.3.1 Taxes Levied under the
1.1.2 Introduction to the Hong Kong Ordinances
Tax System 1.3.2 Stamp Duty
1.1.3 Challenges in Hong Kong under 1.3.3 Capital Gains
the Territorial Source Principle 1.4 Sources and Interpretation of
amid the Worldwide Trends Hong Kong Tax Law
1.2 Basic Law Overview 1.4.1 Inland Revenue Ordinance and
1.2.1 One Country, Two Systems Stamp Duty Ordinance
1.2.2 Basic Law Provisions with 1.4.2 Case Law
Regard to Taxation in 1.4.3 Board of Review Decisions
Hong Kong 1.4.4 Departmental Interpretation and
Practice Notes and Stamp Office
Interpretation and Practice Notes

M14_c01.indd 3 29-01-2021 12:18:31

 TAXATION

LEARNING OUTCOMES

PRINCIPAL LO1: DEMONSTRATE AN UNDERSTANDING OF THE TAX SYSTEM AND ADMINISTRATION

IN HONG KONG
LO1.01: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Principles of taxation
1.01.01 Describe the Hong Kong tax system and contrast it with the tax systems generally adopted
in other parts of the world
1.01.02 Explain and apply the territorial source principle, describe its historical background, and
contrast the differences between tax jurisdictions that adopt a territorial source principle
with those that adopt a residence system
1.01.03 Illustrate the challenges in Hong Kong under the territorial source principle amid the
worldwide trends such as Base Erosion and Profit Shifting (BEPS), Foreign Account Tax
Compliance Act (FATCA) and Common Reporting Standard (CRS)
LO1.02: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Types of tax
1.02.01 Describe the various types of tax levied under the Inland Revenue Ordinance and Stamp
Duty Ordinance
LO1.03: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Sources of Hong Kong tax law – statute, case law, Board of Review decisions
1.03.01 Describe the various sources of tax law
1.03.02 Describe the Doctrine of Precedent in the context of tax law
LO1.04: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Interpretation of tax statutes
1.04.01 Explain the rules of interpretation of tax law and their applications
1.04.02 Explain the purposive interpretation and the significance of the Ramsay Principle
LO1.05: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
The Basic Law
1.05.01 State the tax relations between the HKSAR and the Mainland of China with reference to
Departmental Interpretation and Practice Notes (DIPN) 29
1.05.02 State the major articles of the Basic Law relating to taxation
1.05.03 State the important principles of DIPN No. 29
LO1.06: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Departmental Interpretation and Practice Notes and Stamp Office Interpretation
and Practice Notes
1.06.01 Describe the status and application of DIPNs and Stamp Office Interpretation and Practice
Notes (SOIPN)

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OPENING CASE

THE TANAKA FAMILY

T aro Tanaka is a Japanese national and married to Kiyohime Tanaka. They have two young
daughters, Kumi Tanaka and Motoko Tanaka. The family used to live in their house located
in a suburb of Tokyo, Japan. Taro is the legal owner of this house and the land.

Taro works for Hachiko Inc, a Japanese pharmaceutical MNC that divides its business into
the following three regions:

• Asia Pacific region

• Europe, Middle East and Africa region

• Americas region

In the Asia Pacific region, Hachiko Inc has manufacturing operations in the People’s
Republic of China (PRC) and Thailand (i.e. Hachiko Thai Ltd); a R&D Centre in Singapore; various
sourcing and distribution offices in other ASEAN countries, Australia and New Zealand; and its
Regional Headquarters in Hong Kong, that is, Hachiko Asia Pacific Ltd. He is employed by the
Japanese parent company to take up the Regional Quality Control Director role in Hong Kong
with an initial term of two years commencing from 1 April 2018. He is required to travel to the
company’s subsidiaries in the jurisdictions mentioned above on a regular basis in order to
execute his job duties.

In February 2018, the Tanaka family relocated to Hong Kong. Kiyohime is working as a
part-time Japanese language teacher at one of the local universities in Hong Kong, while Kumi
and Motoko continue their secondary education in the Japanese International School in Tai Po,
New Territories.

Prior to their relocation to Hong Kong, Kiyohime arranged to lease out the family house
to a young couple of Singaporean expatriates who were working in Tokyo, Japan, for a term of
two years.

Kiyohime also holds some shares of a few public companies listed on the Tokyo Stock
Exchange for earning dividend income.

We will use various situations that the Tanaka family has experienced during this relocation
from Japan to Hong Kong to illustrate the tax principles and implications as stipulated by the
learning outcomes of this chapter.

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OVERVIEW

In this Module, we will:

• revisit the fundamentals of Hong Kong taxation to reinforce the knowledge on

Hong Kong tax systems you have acquired in your previous studies;

• provide you with information on the advanced areas of taxation, such as the
anti-avoidance provisions in the Inland Revenue Ordinance (IRO) (Cap.112), the
relevant principles established by case law and the latest developments in transfer
pricing (TP) for cross-border related parties’ transactions and so on;

• introduce the current mechanisms for allocating the taxing rights between jurisdictions
and for mitigating double taxation risk through the conclusion of double taxation
agreements (DTA); and

• provide an overview of the tax regime of the People’s Republic of China (PRC) and its
interaction with the Hong Kong Special Administrative Region (hereinafter referred to as
HKSAR or Hong Kong).

In this chapter, we will have a recap on the following topics with reference to the Tanaka
family case:

• What are the principles of taxation?

• What are the unique features of the tax system in Hong Kong?

• What is the legal basis of taxation in Hong Kong?

• What types of tax are currently being levied in Hong Kong?

In addition, we will also have a brief discussion on the current developments in the
international taxation arena impacting and challenging the Hong Kong tax system.

1 . 1
PRINCIPLES OF TAXATION

Let us begin by reiterating the two broad principles for asserting a right to tax:

• Source Jurisdiction (i.e. Territorial Tax System or Territorial Basis) – taxing rights are
allocated based on the nexus between that jurisdiction and the business activities that
generated the chargeable income, that is, the source of the income being situated
within its territory.

• Residence Jurisdiction (i.e. Residence Tax System or Residence Basis) – taxing rights
are allocated based on the nexus between that jurisdiction and the person subject
to tax, such as the location of incorporation of a company or the location where its
effective central management function is exercised.

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1.1.1 Scope and Purpose

In contrast to most other tax systems around the world, Hong Kong has adopted a territorial
system of taxation. This means that income generated or derived outside Hong Kong is not
generally taxable in Hong Kong.

The current tax regime of Hong Kong, on the one hand, has been criticised as lacking
transparency and fostering undue tax competition between advanced economies. On the
other hand, it is a relatively simple and easy-to-administer tax system that also provides some
interesting planning possibilities.

The tax risks and opportunities will be discussed in detail in this Module.

Enjoy the journey of taxation!

1.1.2 Introduction to the Hong Kong Tax System

Among all the taxation related ordinances you will be introduced to in Section 1.3.1 of this
chapter, the primary legislation governing the income taxation in Hong Kong is the IRO.
Supplemented by the Inland Revenue Rules (IRR) (Cap.112A), the IRO imposes three separate
schedules of income taxation in Hong Kong:

• Property Tax

• Salaries Tax

• Profits Tax

The respective charging section of the aforesaid taxes, that is, ss.5, 8 and 14, provide that
only income arising in or derived from Hong Kong is taxed. Such a schedular system indicates
that each source of income is assessed separately, and there is neither a total income concept
nor any comprehensive income tax system, although with the introduction of the personal
assessment regime (refer to Chapter 6), the current structure of individual tax administration in
Hong Kong shares much in common with the general income taxes levied in other jurisdictions.

Because tax in Hong Kong is territorial, residence is generally irrelevant for the purposes of
charging tax in Hong Kong from a practical standpoint.

Other unique features of the tax system in Hong Kong are that it does not offer any
consolidated filing mechanism for companies within a group and headline tax rates have
remained virtually flat for many years.

1.1.2.1 Territorial Source Principle

To assess the territorial source principle and how it works in the context of Hong Kong, let us
revisit the key charging provisions of the three forms of income taxation imposed by the IRO
and analyse each of them one by one.

S.5(1) – Property Tax

Property Tax shall, subject to the provisions of this ordinance, be charged for each year of
assessment on every person being the owner of any land or buildings or land and buildings
wherever situated in Hong Kong and shall be computed at the standard rate on the net
assessable value of such land or buildings or land and buildings for each such year.

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There are two factors needed to be taken into account, that is, whether a person owns any
land and/or buildings situated in Hong Kong and whether this property has generated any net
assessable value in a year of assessment or not. We can see therefore that it is the location of
the property that is critical here, and not where the owners live.

Illustrative Example 1
Accordingly, the rental income earned by the Tanaka family for renting out their family
house in Tokyo should be treated as outside the chargeable scope of Property Tax in
Hong Kong. That is because the property in question is situated outside of Hong Kong.
That the income may be received in Hong Kong is fiscally irrelevant.

S.8(1) – Salaries Tax

Salaries Tax shall, subject to the provisions of this ordinance, be charged for each year of
assessment on every person in respect of his/her income arising in or derived from Hong Kong
from the following sources:

(a) any office or employment of profit; and

(b) any pension.

There are, again, two requirements to be taken into considerations. First, only income arising
in or derived from Hong Kong, that is, Hong Kong-sourced income, is subject to Salaries Tax.
Second, only Hong Kong-sourced income derived from employment, office and pension is
chargeable, but not any other income. Again, it is the location of the source of the income
rather than the residence of the recipient that is pivotal.

Illustrative Example 2
Given that Taro has a non-Hong Kong employment and that he is required to travel
extensively within the Asia Pacific region to execute his job duties, his liability to
Salaries Tax can only arise under s.8(1A), which brings to charge income derived from
services actually rendered in Hong Kong during the two-year assignment. Under the
current assessing practice, as explained by the IRD in DIPN No. 10 (Revised), Taro’s
Hong Kong-sourced income should be quantified by apportioning his total income based
on a time-in time-out basis.

S.14(1) – Profits Tax

Subject to the provisions of this ordinance, Profits Tax shall be charged for each year of
assessment on every person carrying on a trade, profession or business in Hong Kong in respect of
the person’s assessable profits arising in or derived from Hong Kong for that year from such trade,
profession or business (excluding profits arising from the sale of capital assets) as ascertained
in accordance with this part.

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To ascertain whether a profit is subject to tax according to s.14(1), three conditions must
be satisfied in accordance with Lord Bridge of Harwich’s view provided in the appeal hearing of
CIR v Hang Seng Bank Ltd (1990) 1 HKRC before the Privy Council:

1. The taxpayer must carry on a trade, profession or business in Hong Kong.

2. The profits to be charged must be from that trade, profession or business carried on by
the taxpayer in Hong Kong.

3. The profits must be profits arising in or derived from Hong Kong.

As with the previous income schedules, it is the location of the source of the income that is
important rather than the residence of the recipient of the income.

Illustrative Example 3
Let us look at a common business transaction of Taro Tanaka’s company as an example.
Hachiko Thai Ltd, the medicine manufacturer, sells medicines to Hachiko Hong Kong
Ltd, the distributor in Hong Kong, for reselling or distributing in Hong Kong. Assuming
that Hachiko Thai Ltd negotiates and concludes the sales contracts and conducts all its
business activities outside of Hong Kong, it logically cannot carry on a business in Hong
Kong. Even if it did carry on a business in Hong Kong, to the extent that the contracts
for the sale and purchase of the medicine were effected outside of Hong Kong, the
profits thereof are not Hong Kong sourced and would in any event escape the Hong
Kong tax net.

1.1.2.2 Territorial versus Residence Tax Systems

Tax is a mandatory levy imposed by a government or other public body for funding various
public expenditures. Originally, out of practical reasons more than considered philosophy, most
taxes applied in different countries were territorial by nature.

As taxation evolved in the twentieth century, however, most jurisdictions adopted a

residence-based approach to taxation. That means that persons that are resident in that
jurisdiction for tax purposes will, subject to the application of any double taxation treaty or
relief, prima facie be chargeable to tax on their worldwide income. In effect, this means that
taxpayers are subject to tax by their county of residence on all income, even if some of it is
sourced outside of the country.

Hong Kong and a few similar jurisdictions, such as Malaysia and Singapore, have tax
regimes that remain territorial or essentially territorial in scope. A territorial tax regime may
be perceived as advantageous for foreign investors and multinational enterprises because it
typically provides greater structuring opportunities relative to residence-based systems.

One of the key challenges for countries or jurisdictions adopting a territorial tax system,
such as Hong Kong, is the ascertainment of the locality of profits.

Alternatively, a residence tax system can lead to difficult issues in defining a resident
corporation when a company has been incorporated in its home country, but the effective
central management and control of the corporation is exercised overseas. Furthermore,
a residence tax system often operates a foreign tax credit regime to eliminate any double

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taxation due to the possible conflict between foreign territorial tax system and its domestic
residence tax system. A typical foreign tax credit regime of a residence tax system would
allow the domestic tax payable on worldwide income generated by its resident to be reduced
by the foreign taxes paid by the resident to a territorial tax jurisdiction on its foreign source
income derived.

The tension between a territorial tax system and a residence tax system can also be
reflected in the following areas of double tax agreements, as well as in the respective
underlying domestic tax codes:

• Thresholds for constituting a permanent establishment.

• Thresholds for taxing travelling individuals.

• How to determine residence in an international context where domestically the notion

of residence is of limited fiscal impact.

• Treatment of passive income – that is, dividends, royalties and interest.

1.1.3 Challenges in Hong Kong under the Territorial Source Principle amid
the Worldwide Trends
Historically, Hong Kong did not allow for the automatic exchange of information with other
jurisdictions unless it was made under a DTA or Tax Information Exchange Agreement and on
a request basis. It in general prioritised the retention of its ‘low and simple’ tax regime. The
government was further indifferent to the fact that many enterprises chose to use Hong Kong
as a tax structuring jurisdiction. The problem with that policy, however, was that Hong Kong
was regarded by many other jurisdictions as promoting ‘base erosion’, that is, multinational
enterprises would shift their taxable profits from their jurisdictions of residence to Hong Kong
to take advantage of the lower rates of tax and benefit from the territorial tax regime, which
by its nature did not tax income sources from outside Hong Kong. This phenomenon is called
‘base erosion’ because it involves reducing (i.e. eroding) the tax base of other jurisdictions by
diverting taxable profits.

Following the global financial crisis of 2007–2008, governments of major economies, such
as the United States of America (US), have begun stressing the importance of transparency
and exchange of information for the purposes of countering aggressive tax avoidance and
tax evasion, double non-taxation and other tax planning arrangements. The enactment and
implementation of the Foreign Account Tax Compliance Act (FATCA) in the US is a typical
example in this regard.

The initiative to reform international taxation has been spearheaded by the Organisation
for Economic Co-operation and Development (OECD), which has developed a number of
guidelines and model instruments to foster cross-border collaboration in tax affairs and
improve transparency by establishing the following new avenues for automatic exchange of tax
related information:

• OECD’s Model Tax Convention on Income and Capital;

• OECD’s Model Agreement on the Exchange of Information on Tax Matters;

• Base Erosion and Profit Shifting (BEPS); and

• OECD’s Common Reporting Standard (CRS).

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In order not to be perceived as a tax haven by the international community and to enhance its
competitiveness as one of the major financial centres of the world, Hong Kong has committed
to complying with the OECD’s BEPS action points and automatic exchange of tax information
under the CRS.

While this section provides you with a general overview on BEPS, FATCA and CRS, we shall
revisit the fundamentals of these three topics in a detailed manner and study their respective
impacts towards the Hong Kong tax regime in Chapter 10 and Chapter 11.

1.1.3.1 Base Erosion and Profit Shifting

In a meeting held in Los Cabos, Mexico, in June 2012, the leaders from the G20 countries
discussed the need to prevent BEPS. In early 2013, the OECD was requested to embark on
an ambitious project, namely, the BEPS project, to determine what could be done to ensure
that, as a general matter, multinational corporations pay tax in each jurisdiction in which they
do business, commensurate with the profits generated in that jurisdiction. In particular, the
BEPS project has its focus on combating tax avoidance in the areas of double non-taxation and
aggressive tax planning arrangements.

The OECD presented its final reports of the 15 identified action plans in October 2015
(Exhibit 1.1).

Action Title
1. Address the tax challenges of the digital economy.
2. Neutralise the effects of hybrid mismatch arrangements.
3. Strengthen controlled foreign corporation rules.
4. Limit base erosion via interest deductions and other financial payments.
5. Counter harmful tax practices more effectively, taking into account transparency and
substance.
6. Prevent treaty abuse.
7. Prevent the artificial avoidance of permanent establishment status.
8. Ensure that transfer pricing outcomes are in line with value creation (intangibles).
9. Ensure that transfer pricing outcomes are in line with value creation (risk and capital).
10. Ensure that transfer pricing outcomes are in line with value creation (other high-risk
transactions).
11. Establish methodologies to collect and analyse data on BEPS and the actions to address it.
12. Require taxpayers to disclose their aggressive tax planning arrangements.
13. Re-examine transfer pricing documentation.
14. Make dispute resolution mechanisms more effective.
15. Develop a multilateral instrument (MLI).

EXHIBIT 1.1 Action plans identified by OECD in 2015

The G20 leaders subsequently endorsed this final report on the BEPS project in November
2015 and requested OECD to establish a ‘BEPS Inclusive Framework’ in January 2016 to enable
all interested non-G20 countries and jurisdictions, including developing economies, to work
together for a timely implementation of four minimum action plans in the BEPS model.

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Broadly speaking, the objective of BEPS is to align value creation with taxation, discourage
so-called harmful tax practices and align international taxation standards to prevent aggressive
tax planning. Hong Kong has joined the OECD’s BEPS Inclusive Framework and agreed to
implement the following four action points:

• Action 5: Counter harmful tax practices more effectively, taking into account
transparency and substance.

• Action 6: Prevent treaty abuse.

• Action 13: Re-examine TP documentation.

• Action 14: Make dispute resolution mechanisms more effective.

After a series of public consultations, the HKSAR government tabled the draft legislation
Inland Revenue (Amendment) (No. 6) Bill 2017 (the BEPS Bill), to the Legislative Council in late
2017. The BEPS Bill was passed by the Legislative Council on 4 July 2018 and gazetted on 13 July
2018 after receiving the signature of the Chief Executive.

This is the first time that a comprehensive TP regime has been introduced in Hong Kong. Its
most important provisions are sections 50AAF and 50AAK, which are the operative provisions
that, respectively, apply the so-called arm’s length principle (ALP) to transactions between
associated parties and to transactions between a head office and its permanent establishment.
In substance, the ALP requires that provisions – including the terms of transactions and
arrangements – made between associated parties be made as though the associated parties
were independent parties acting commercially. The purpose of TP rules is in essence to prevent
associated parties from exploiting their association to obtain a tax advantage.

It introduced the following new elements to the IRO (Cap.112), some of which will be
covered extensively in Chapter 11:

• Amendments to the preferential tax treatments on corporate treasury centres,

professional reinsurance and captive insurance businesses, and aircraft leasing (ss.14B,
C, D, H, J, and ss.23A, B).

• Newly enacted or amended guidance on transactions relating to intellectual properties,

permanent establishment and penalties for non-compliance (s.15F, s.17G).

• Extension of time limits for taxpayers to claim foreign tax credit and corresponding
adjustments (ss.49, 50, 50AAN).

• Newly codified TP rules (ss.50AAF, AAK).

• Newly codified advance pricing arrangement regime (s.50AAP).

• New three-tier TP documentation requirements (ss.58B-I).

1.1.3.2 Foreign Account Tax Compliance Act

FATCA is legislation in the US for combating tax evasion by US taxpayers who keep assets in
offshore financial institutions where such assets have not been reported for tax purposes
in the US.

Pursuant to FATCA, all types of investment income (including interest, dividends, income
from certain insurance policies and other types of income) of specified accounts held by US

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taxpayers must be reported, including account balances and sales proceeds from financial assets.
Reportable accounts include accounts held by US individuals and US corporations. The regime
imposes a 30% withholding tax on any US source payment to a foreign entity that is not FATCA
compliant.

FATCA has increased the compliance burden of those financial institutions located both
inside and outside of the US, which have US taxpayers as their customers, to report financial
account information of US taxpayers to the US tax authority, the Internal Revenue Service
(IRS). In order to facilitate FATCA compliance, two types of intergovernmental agreements
(Model 1 IGA and Model 2 IGA) have been developed for the US to conclude with other
jurisdictions.

A Model 1 IGA allows a non-US financial institution to report the account information of US
taxpayers only to the tax authority in its own resident jurisdiction; while a Model 2 IGA requires
the non-US financial institutions to report the relevant information directly to the US IRS.

The extra-territorial impact of FATCA’s legal provisions has caused issues with data
protection legislation and information exchange provisions in the tax codes in other
jurisdictions, such as Hong Kong. To facilitate the exchange of information for FATCA
compliance’s sake, Hong Kong and the US have concluded a Model 2 IGA.

1.1.3.3 Common Reporting Standard

The OECD released the Standard for Automatic Exchange of Financial Account Information
– Common Reporting Standard on 13 February 2014, with a Model Competent Authority
Agreement (CAA) as an appendix. The objective of the CRS is to formulate a global standard
for automatic exchange of financial account information amongst different jurisdictions
whose competent authorities are signatories to a multilateral CAA for the sharing of
information. The CRS rules have been transposed into domestic Hong Kong legislation as
Part 8A of the IRO.

To a large extent, the CRS is explicitly modelled on FATCA of the US. In general, financial
institutions, defined broadly to include any person who holds money or assets on behalf of
another, act as information gathering proxies: they are required to gather information from the
persons on whose behalf they hold assets and submit annual returns to the Inland Revenue
Department (IRD) with respect to such persons. These returns contain, amongst other things,
the relevant person’s jurisdiction of tax residence and the amount held by the relevant financial
institution to that person’s name. For example, if an individual (P) is resident in Japan but has
a bank account with a credit of HK$1 million with bank (B) in Hong Kong, B will be required
to furnish an annual return with respect to P to the IRD. The IRD will, in turn, exchange the
information contained in the said return with the Japanese National Tax Agency. The scope
of CRS is broad and seeks to facilitate a common global approach for jurisdictions to access
information on financial accounts held by their residents in financial institutions located in both
the account holder’s residence jurisdiction and foreign jurisdictions.

CRS is different to FATCA in that it contemplates reporting only to the tax authority of
the financial institution’s residence jurisdiction, which would then exchange the relevant
information with its counterparts in the account holder’s jurisdiction by means of the CAA.

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Key Learning Point

It is important to distinguish the different features of a territorial tax system and a
residence tax system, which builds the foundation for candidates to be able to critically
evaluate the features of the Hong Kong tax code and the various international factors
(i.e. FATCA, CRS and BEPS) driving the recent changes to the Hong Kong tax regime.

Knowledge Check Questions

Question 1
The easy-to-administer and territorial basis features of the tax system in Hong Kong
play an important role in attracting foreign investment. Identify which of the following
generalisations about Hong Kong tax law are correct.
(I) There is no withholding tax
(II) It provides group loss relief
(III) There is no capital gains tax
(IV) There is no tax on dividends

A I and II only
B II and III only
C III and IV only
D I and IV only

Question 2
Assume that Taro Tanaka did not take up the proposed secondment to Hong Kong, but was
appointed as one of the directors of Hachiko Inc in Japan. He was subsequently employed
in Hong Kong by Hachiko Inc’s Hong Kong subsidiary for the purposes of supervising
a designated quality control project and conducting a quality control audit afterwards.
Identify which of the statements regarding Taro’s Hong Kong tax position is correct.
A He would pay less tax if he would draw more of his remuneration as salary rather than
as director’s fees.
B He would pay less tax if he would draw more of his remuneration as director’s fees
rather than as salary.
C The total tax payable would not change regardless of the proportion of salary and
director’s fees as his income would be fully taxable.
D The total tax payable would not change regardless of the proportion of salary and
director’s fees as his income would be fully exempt.

Question 3
List the 4 BEPS action items that Hong Kong has committed to implementing after joining
as a BEPS Associate of the OECD’s BEPS Inclusive Framework.

Question 4
Describe the general differences between a residence and territorial taxing jurisdiction.

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1 . 2
BASIC LAW OVERVIEW

With the transfer in sovereignty from the United Kingdom (UK) to China, Hong Kong officially
became the HKSAR of the PRC on 1 July 1997. On the same date, the Basic Law of the HKSAR
of the PRC (the Basic Law) came into effect. The Basic Law is essentially the constitutional
document of the HKSAR.

In accordance with Article 2 of the Basic Law, the National People’s Congress of the PRC
authorises the HKSAR to exercise a high degree of autonomy and enjoy executive, legislative
and independent judicial power, including that of final adjudication. This means that the courts
of Hong Kong remain exclusively competent to adjudicate disputes in the jurisdiction.

Further, Article 8 of the Basic Law provides that the laws previously in force in Hong Kong,
that is, the common law, rules of equity, ordinances, subordinate legislation and customary
law shall be maintained, except for any that contravene the Basic Law, and subject to any
amendment by the legislature of the HKSAR, that is, the Legislative Council (or its predecessor,
the Provisional Legislative Council).

The previously mentioned two articles of the Basic Law in effect ensure Hong Kong remains
fully autonomous, including through the promulgation of local laws by the Legislative Council
and the retention of a common law judiciary and legal systems that are independent from the
code law systems as adopted by the PRC.

Consequently, the Provisional Legislative Council of HKSAR enacted Hong Kong

Reunification Ordinance (Instrument A601) on 1 July 1997 of which one of the purposes was
to give effect to the Basic Law provisions by adding s.2A to the Interpretation and General
Clauses Ordinance (IGCO) (Cap.1). That stipulated that all laws previously in force shall
be construed with such modifications, adaptations, limitations and exceptions as may be
necessary so as not to contravene the Basic Law and to bring them into conformity with the
status of HKSAR. As a result, all laws, ordinances and other subsidiary legislations previously in
force and not contradictory to the Basic Law shall continue to be in force after the handover of
Hong Kong.

1.2.1 One Country, Two Systems

The principle of ‘One Country, Two Systems’ should be regarded as the ideological
cornerstone of the Basic Law. Article 5 of the Basic Law specifically states that the PRC system
and policies shall not be practised in the HKSAR, and the previous Hong Kong system and way
of life shall remain unchanged for 50 years.

That principle ensures that the HKSAR is to operate separately and autonomously from the
mainland of the PRC, and in particular shall:

• continue to apply the common law and rules of equity (Article 8);

• practice an independent taxation system (Article 108);

• continue to circulate the Hong Kong Dollar as its legal tender (Article 111); and

• remain as a free port and a separate customs territory (Articles 114 and 116).

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Accordingly, the tax laws and regulations promulgated in the mainland of the PRC will not
be applicable to, and implemented in, the HKSAR. In this connection, the PRC and the HKSAR
remain two separate tax jurisdictions.

Given the differences in the legal and tax systems in the PRC and the HKSAR, and pursuant
to Article 151 of the Basic Law, the HKSAR is to negotiate, conclude and implement any tax
treaty with its trading partners using the name ‘Hong Kong, China’. Any tax treaty concluded by
the PRC with its trading partners is not applicable to the HKSAR.

1.2.2 Basic Law Provisions with Regard to Taxation in Hong Kong

The IRD issued DIPN No. 29, in August 1997, to outline the tax relations between the HKSAR
and the PRC as a result of the transfer of the sovereignty of Hong Kong from the UK.

With reference to the Basic Law itself and DIPN No. 29, it is worth noting that the following
articles of the Basic Law are highlighted to be relevant in the context of taxation in Hong Kong:

• Article 73

The Legislative Council of the Hong Kong Special Administrative Region shall exercise
the following powers and functions:

(2) To examine and approve budgets introduced by the government;

(3) To approve taxation and public expenditure.

• Article 106

The Hong Kong Special Administrative Region shall have independent finances.

The Hong Kong Special Administrative Region shall use its financial revenues
exclusively for its own purposes, and they shall not be handed over to the Central
People’s Government.

The Central People’s Government shall not levy taxes in the Hong Kong Special
Administrative Region.

• Article 107

The Hong Kong Special Administrative Region shall follow the principle of keeping the
expenditure within the limits of revenues in drawing up its budget, and strive to achieve
a fiscal balance, avoid deficits and keep the budget commensurate with the growth rate
of its gross domestic product.

• Article 108

The Hong Kong Special Administrative Region shall practise an independent

taxation system.

The Hong Kong Special Administrative Region shall, taking the low tax policy previously
pursued in Hong Kong as reference, enact laws on its own concerning types of taxes, tax
rates, tax reductions, allowances and exemptions, and other matters of taxation.

• Article 151

The Hong Kong Special Administrative Region may on its own, using the name ‘Hong
Kong, China’, maintain and develop relations and conclude and implement agreements

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with foreign states and regions and relevant international organisations in the
appropriate fields, including the economic, trade, financial and monetary, shipping,
communications, tourism, cultural and sports fields.

• Article 153

The application to the Hong Kong Special Administrative Region of international

agreements to which the People’s Republic of China is or becomes a party shall be
decided by the Central People’s Government, in accordance with the circumstances and
needs of the Region, and after seeking the views of the government of the Region.

International agreements to which the People’s Republic of China is not a party but
which are implemented in Hong Kong may continue to be implemented in the Hong
Kong Special Administrative Region. The Central People’s Government shall, as necessary,
authorise or assist the government of the Region to make appropriate arrangements for
the application to the Region of other relevant international agreements.

Key Learning Point

The principle of ‘One Country, Two Systems’ and the relevant articles of the Basic Law
form the legal basis on preserving Hong Kong as a separate tax jurisdiction from the PRC.
Particular reference should be made to the principles documented in DIPN No. 29.

Knowledge Check Questions

Question 5
With reference to the Basic Law and DIPN No. 29, identify the relevant article(s) of the
Basic Law that stipulated that Hong Kong should maintain a separate tax system from the
mainland of the PRC.

Question 6
Identify which article(s) of the Basic Law provides the legal basis to negotiate and conclude
tax treaties with its trading partners.

1 . 3
TYPES OF TAXES

As regards tax law, the first taxonomical distinction is between direct tax and indirect tax.
Direct tax is charged on an income stream or a gain, generally on a receipts or accrual basis. It
is called direct tax because it is collected directly from the taxpayer. Conversely, indirect tax is
charged on a transaction. It is indirect because it is usually collected through an intermediary,
for example, a company selling a product, and not from the taxable person itself.

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Typical examples of direct tax and indirect tax are listed as follows:

• Direct Tax

°° Enterprise income tax (i.e. Profits Tax in Hong Kong)

°° Individual income tax (i.e. Salaries Tax in Hong Kong)

°° Property Tax

°° Inheritance Tax (i.e. Estate Duty in Hong Kong prior to abolition in February 2006)

°° Poll tax

• Indirect Tax

°° Value-added tax

°° Goods and services tax

°° Sales tax

°° Consumption tax

°° Excise duty

Illustrative Example 4
Mrs. Kiyohime Tanaka, before relocating to Hong Kong, used to go to a supermarket
located in her neighbourhood in Tokyo to purchase groceries for the family. Since
Japan imposes a Consumption Tax of 8% on any taxable supplies, the supermarket
is required to charge Consumption Tax on those taxable items on top of the sales
price. In this scenario, Mrs. Tanaka, being the end user or consumer of the taxable
commodities, bears the ultimate economic burden of the Consumption Tax liability
and the supermarket acts as an intermediary to collect the Consumption Tax due from
Mrs. Tanaka on behalf of the Japanese tax authorities. The supermarket would then have
the obligation to report periodically to the tax authorities and settle any amount due.

When we narrow our focus on appraising the type of taxes in the context of Hong Kong,
we can take a different angle by considering a question on ‘who is chargeable for what’. This is
because Hong Kong does not impose any indirect tax, apart from a very limited customs duties
levied on spirits, tobacco products and fuel. Hong Kong is relatively unusual amongst wealthy
tax jurisdictions in this regard.

The IRO was originally enacted on 3 May 1947 based on the Model Colonial Territories
Income Tax Ordinance 1922, which was the tax code the UK originally formulated for its various
colonies and dependent territories. It has been amended almost on an annual basis by the Inland
Revenue Amendment Bill tabled in the Legislative Council by the Financial Secretary through the
Annual Budget Speech. It imposes three separate types of taxation under a scheduler system,
namely, Property Tax under Part 2, Salaries Tax under Part 3 and Profits Tax under Part 4.

S.2(1) of the IRO defines a person to be subject to tax under the IRO as including a natural
person, a corporation, partnership, trustee, whether incorporated or unincorporated, or a
body of persons. Therefore, a simple answer to the question ‘who is chargeable for what’ is
illustrated in Exhibit 1.2.

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Property tax Salaries tax Profits tax

Natural person ✓ ✓ ✓
Corporation ✓ ⨯ ✓
Partnership ⨯ ⨯ ✓
Trustee ✓ ⨯ ✓
Body of persons ✓ ⨯ ✓

EXHIBIT 1.2 Entities subject to tax

1.3.1 Taxes Levied under the Ordinances

As previously mentioned, the IRO provides for three separate taxes. They are briefly introduced
as follows:

• Property Tax is levied on the owner of land and/or buildings situated in Hong Kong in
respect of the considerations earned from the leasing or licensing of the land and/or
buildings. In the event that the owner is a person that generates income from letting or
subletting of land and/or buildings located in Hong Kong by way of trade or business,
such income should be chargeable under Profits Tax instead of Property Tax. Please
refer to Chapter 5, Property Tax, for details.

• Salaries Tax is charged on individuals who derive Hong Kong-sourced income from an
employment, an office and pension. You will be taken through the details of Salaries
Tax in Chapter 4.

• Profits Tax, as provided under s.14 of the IRO, is charged for each year of assessment
on every person carrying on a trade, profession or business in Hong Kong in respect
of his/her assessable profits arising in, or derived from, Hong Kong for that year from
such trade, profession or business, but excluding profits arising from the sale of capital
assets. The detailed rules governing Profits Tax will be outlined in Chapter 3.

Apart from administering the IRO, the Commissioner of Inland Revenue (CIR), who
also holds the statutory appointments of Collector of Stamp Revenue and Estate Duty
Commissioner, is also responsible for the administration of the ordinances and the rules and
regulations made under these ordinances (Exhibit 1.3).

Ordinance Taxes Levied

Inland Revenue Ordinance (Cap.112) Property Tax
Salaries Tax
Profits Tax
Stamp Duty Ordinance (Cap.117) Stamp Duty
Estate Duty Ordinance (Cap.111) Estate Duty
Betting Duty Ordinance (Cap.108) Betting Duty
Tax Reserve Certificates Ordinance (Cap.289) Tax Reserve Certificate
Business Registration Ordinance (Cap.310) Business Registration Fee
Hotel Accommodation Tax Ordinance (Cap.348) Hotel Accommodation Tax

EXHIBIT 1.3 Taxes levied by the administration of ordinances

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Candidates may visit the Hong Kong e-Legislation website of the Department of
Justice in respect of the details of the ordinances and the related rules and regulations
(www.elegislation.gov.hk).

It is worth noting that Estate Duty has been abolished in respect of any death occurring
after 10 February 2006, although the Estate Duty Ordinance continues to be in effect and
impose an ad valorem rate of duty on any death that occurred before 15 July 2005. Regarding
any death between 15 July 2005 and 10 February 2006, a nominal amount of HK$100 of Estate
Duty is charged.

Furthermore, the Hotel Accommodation Tax has been waived with effect from 1 July 2008.

Apart from the previously mentioned types of tax, Hong Kong does not impose any payroll
withholding tax (such as pay-as-you-earn in the UK), capital gains tax, sales tax, value-added
tax or dividend distribution tax. Generally speaking, Hong Kong does not impose withholding
tax on passive income derived by both residents and non-residents. It does, however, impose
a withholding obligation on resident payment agents of certain types of income generated by
non-residents of Hong Kong, for example,

• royalty income generated in Hong Kong;

• fees for exhibitions held and films and tapes used in Hong Kong; and

• sums paid to entertainers and sportsmen/sportswomen for performances in

Hong Kong.

The purpose of withholding tax is to ensure that the tax obligations of non-resident persons
are discharged with respect to their Hong Kong-sourced income: In practice, the easiest way to
achieve this is to impose an administrative withholding obligation on the resident payor. It is
the payor who is required to pay income net of tax withheld. Detailed rules on administering
the withholding obligations will be discussed in Chapter 8.

Apply and Analyse 1

Kumi Tanaka and Motoko Tanaka used to take singing lessons from Madam Yoko
Yamaguchi, a famous musical actress retired from the Takarazuka Revue, when they were
living and studying in Japan.

Given that the Japanese national rugby team has qualified for the Hong Kong Rugby
Sevens to be held in March 2019, Madam Yamaguchi has been approached by Kowloon
Musical Ltd, a Hong Kong resident company mainly engaged in organising famous
overseas artists to perform in Hong Kong. Kowloon Musical Ltd would like Madam
Yamaguchi to perform one song in the stadium before the Japanese team’s first game as
well as a musical performance at the Hong Kong Coliseum afterwards.

The remuneration for Madam Yamaguchi’s performance in Hong Kong has been
agreed as HK$10 million.

Explain whether Madam Yamaguchi will be liable to pay Hong Kong tax or not.

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Apply and Analyse 1 (continued)

Analysis

Any person earning profits from a source in Hong Kong by carrying on a trade, profession
or business is liable to pay Profits Tax in Hong Kong (s.14). Arguably, Madam Yamaguchi
may carry out her profession as a singer in Hong Kong, and so earn Hong Kong-sourced
profits liable to tax under s.14 by performing in Hong Kong. It can be argued that Madam
Yamaguchi’s presence in Hong Kong is transitory, that she is not carrying on a trade,
profession or business in Hong Kong; however, she will nonetheless be liable to pay
Profits Tax by virtue of the provision in s.15(1)(bb), which provides that sums received by a
performer in relation to a performance given by the performer in Hong Kong are liable to
Profits Tax, notwithstanding anything in s.14.

Madam Yamaguchi is plainly a performer and an entertainer within the meaning of the
IRO (see s.15(8) and s.20B(4)). The taxable sum includes amounts paid for any appearance
made in connection with the promotion of a commercial occasion or event; and any
participation by the entertainer in sound recording, films, videos, radio, television or similar
transmissions, whether live or recorded (s.20B(1)(b)), or otherwise any sum deemed by
virtue of s.15(1)(bb) to be chargeable to Profits Tax.

Since Madam Yamaguchi is a non-resident entertainer, Kowloon Musical Ltd has a

withholding obligation for Profits Tax due to the IRD before settling the net payment to
Madam Yamaguchi.

1.3.2 Stamp Duty

The term stamp duty (SD) reflects its history, in that it was originally developed as a levy on
documents (i.e. dutiable goods). In Hong Kong, SD is levied by the Stamp Duty Ordinance (SDO)
and is the oldest type of tax administered by the IRD with its origins in legislation enacted in
1866. Section 3 of the SDO provides that the Collector of Stamp Revenue who, in effect, is also
the CIR, is empowered to administer the SDO.

Currently, only written documents that fall within one of the four specified heads of charge
described in The First Schedule of the SDO are subject to SD. The four heads of charge are
listed as follows:

• Immovable property in Hong Kong

• Hong Kong stock

• Hong Kong bearer instrument

• Duplicates and counterparts

Generally speaking, SD is charged either as a fixed duty or an ad valorem duty. The payable
amount of the ad valorem type of SD depends on the value of the property in Hong Kong being
transferred or the amount of consideration noted in the dutiable document.

To manage property speculation and cool the overheated property market in Hong Kong, the
government introduced three types of new SD, namely the Special SD, the Buyer’s SD and New Ad
Valorem SD, on 19 November 2010, 26 October 2012 and 22 February 2013, respectively.

We shall learn more about SDs in Chapter 7.

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1.3.3 Capital Gains

Section 14(1) of the IRO specifically exempts gains from the sale of capital assets from Profits
Tax. It would follow that most capital gains are expressly exempt from Profits Tax.

It is worth noting the respective definitions of capital assets and trading assets in order
to ascertain the correct tax treatment to be adopted. Whether an asset is a capital asset or
revenue asset is determined by fact and law, depending on the trade or business carried on by
the taxpayer. For example, a gain arising from the sale of a single immovable property held by
an individual as an investment is unlikely to be chargeable to Profits Tax; however, the sale of
a unit by a developer that redeveloped that unit as part of the construction of a housing block
will be a disposal in the course of that developer’s trade and will therefore be liable to Profits
Tax. Analysis on ‘capital’ versus ‘revenue’ is covered in Chapter 3.

Apply and Analyse 2

Upon the expiry of Taro Tanaka’s secondment to Hong Kong, he has been offered a
permanent managing director position at the R&D Centre in Singapore, that is, Hachiko
R&D Singapore Pte Ltd. As a result, the Tanaka family will be relocating from Hong Kong
to Singapore. Since this is a permanent position in Singapore and both Kumi and Motoko
have already secured their respective university offers with the National University in
Singapore, Taro and Kiyohime have then decided to dispose of their original house and the
land in the suburbs of Tokyo.

Meanwhile, Taro and Kiyohime have also decided to dispose of a property that was
to be used as their family home, located in Tai Po and near the Japanese International
School. This property was acquired because it suited their daughters’ schooling schedules,
although the property was still under construction before the completion of the disposal
transaction. The completion of the property was delayed due to an unexpected fire. The
property was sold as it no longer suited the family’s needs, that is, the daughters would
no longer be attending the Japanese International School as a result of Taro’s forthcoming
relocation to Singapore.

Analysis

Given that s.14(1) of the IRO expressly provides that profits arising from the sale of
capital assets are excluded from the Profits Tax, any gains derived from the sale of the
above-mentioned properties are not subject to tax in Hong Kong.

Property located in Japan:

The possible gains derived from the disposal of the property located in Tokyo, Japan, will
be treated as offshore in nature, that is, non-Hong Kong-sourced income, and thus not
subject to tax in Hong Kong anyway.

Moreover, as the agreement for sale and purchase did not relate to property situated
in Hong Kong, that instrument will further be exempt from any kind of Hong Kong SD.

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Apply and Analyse 2 (continued)

Property Located in Tai Po, Hong Kong:

The potential gains derived from the sale of the property located in Tai Po, Hong
Kong, should also be regarded as capital receipts and not assessable for Profits Tax in
accordance with the BOR Decision made in D12/98.

Key Learning Point

It is important to acquire a general understanding on the types of taxes that are currently
being imposed in Hong Kong, the different features of direct tax and indirect tax, and the
difference between the basic concept of capital in nature and revenue in nature so as to
understand that any gains derived from the sale of capital assets in Hong Kong and outside
Hong Kong are generally not subject to tax in Hong Kong.

Knowledge Check Questions

Question 7
Identify which of the following taxes have not been imposed in Hong Kong.
(I) The Special SD
(II) Profits Tax
(III) Goods & Services Tax
(IV) Capital Gains Tax
(V) Salaries Tax
A I and II only
B II and III only
C III and IV only
D IV and V only

Question 8
List two examples of direct tax and indirect tax and explain the difference between direct
and indirect taxes.

Question 9
List the four heads of charge of stamp duty.

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1 . 4
SOURCES AND INTERPRETATION
OF HONG KONG TAX LAW

The table in Section 1.3 of this chapter shows the applicable legislations governing the
imposition of different types of tax in Hong Kong.

Section 85 of the IRO empowers the Board of Inland Revenue, which is established
according to s.3(1) of the IRO, to make rules generally for carrying out the provisions of the
IRO and for the ascertainment and determination of any class of income or profits. These rules
made by the Board of Inland Revenue are called Inland Revenue Rules (IRR).

Candidates should refer to the official website of Hong Kong e-Legislation (https://www.
elegislation.gov.hk/hk/cap112A) for accessing the latest version of the IRR.

1.4.1 Inland Revenue Ordinance and Stamp Duty Ordinance

The two main tax related statutes in Hong Kong are:

• The IRO, which established three separate and distinct taxes which would tax different
types of Hong Kong-sourced income; and

• SDO, which imposes a duty on instruments evidencing certain types of dutiable

transactions that fall within the four Heads of Charge in Schedule 1.

1.4.1.1 Interpreting the Provisions in the Ordinances

Taxation involves dealing with both matters of computation (quantum of tax liability and tax
returns) and statutory construction (tax legislation). In essence, the quantum of tax is computed
by reference to the relevant provisions in a tax legislation. Therefore, it is crucial to understand
the general rules of statutory interpretation. These rules include the Interpretation and General
Clauses Ordinance (IGCO) and the principal rules of statutory interpretation developed by the
common law system over time.

IGCO is the key reference for interpreting the provisions in the ordinances in Hong Kong.
In particular, s.19 of IGCO sets forth the general principles of interpretation as follows:

An ordinance shall be deemed to be remedial and shall receive such fair, large and liberal
construction and interpretation as will best ensure the attainment of the object of the ordinance
according to its true intent, meaning and spirit.

Additionally, the principal rules of statutory interpretation in common law relevant and
useful to apply on interpreting the provisions in the tax ordinances are as follows:

The Literal Rule

The fundamental rule on statutory interpretation in the common law system is the Literal
Rule. As self-explained by its name, the court relies on the literal meaning of the words in the
statute to interpret the provisions in tax legislations. The following paragraph quoted from
Justice Reed in United States v American Trucking Association (1940) 310 US 534 explains the
Literal Rule:

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There is, of course, no more persuasive evidence of the purpose of a statute than the words by
which the legislature undertook to give expression to its wishes. Often these words are sufficient
in and of themselves to determine the purpose of the legislation. In such cases we have followed
their plain meaning. When that meaning has led to absurd or futile results, however, this court
has looked beyond the words to the purpose of the act. Frequently, however, even when the plain
meaning did not produce absurd results but merely an unreasonable one ‘plainly at variance with
the policy of the legislation as a whole’ this court has followed that purpose rather than literal
words. When aid to construction of the meaning of words, as used in the statute, is available, there
certainly can be no ‘rule of law’ which forbids its use, however clear the words may appear on
‘superficial examination’.

The Golden Rule

The Golden Rule is evolved from the Literal Rule to tackle a situation whereby the court should
look for another meaning of the words to avoid a contradictory result if the application of the
Literal Rule will give rise to an absurdity. This rule was first adopted by Lord Wensleydale in
Becke v Smith (1836) 2 M&W 195 and fine-tuned by the same judge in the following quotes in
Grey v Pearson (1857) HL CAS 61 two decades later:

In construing statutes, and all written instruments, the grammatical and ordinary sense of the
words is to be adhered to, unless that would lead to some absurdity or inconsistency with the
rest of the instrument, in which case the grammatical and ordinary sense of the words may be
modified, so as to avoid that absurdity or inconsistency, but not farther.

Accordingly, technical words must be given their technical meaning.

The Mischief Rule and the Purposive Approach

The Mischief Rule was originally established by the Barons of the Court of Exchequer in
Heydon’s Case (1584) 76 ER 637, stressing that it was the court’s duty to look into the underlying
purposes of the legislation by referring to the intention of the legislature in enacting the
legislation with a view to understanding the issue or problem (i.e. the mischief) the legislation
intended to cure.

Purposive construction simply means that the court is required to give effect to the
intention of the legislature, so far as this may be inferred from the words of the statute,
in interpreting a statute. Referring to the modern application of the Mischief Rule, it was
reaffirmed in Medical Council of Hong Kong v Chow Siu Shek David (2000) 2 HKC 428, by the Court
of Final Appeal (CFA) of Hong Kong that:

when the true position under a statute is to be ascertained by interpretation, it is necessary to read
all of the relevant provisions together and in the context of the whole statute as a purposive unity
in its appropriate legal and social setting. Furthermore, it is necessary to identify the interpretative
considerations involved and then, if they conflict, to weigh and balance them.

Accordingly, the CFA has summarised a modern approach to the Mischief Rule, which
is commonly referred to as the purposive approach. Furthermore, s.19 of IGCO has also
been recognised by the Hong Kong courts as providing the statutory recognition to the
purposive approach.

Tax is a particular kind of legislation because it requires the expropriation of private

property. Thus, courts tend to favour a narrow construction as a matter of legal certainty and

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fairness to both the revenue and the taxpayer. In W.T. Ramsay Ltd v IRC (1982) AC 300, Lord
Wilberforce said (at 323) that:

A subject is only to be taxed on clear words, not in ‘intendment’ or on the ‘equity’ of an Act. . . . What
are ‘clear words’ is to be ascertained on normal principles; these do not confine the courts to literal
interpretation. There may, indeed should, be considered the context and scheme of the relevant Act
as a whole, and its purpose may, indeed should, be regarded.

The purposive approach is relevant to the Ramsay Principle, which is to be briefly

introduced in Section 1.4.2.2.

1.4.2 Case Law

Apart from the mentioned rules of construction of a statute, the interpretation of the tax
legislations in Hong Kong also relies on case law decided by the courts of Hong Kong and other
common law jurisdictions. Common law jurisdictions share similar legal codes and, relevantly,
have tax codes that depart from analogous first principles. Common law systems, more so than
civil law systems, operate on the principle of stare decisis – that is, the Doctrine of Precedent.
That means that judgements on a given matter of law are binding until overruled by a higher
court. Technically, only decisions of the Hong Kong courts and pre-1997 decisions of the Privy
Council on matters of Hong Kong law are binding on the courts of Hong Kong. Decisions of
the higher courts of other common law jurisdictions – most importantly, the United Kingdom,
Australia, Singapore, New Zealand and (historically) South Africa are regarded as persuasive.
That means that they do not bind a Hong Kong court, but will in practice be used to guide their
reasoning and conclusions. It is therefore common for the judgements of a Hong Kong court to
refer to authorities decided in other jurisdictions.

Notwithstanding the reversion of Hong Kong to the Chinese sovereignty in 1997, the
common law system remains in effect in the HKSAR in accordance with Article 8 of the Basic
Law. Accordingly, tax-related judicial decisions of courts in the HKSAR and courts in other
common law jurisdictions in respect of cases concluded both before and after the handover are
still legally binding or persuasive in the interpretation of the provisions of the tax legislations in
Hong Kong.

1.4.2.1 Doctrine of Precedent
To understand the Doctrine of Precedent of the common law system, it is useful to refer to the
following definition of ‘precedent’ quoted in the Oxford Dictionary of Law that it is:

a judgment or decision of a court, normally recorded in a law report, used as an authority for
reaching the same decision in subsequent cases. In English law, judgments and decisions can
represent authoritative precedent (which is generally binding and must be followed) or persuasive
precedent (which need not be followed). It is that part of the judgment that represents the legal
reasoning (or ratio decidendi) of a case that is binding, but only if the legal reasoning is from a
superior court and, in general, from the same court in an earlier case. Accordingly, ratio decidendi
of the House of Lords are binding upon the Court of Appeal and all lower courts and are normally
followed by the House of Lords itself. The ratio decidendi of the Court of Appeal are binding on all
lower courts and, subject to some exceptions, on the Court of Appeal itself. Ratio decidendi of the
High Court are binding on inferior courts, but not on itself. The ratio decidendi of inferior courts do
not create any binding precedent.

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In essence, the decisions handed down by a higher court in the judicial hierarchy are
treated as principles or rules established by the judiciary. Such principles or rules are either
binding on or persuasive for a lower court or tribunal when deciding subsequent cases with
similar issues or fact.

In the context of Hong Kong, ratio decidendi of the CFA of HKSAR are binding on the Court of
Appeal and all lower courts and tribunals because the CFA assumes the final adjudication of the
HKSAR in accordance with Article 2 of the Basic Law.

1.4.2.2 Ramsay Principle
In the landmark case of Inland Revenue Commissioners v Duke of Westminster (1936) A.C. 1 (HL),
Lord Tomlin provided the following remarkable quote in the field of tax planning:

Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate
Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result,
then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be
of his ingenuity, he cannot be compelled to pay an increased tax.

The way tax legislations were interpreted as established by the Westminster case was
revamped when the UK House of Lords handed down the decisions in W.T. Ramsay v IRC (1982)
AC 300 (HL) that the court was entitled to look at the intention of a series of transactions
whether all the transactions were conducted in a commercially realistic manner. It was held
that certain self-cancelling or circular transactions were disregarded because those steps
were judged to be pre-ordained ones with no commercial substance, their eventual outcome
could be predicted with certainty and the sole or dominant purpose was of obtaining a tax
benefit. Strictly speaking, the Ramsay Principle is a principle of statutory construction. It does
not seek to recharacterise the legal effect of transactions, but to apply the taxing statute to the
transaction as a commercial whole, which involves looking beyond the individual components
of an arrangement if those arrangements serve no identifiable commercial purpose, and
applying the relevant provisions in tax legislation to the whole. The approach taken by the
House of Lords in this case is in line with the purposive approach of interpreting the tax
legislations.

The Ramsay Principle was applied and further developed in the case of Furniss v Dawson
(1984) 1 AII ER 530 to be applied not only to the UK Capital Gains Tax regime but to all forms of
direct taxation.

The IRD sought to apply the Ramsay Principle the first time in the Board of Review Case
No. D52/86. However, the CIR’s claim was denied by the Board of Review with reference to the
decisions held in the Australian cases of Patcorp Investments Ltd v FCT (1976) 140 CLR 247 and
Oakey Abattoir v FCT (1984) 55 ALR 291 that the Ramsay Principle was a court decision to combat
tax avoidance and it had no application to taxes imposed under the IRO (Cap.112) because the
general anti-avoidance provisions (i.e. ss. 61 and 61A) had been enacted.

However, the UK House of Lords took a different view in IRC v McGuckian (1997) STC 908
and held that the Ramsay Principle was developed as a rule of statutory construction and the
approach to the interpretation of tax legislation did not depend on the general anti-avoidance
provisions therein but was rather antecedent to or collateral with them.

With the further development of the subsequent cases in this line, that is, Shiu Wing Ltd v
Commissioner of Estate Duty (2000) 3 HKLRD 76, Collector of Stamp Revenue v Arrowtown Assets Ltd

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 TAXATION

(2004) HKLRD 77 and Barclays Mercantile Business Finance Ltd v Mawson (2005) STC 1, the CIR
has set forth its position in DIPN No. 15 (Revised) that the CIR is entitled to adopt this purposive
interpretation of the statutory provisions to the facts viewed realistically and take the position
that the Ramsay Principle can co-exist and operate alongside the general anti-avoidance
provisions in the IRO (Cap.112). In this connection, where there was a single pre-ordained,
composite transaction intended to be carried out in its entirety, the CIR would not ignore the
composite character and apply the legislation to the individual constituent steps separately.
If the purpose of intermediate steps in the composite transaction was fiscal, the CIR would
disregard them and bring the composite transaction within a charging provision.

Notwithstanding the previous information, we will discuss the application of the

Ramsay Principle, alongside the general anti-avoidance provisions in the IRO (Cap.112) in a
comprehensive manner in Chapter 10.

Apply and Analyse 3

Explain the conditions that enable the court to apply the Ramsay Principle (also known
as the fiscal nullity principle) to disregard a pre-ordained series of transaction containing
steps that are self-cancelling or without commercial substance.

Analysis

The Ramsay Principle would apply when:

1. There is a pre-ordained series of transactions or a single composite transaction,

whereby ‘pre-ordained’ means there was a practical likelihood that all the steps in
the composite transaction must have been determined when the initial steps were
carried out; and

2. There are steps inserted that have no commercial or business purpose apart from
the avoidance of a liability to tax.

If the above conditions exist, the inserted steps are to be disregarded for fiscal
purposes and the court must then look at the end result as per the precedent established
by the Ramsay case.

1.4.3 Board of Review Decisions

The Board of Review (BOR) is Hong Kong’s tax tribunal of first instance. It is an independent
quasi-judicial adjudicator appointed by the Chief Executive of the HKSAR. Its constitution and
powers are governed by ss.65, 68, 68AA, 68AAB and 68A of the IRO. Section 66 of the IRO
provides that if a taxpayer does not agree with the CIR’s determination of their objection, he or
she has the right of appeal to the BOR. In essence, the BOR is usually where the first hearing is to
be received for most tax disputes before any legal proceeding to be held in a Hong Kong court.

Given that it is a tribunal of first instance, decisions of the BOR are not binding, but are
persuasive. The BOR is also the primary fact-finding tribunal in revenue law matters. It admits
written and oral evidence and adjudicates disputes on the basis of the evidence before it and
the provisions of the IRO. Appeals from the BOR to the Court of First Instance or the Court of
Appeal must be on points of law and not, in general, on points of fact.

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Hearings before the BOR are not expressly governed by rules of civil procedure in Hong
Kong and may therefore be less formal than court hearings; however, standard rules of civil
procedure are generally followed.

The BOR hearings are ‘in camera’, that is, they are not open to the public and decisions of
the BOR are generally anonymised when published in law reports to prevent the reader from
identifying the taxpayer(s) in question. Appellant taxpayers may be represented by a CPA or a
lawyer, or they may otherwise appoint any other person to appear for them or may appear in
their own right.

Apply and Analyse 4

Assuming that Taro had a tax dispute on his time apportionment claim on his Salaries
Tax position for the year of assessment 2018/19 with the IRD and he was considering
appealing against the CIR’s determination dismissing his objection, the major advantages
of having an appeal to be heard before the Board of Review instead of any Hong Kong
court, for instance, the Court of First Instance, are:

• The hearings are held in private and published reports do not identify the taxpayer.

• The taxpayer can appoint any person who is not necessarily a barrister as his
representative and therefore limit his professional expenditure.

• The hearing is more informal.

• Unlike the case in a court where the loser generally pays the legal costs of the
successful party, each party before the Board of Review bears its own costs
regardless of the outcome (subject to a potential costs order of a maximum of
HK$25,000 if the BOR feels that the appeal was vexatious).

1.4.4 Departmental Interpretation and Practice Notes and Stamp Office

Interpretation and Practice Notes
The IRD, from time to time, issues Departmental Interpretation and Practice Notes (DIPN) and
Stamp Office Interpretation and Practice Notes (SOIPN) in the name of the CIR and Collector of
Stamp Revenue, respectively, to state the assessment practice and the position on interpreting
certain provisions of the IRO and SDO adopted by the IRD.

The CIR, who also holds the statutory appointment of Estate Duty Commissioner, released
Estate Duty Office Interpretation and Practices Notes (EDOIPN) for the purposes of stating their
opinion on the interpretation and practices in relation to the Estate Duty Ordinance.

Although the IRD stresses that the issuance of DIPN, SOIPN and EDOIPN are merely for
the information of taxpayers and their tax representatives and these notes are not meant to
have any binding force of law, the notes do play an important role in the practical application
of the tax rules in Hong Kong (see Appendix 1.A, 1.B and 1.C for a summary of DIPN, SOIPN
and EDOIPN issued). They enhance the transparency of the IRD’s position in terms of how the
relevant provisions in the IRO, SDO and Estate Duty Ordinance are to be interpreted and the
consistency of the application of the published tax policies.

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As previously mentioned, Estate Duty has been abolished in respect of any person dying
after 10 February 2006 and only a nominal amount of HK$100 is chargeable to the dutiable
estates of persons dying between 15 July 2005 and 10 February 2006. However, the existing
valid EDOIPN is also included in the following table, together with the enforceable DIPNs and
SOIPNs, for completeness sake. You are recommended to visit the official website of the IRD
(www.ird.gov.hk) for any updated version of these notes.

Key Learning Point

Candidates are expected to understand the various sources of, and rules on interpreting,
the Hong Kong tax laws with a particular focus on the purposive approach adopted by the
courts, which lead to the formulation of the Ramsay Principle.

Knowledge Check Questions

Question 10
Identify which of the following rule(s) of interpreting tax legislations as developed in the
common law system is conceptually close to the purposive approach.
A The Provision of Credit Rule
B The Golden Rule
C The Doctrine of Precedent Rule
D The Mischief Rule

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SUMMARY

• Candidates should be able to distinguish the differences between and the conflicts caused by
source jurisdiction and residence jurisdiction.

• The principle of ‘One Country, Two Systems’ and the relevant articles of the Basic Law stipulate
the legal foundation of ensuring Hong Kong as a separate and independent tax jurisdiction
after the handover and its legal basis for negotiating and concluding tax treaties with its
trading partners.

• With reference to the Tanaka family’s case, you should be able to explain the technical
meaning of the concept of income arising in or derived from Hong Kong and its implications
under the three major income taxations of Hong Kong.

• You should be aware of the various challenges to the current territorial tax regime of Hong
Kong, such as BEPS, FATCA and CRS, and so on.

• Further to Hong Kong’s commitment to joining the OECD as a BEPS Associate, it has enacted
the new codified TP rules into the IRO.

• Amongst various rules on interpreting the tax legislations, the crucial one is the purposive
approach that influenced the development of the Ramsay Principle, which stresses substance
over form in any tax planning arrangement.

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MIND MAP

PRINCIPLES OF TAXATION THE BASIC LAW

Source jurisdiction vs. Residence jurisdiction Constitutional document for HKSAR
Incomes arising in or derived from One Country, Two Systems
Hong Kong are taxed Article 108 and other relevant ones
A scheduler system of taxation with DIPN No. 29
neither total income concept nor any
comprehensive income tax system SOURCES AND INTERPRETATION OF
No consolidated filing mechanism available HONG KONG TAX LAW
for companies of a same group IRO, SDO, IRR and other related tax
KEY ASPECTS OF legislations
CHALLENGES AND LATEST DEVELOPMENTS
THE TAX SYSTEMS The Literal Rule, the Golden Rule, the
More requests on transparency and exchange IN HONG KONG Mischief Rule and the purposive approach
of information internationally for interpreting tax legislations
More pressure for combatting offshore tax Case law/Doctrine of Precedent
avoidance, double non-taxation and aggressive
Ramsay Principle
tax planning arrangements internationally
Board of Review Decisions
OECD’s Model Tax Convention on Income
and Capital DIPNs, SOIPNs and EDOIPN
OECD’s Model Agreement on the Exchange ORDINANCES AND LEGISLATIONS
of Information on Tax Matters
Inland Revenue Ordinance (’IRO’) (Cap.112)
FATCA of the US
Inland Revenue Rules (’IRR’) (Cap.112A)
BEPS/New codified transfer pricing rules
incorporated into IRO Stamp Duty Ordinance (’SDO’) (Cap.117)
CRS formulated by OECD Estate Duty Ordinance (Cap.111)
Betting Duty Ordinance (Cap.108)
TYPES OF TAXES
Tax Reserve Certificates Ordinance (Cap.289)
Direct Tax Business Registration Ordinance (Cap.310)
• Property Tax
Hotel Accommodation Tax Ordinance (Cap.348)
• Salaries Tax
• Profits Tax
Indirect Tax
• Stamp Duty
Others (e.g. Betting Tax)

APPENDIX
1.A Summary of DIPN Issued (as of 31 August 2020)

DIPN no. Title Date issued

1 (Revised) Profits Tax July 2006
Part A: Valuation of Stock-in-Trade and Work-in-Progress
Part B: Ascertainment of Profits and The Valuation of
Work-in-Progress
(A) Building and Engineering Contracts
(B) Property Development and Property Investment
2 (Revised) Profits Tax April 1999
Part A: Industrial Buildings Allowances
Part B: Commercial Buildings Allowances
3 (Revised) Profits Tax – Apportionment of Expenses July 2008
4 (Revised) Lease Premiums/Non-returnable Deposits/Key or Tea Money/ February 2006
Construction Fees, etc.
5 (Revised) Profits Tax Deductions for Expenditure on April 2019
Technical Education
Building Refurbishment
Prescribed Fixed Assets
Environmental Protection Facilities

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DIPN no. Title Date issued

6 (Revised) Inland Revenue Ordinance – Provisions as to November 2016
(A) Objections to the Commissioner
(B) Appeals to the Board of Review
(C) Appeals to the Courts
7 (Revised) Machinery and Plant – Depreciation Allowances August 2009
8 (Revised) Profits Tax – Losses September 2009
9 (Revised) Major Deductible Items under Salaries Tax September 2006
10 (Revised) The Charge to Salaries Tax June 2007
11 (Revised) Field Audit and Investigation October 2007
12 (Revised) Commissions, Rebates and Discounts September 2001
13 (Revised) Profits Tax – Taxation of Interest Received December 2004
13A Profits Tax – Deductibility of Interest Expense December 2004
14 (Revised) Property Tax March 2011
15 (Revised) (A) Limitation of Loss Relief (s.22B) January 2006
(B) Leasing Arrangements (s.39E)
(C) General Anti-Avoidance Provision (s.61)
(D) General Anti-Avoidance Provision (s.61A)
(E) Loss Companies (S.61B)
(F) Ramsay Principle
(G) Penalty on Tax Avoidance Cases
(H) Guidelines on Lease Financing
(I) Advance Rulings
16 (Revised) Salaries Tax – Taxation of Fringe Benefits October 2003
17 (Revised) The Taxation of Persons Chargeable to Profits Tax on behalf of January 2005
Non-residents
18 (Revised) Assessment of Individuals under Salaries Tax and Personal February 2020
Assessment
19 The Agreement between the United States of America and Hong September 1989
Kong in Respect of the Taxation of Shipping Profits
20 (Revised) Mutual Funds, Unit Trusts and Similar Investment Schemes June 2012
21 (Revised) Locality of Profits July 2012
22 (Revised) Taxation of Royalties and Other Income from Intellectual August 2020
Properties
23 (Revised) Recognised Retirement Schemes May 2019
24 (Revised) Profits Tax – Service Company ‘Type II’ Arrangements July 2009
25 (Revised) Service Company ‘Type I’ Arrangements – Salaries Tax November 2011
26 (Revised) Profits Tax – Specified Securities for the purposes of s.15E of the June 2009
Inland Revenue Ordinance
27 (Revised) Profits Tax – Stock Borrowing and Lending June 2010
28 (Revised) Profits Tax – Deductibility of Foreign Taxes July 2019
29 Tax Relations between the Hong Kong Special Administrative August 1997
Region and the People’s Republic of China
30 (Revised) Profits Tax – s.20AA September 2009
Persons not Treated as Agents

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DIPN no. Title Date issued

31 (Revised) Advance Rulings April 2020
32 (Revised) Arrangement between the Mainland of China and the Hong Kong October 2011
Special Administrative Region for the Avoidance of Double Taxation
on Income (Note: This Arrangement ceased to apply after the year
of assessment 2006/07.)
33 (Revised) Insurance Agents October 2009
34 (Revised) Exemption from Profits Tax (Interest Income) Order 1998 December 2004
35 (Revised) Concessionary Deductions: ss.26E and 26F – Home Loan Interest February 2020
36 (Revised) Concessionary Deductions: s.26D – Elderly Residential Care Expenses February 2020
37 (Revised) Concessionary Deductions: s.26C – Approved Charitable Donations February 2020
38 (Revised) Salaries Tax – Employee Share-based Benefits March 2008
39 (Revised) Profits Tax – Digital Economy, Electronic Commerce and Digital Assets March 2020
40 (Revised) Profits Tax – Prepaid or Deferred Revenue Expenses August 2010
41 Salaries Tax – Taxation of Holiday Journey Benefits August 2003
42 (Revised) Profits Tax June 2020
Part A: Taxation of Financial Instruments
Part B: Taxation of Foreign Exchange Differences
43 (Revised) Profits Tax Exemption for Offshore Funds1 May 2016
44 (Revised) Arrangement between the Mainland of China and the Hong Kong August 2008
Special Administrative Region for the Avoidance of Double Taxation
and the Prevention of Fiscal Evasion with respect to taxes on Income
45 Relief from Double Taxation due to Transfer Pricing or Profit April 2009
Reallocation Adjustments2
46 Transfer Pricing Guidelines – Methodologies and Related Issues2 December 2009
47 (Revised) Exchange of Information on Request July 2020
48 (Revised) Advance Pricing Arrangement July 2020
49 (Revised) Profits Tax Deduction of Capital Expenditures on Patent Rights, August 2020
Rights to Know-how and Specified Intellectual Property Rights
50 Taxation of Specified Alternative Bond Schemes July 2014
51 Profits Tax Exemption for Offshore Private Equity Funds 1
May 2016
52 Taxation of Corporate Treasury Activity September 2016
53 (Revised) Tax Treatment of Regulatory Capital Securities August 2020
54 Taxation of Aircraft Leasing Activities October 2017
55 Deduction for Research and Development Expenditure April 2019
56 (Revised) Concessionary Deductions: Sections 26H to 26M Health February 2020
Insurance Premiums
57 (Revised) Concessionary Deductions: Sections 26N to 26U Annuity Premiums February 2020
and MPF Voluntary Contributions
58 Transfer Pricing Documentation and Country-by-country Reports July 2019
59 Transfer Pricing between Associated Persons July 2019

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DIPN no. Title Date issued

60 Attribution of Profits to Permanent Establishments in Hong Kong July 2019
61 Profits Tax Exemption for Funds June 2020
1
 ax exemption explained therein will only apply to non-resident persons or entities not falling within the meaning of
T
‘fund’ under s.20AM for any year of assessment commencing on or after 1 April 2019.
2
 ransactions between associated persons or non-Hong Kong resident persons’ permanent establishments in Hong
T
Kong, to which the transfer pricing-related provisions in the Inland Revenue (Amendment) (No. 6) Ordinance 2018 do
not apply, should be dealt with in accordance with DIPNs Nos. 45 and 46.

1.B Summary of SOIPN Issued (as of 31 August 2020)

SOIPN no. Title Date issued

1 (Revised) Stamping of Agreements for Sale and Purchase of November 2018
Immovable Property
2 (Revised) Relief for Stock Borrowing and Lending Transactions February 2011
3 Deemed Consideration under s.24 of the Stamp Duty Ordinance September 1998
4 Deemed Sale and Purchase under s.19(1E) of the Stamp January 2000
Duty Ordinance
5 (Revised) Special Stamp Duty July 2014
6 Alternative Bond Schemes August 2014
7 Buyer’s Stamp Duty July 2014
8 (Revised) Ad Valorem Stamp Duty November 2018

1.C Summary of EDOIPN Issued

EDOIPN no. Title Date issued

1 Controlled Companies Provisions under the Estate Duty Ordinance December 2000

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Hong Kong does impose withholding tax on non-residents in respect
of royalty income generated in Hong Kong, and the current tax regime in Hong Kong does
not provide any group loss relief.
Answer B is incorrect. The current tax regime in Hong Kong does not provide any group
loss relief.
Answer C is correct. Hong Kong does not impose any capital gains tax nor any tax on
dividends.
Answer D is incorrect. Hong Kong does impose withholding tax on non-residents in respect
of royalty income generated in Hong Kong.

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Question 2
Answer A is incorrect. He is not taxed in Hong Kong for director’s fees earned in Japan.
Answer B is correct. In accordance with the decision handed down in McMillan v. Guest
(1942) 24 TC 190, the office of director of a corporation is located in a place where the
central management and control of the corporation is exercised. Thus, Taro’s director’s
fees received in respect of his directorship with Hachiko Inc whose central management
and control are exercised in Japan should not be taxed in Hong Kong.
Answer C is incorrect. His total income is not fully taxable.
Answer D is incorrect. He is not fully exempt from Hong Kong taxes.

Question 3
The following four action items have been implemented or are in the process of being
implemented in Hong Kong through legislative and administrative changes:
Action 5: Counter harmful tax practices more effectively, taking into account transparency
and substance.
Action 6: Prevent treaty abuse.
Action 13: Re-examine TP documentation.
Action 14: Make dispute resolution mechanisms more effective.

Question 4
Source-based regimes tax on the basis of the nexus of the profit-making activity being
carried on or the place where the income generating assets are situated. Conversely,
residence-based regimes use the residence of the taxpayer as the relevant nexus for
taxation. Generally, an individual is resident where he or she physically resides and
a company is resident where it is centrally managed and controlled, though different
jurisdictions may adopt different tests.

Question 5
It should be Articles 106 and 108 of the Basic Law.
Article 106: ‘The Hong Kong Special Administrative Region shall have independent
finances. The Hong Kong Special Administrative Region shall use its financial revenues
exclusively for its own purposes, and they shall not be handed over to the Central People’s
Government. The Central People’s Government shall not levy taxes in the Hong Kong
Special Administrative Region’.
Article 108: ‘The Hong Kong Special Administrative Region shall practise an
independent taxation system. The Hong Kong Special Administrative Region shall, taking
the low tax policy previously pursued in Hong Kong as a reference, enact laws on its own
concerning types of taxes, tax rates, tax reductions, allowances and exemptions, and other
matters of taxation’.

Question 6
It should be Articles 151 and 153 of the Basic Law.
Article 151: ‘The Hong Kong Special Administrative Region may on its own, using the
name ‘Hong Kong, China’, maintain and develop relations and conclude and implement
agreements with foreign states and regions and relevant international organisations in
the appropriate fields, including the economic, trade, financial and monetary, shipping,
communications, tourism, cultural and sports fields’.

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Article 153: ‘The application to the Hong Kong Special Administrative Region of
international agreements to which the People’s Republic of China is or becomes a party
shall be decided by the Central People’s Government in accordance with the circumstances
and needs of the Region, and after seeking the views of the government of the Region.
International agreements to which the People’s Republic of China is not a party but which
are implemented in Hong Kong may continue to be implemented in the Hong Kong Special
Administrative Region. The Central People’s Government shall, as necessary, authorise or
assist the government of the Region to make appropriate arrangements for the application
to the Region of other relevant international agreements’.

Question 7
Answer A is incorrect. Special SD and Profits Tax are both imposed in Hong Kong.
Answer B is incorrect. Profits Tax is imposed in Hong Kong.
Answer C is correct. Hong Kong currently does not impose any Goods & Services Tax and
Capital Gains Tax.
Answer D is incorrect. Salaries Tax is imposed in Hong Kong.

Question 8
Both Profits Tax and Salaries Tax in Hong Kong are typical examples of direct tax. The two
examples of indirect tax can be Consumption Tax and Value-added Tax. The difference
between direct tax and indirect tax can sometimes be reflected by their respective way of
collection. The direct tax liability is collected directly by the government from the taxable
person and/or property. In contrast, indirect tax liability is collected by an intermediary
from the person who bears the ultimate tax burden of a transaction.

Question 9
The four heads of charge of SD are as follows:
• Immovable property in Hong Kong
• Hong Kong stock
• Hong Kong bearer instrument
• Duplicates and counterparts

Question 10
Answer A is incorrect. The Provision of Credit Rule is not close to the purposive approach.
Answer B is incorrect. The Golden Rule is not close to the purposive approach.
Answer C is incorrect. The Doctrine of Precedent Rule is not close to the purposive approach.
Answer D is correct. As explained in Section 1.4.1.1 of this chapter, the Mischief Rule of
interpreting tax legislations as developed in the common law system is conceptually close
to the purposive approach.

EXAM PRACTICE

QUESTION 1
Discuss the importance of local court cases on tax matters, BOR decisions and DIPN in the
tax regime of Hong Kong (Adapted from Module D June 2015 Paper).

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QUESTION 2
(a) Describe the aims of the Base Erosion and Profit Shifting (BEPS) Project initiated
by OECD/G20.

(b) Identify and describe three of the actions agreed on by the OECD/G20 in the resulting
action plan.

(c) Explain the reason why the BEPS project is relevant in Hong Kong.

ANSWERS TO EXAM PRACTICE

QUESTION 1
DIPN
Issued by the IRD, DIPN clarifies the IRD’s viewpoints on particular tax provisions and/
or the practice of the IRD in certain given situations. It also outlines the IRD’s respective
procedures in administrating relevant provisions of the IRO. Notwithstanding that DIPN
has no binding force in law (BOR D54/06, para. 25), the IRD would follow, in general, what
has been laid down in the DIPNs, for both interpretation of tax provisions and assessing
practices.

BOR Decisions
The BOR is an independent statutory body to determine tax appeals. It is Hong Kong’s tax
tribunal of first instance. It is also the primary fact-finding tribunal in tax disputes, unless
the appeal leapfrogs the BOR and is heard directly before the Court of First Instance under
s.67 of the IRO. Decisions made by the BOR are final with regard to the facts of a particular
case. Decisions of the BOR are not binding on subsequent BOR cases; however, they are in
practice treated as persuasive. With reference to the BOR’s decisions, taxpayers can identify
how the relevant provisions in the IRO are interpreted and applied in the circumstances.
BOR decisions may be cited as persuasive authority before the BOR or the higher courts of
Hong Kong.

Local Court Cases for Tax

In the appeals to the Hong Kong courts, judges are in general required to decide the cases
by expressing their opinion in respect of questions of law. Appeals from the decisions of the
BOR are heard before either the Court of First Instance or the Court of Appeal if the leapfrog
provisions in section 69A are engaged. Decisions of a higher court are binding on the
lower courts and on the BOR under the doctrine of judicial precedent. Hong Kong case law
therefore plays an important role in shaping the interpretation and application of the IRO,
SDO and other taxing statutes.

QUESTION 2
(a) Description of BEPS Aims

The OECD wanted to ensure that multinational corporations pay tax in each jurisdiction
in which they do business, commensurate with the profits generated in that jurisdiction.

To achieve this aim and to combat tax avoidance (e.g. in the areas of double
non-taxation and aggressive tax planning arrangements), the leaders from G20 countries
concluded that a comprehensive package of measures to tackle BEPS was needed.

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(b) OECD Action Plan

The OECD sets out 15 identified action items in its BEPS Action Plan:

Action no. Title and introduction

1. Address the tax challenges of the digital economy (DE).
• Identifies the main difficulties that the DE poses for extant international tax rules.
It proposes detailed options, taking a holistic approach and considering both direct
and indirect taxation.
2. Neutralise the effects of hybrid mismatch arrangements.
• Provides for model treaty provisions and domestic rules to neutralise the effect
(e.g. double non-taxation, double deduction, long-term deferral) of hybrid
instruments and entities.
3. Strengthen controlled foreign corporation (CFC) rules.
• Contains recommendations on the design of CFC rules.
4. Limit base erosion via interest deductions and other financial payments.
• Concerns rules to prevent base erosion through the use of interest expense.
For example, it considers the use of related-party and third-party debt to
achieve excessive interest deductions or to finance the production of exempt or
deferred income. It also considers other financial payments that are economically
equivalent to interest payments.
5. Counter harmful tax practices (HTPs) more effectively, taking into account transparency
and substance.
• Seeks to revamp the work on HTPs. Prioritises transparency, including compulsory
spontaneous exchange on rulings related to preferential regimes, and substantial
activity requirements for any preferential regime.
6. Prevent treaty abuse.
• Develops model treaty provisions and recommendations on the design of
domestic rules to prevent the granting of treaty benefits in inappropriate
circumstances.
7. Prevent the artificial avoidance of permanent establishment (PE) status.
• Concerns changes to the definition of PE to prevent the artificial avoidance of PE
status, including through the use of commissionaire arrangements and the specific
activity exemptions.
8. Ensure that transfer pricing (TP) outcomes are in line with value creation (Intangibles).
• Seeks to ensure that TP rules are in line with value creation in relation to
intangibles by developing rules to prevent BEPS by moving intangibles amongst
group members.
9. Ensure that TP outcomes are in line with value creation (Risk and capital).
• Seeks to ensure that TP rules are in line with value creation in relation to the
transference of risk and the allocation of excessive capital to group members.
10. Ensure that TP outcomes are in line with value creation (other high-risk transactions).
• Seeks to ensure that TP rules are in line with value creation in relation to high-risk
transactions which would not, or only very rarely, occur between third parties.
11. Establish methodologies to collect and analyse data on BEPS and the actions to
address it.
• Concerns establishing methodologies to collect and analyse data on BEPS,
particularly in relation to scale and economic impact.

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Action no. Title and introduction

12. Require taxpayers to disclose their aggressive tax planning arrangements.
• Concerns requiring taxpayers to disclose their aggressive or abusive tax planning
arrangements through mandatory disclosure rules. Emphasis is on administrative
and compliance costs.
13. Re-examine TP documentation.
• Seeks to enhance transparency for tax administrations, taking into consideration
the compliance costs for business.
14. Make dispute resolution mechanisms more effective.
• Concerns removing obstacles to the use of Mutual Agreement Procedures (MAP),
including the absence of arbitration provisions in most treaties and the fact that
access to MAP and arbitration may be denied in certain cases.
15. Develop a multilateral instrument (MLI).
• Concerns developing MLI to modify bilateral tax treaties.

Subsequent to the endorsement of the BEPS Action Plan, the OECD and G20
countries developed and agreed to implement the aforementioned 15 action items
domestically and through tax treaty provisions.

(c) Impact on Hong Kong

To ensure that the BEPS Action Plan will be implemented in a coordinated manner so
as to tackle tax avoidance, improve the coherence of international tax rules, and ensure
a more transparent tax environment on a worldwide basis, an Inclusive Framework
on BEPS (the Framework) was introduced by the OECD specifically applicable to
non-members of the OECD and the G20 countries.

The Framework aims to:

• develop standards in respect of remaining BEPS issues;

• r eview the implementation of agreed minimum standards through an effective

monitoring system;

• monitor BEPS issues, including tax challenges raised by the DE; and

• f acilitate the implementation processes of the members by providing further

guidance and by supporting development of toolkits to support low-capacity
developing countries.

Countries that join the Framework are required to commit to working together
for implementation of four minimum action items in the BEPS Action Plan and pay an
annual member’s fee to cover the costs of the Framework.

From a Hong Kong perspective, it has joined the Framework and agreed to
implement the following four action items:

•  ction 5: Counter HTPs more effectively, taking into account transparency and
A
substance.

• Action 6: Prevent treaty abuse.

• Action 13: Re-examine TP documentation.

• Action 14: Make dispute resolution mechanisms more effective.

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After a series of public consultations, the relevant Inland Revenue Amendment Bill
has been enacted and gazetted in Hong Kong in 2018.

This is the first time that a comprehensive TP regime has been introduced in
Hong Kong. Its most important provisions are related to the codification of the
so-called arm’s length principle (ALP) and its application to transactions between
associated parties and to transactions between a head office and its PE. In
substance, the ALP requires that provisions, including the terms of transactions and
arrangements, made between associated parties be made as though the associated
parties were independent parties acting commercially. The purpose of TP rules is in
essence to prevent associated parties from exploiting their association to obtain a tax
advantage.

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 2
Administration of
the Tax System in
Hong Kong

CHAPTER TOPIC LIST

2.1 Hong Kong Inland Revenue 2.4 Objection, Holdover, Appeal

Department Overview and Error or Omission Claim
and Structure 2.4.1 Objection Process
2.1.1 Administration of the Inland 2.4.2 Holdover of Tax Payment
Revenue Department Under an Objection
2.1.2 Board of Review (Inland 2.4.3 Holdover of Provisional
Revenue Ordinance) Tax Payment
2.2 Obligations of a Taxpayer and 2.4.4 Tax Appeal Process
Other Parties 2.4.5 Error or Omission Claim
2.2.1 The Taxpayer’s Obligations 2.5 Offences and Penalties
2.2.2 The Employer’s Obligations Overview
2.2.3 Returns
2.6 Field Audit and Investigation
2.2.4 Obligations of Other Scope and Objectives
Parties Under the Inland
2.6.1 Field Audit and Investigation
Revenue Ordinance
Essential Issues
2.3 Assessments and Payment 2.6.2 Settlement Methods
2.3.1 Time Limit to Raise Assessment 2.6.3 Assessments and Recovery
2.3.2 Notice of Assessment and of Taxes
Demand for Payment
2.3.3 Payment of Taxes

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LEARNING OUTCOMES

PRINCIPAL LO1: DEMONSTRATE AN UNDERSTANDING OF THE TAX SYSTEM AND ADMINISTRATION

IN HONG KONG
LO1.01: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Principles of taxation
1.01.04 Describe the roles of the taxpayer, the tax advisor and the Inland Revenue Department (IRD)
LO1.07: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Structure and administration of the Inland Revenue Department
1.07.01 State the structure of the IRD
1.07.02 Explain the administration of the IRD
LO1.08: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Duties and powers of officers of the Inland Revenue Department and official secrecy
1.08.01 Explain the duties and powers of IRD officers
1.08.02 Explain the secrecy provisions under the IRO
LO1.09: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Obligations and liabilities of a taxpayer, their agent, a trustee or an executor
1.09.01 Explain the obligations and liabilities of a taxpayer, their agent, a trustee or an executor
under the IRO and the SDO
LO1.10: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Returns, offences and penalties
1.10.01 Describe the powers of IRD officers to require the furnishing of returns, statements and
information
1.10.02 Describe the powers of IRD officers to seize books, records and documents by way of
search warrant
1.10.03 Describe the obligations of a taxpayer in relation to keeping of business and rent records
1.10.04 Describe the obligations and rights of an employer under the IRO
1.10.05 Describe the tax offences and apply the penalty provisions under the IRO
LO1.11: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Assessments, additional assessments and provisional assessments
1.11.01 Apply the provisions under the IRO regarding the raising of tax assessments
LO1.12: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Payment, recovery, holding over and refund of tax
1.12.01 Explain the provisions under the IRO regarding payment of tax
1.12.02 Explain the provisions under the IRO regarding recovery, holding over and refund of tax

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LO1.13: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Objections, appeals and claims
1.13.01 Describe and apply the objection and appeal procedures and the requirements to lodge
a claim to correct error or omission in a tax return or statement
1.13.02 Describe and apply the provision under the IRO regarding finality of tax assessments
1.13.03 Apply DIPN No. 6
LO1.14: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Board of Review
1.14.01 Describe the role, formation and functions of the Board of Review
LO1.15: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Board of Inland Revenue
1.15.01 Describe the role, formation and functions of the Board of Inland Revenue
1.15.02 Describe and apply the Inland Revenue Rules (IRR)
1.15.03 Justify the circumstances under which IRR can be used to compute the profits of a Hong
Kong branch and apply the applicable computation methods
1.15.04 Explain the difference between the permanent establishment (PE) definition under the
IRR and that under double taxation agreements/arrangements
LO1.16: S
 tate, describe and apply the following key aspects of the tax system in Hong Kong:
Field audit and investigation
1.16.01 Describe the essential issues concerning field audit and investigation
1.16.02 Describe the efficient ways to lead a tax investigation to an early settlement
1.16.03 Explain and apply the settlement methods used by the IRD in the quantification process
1.16.04 Describe and apply judicial review cases on the raising of assessments and recovery of taxes
1.16.05 Apply DIPN No. 11

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OPENING CASE

M rs. Johnson operates, as a sole proprietor, an upscale boutique business that sells luxury
wedding gowns in Central Hong Kong Shopping Mall. The boutique has one full-time sales
assistant, one full-time buyer and a part-time accounts clerk who is responsible for preparing
the financial statements and tax reporting for Mrs. Johnson. Mrs. Johnson relies heavily on
the accounts clerk to handle, with the help of accounting software, all the accounting and tax
matters for the business.

In 2018, Mrs. Johnson decided to hire two additional sales assistants to help manage her
business. Mr. Tang, the buyer of the boutique, decided to retire on 30 June 2018. Mrs. Johnson
is aware that she needs to notify the Inland Revenue Department (IRD) when hiring new
employees, but was uncertain as to the detailed requirements and timeline to do so. She plans
to consult with her business associate on what to do at a later time.

During the year of assessment 2017/18, the boutique made sales to a group of visitors
from Mainland China. These visitors made enquiries to Mrs. Johnson over the telephone and
via e-mails. Mrs. Johnson left all the responsibilities of keeping the business and employment
records with her accounts clerk as she was busy running the business.

Mrs. Johnson discussed the tax reporting position of these sales with the accounts clerk
and was advised that the assessable profits from these sales do not have to be reported in the
tax return on the basis that both the purchases and the sales were offshore in nature. As such,
the said income should not be subject to Hong Kong tax as Hong Kong adopts a territorial tax
regime as outlined in Chapter 1.

On 30 September 2018, the IRD advised Mrs. Johnson that the 2017/18 tax assessment was
under investigation. The IRD also issued an additional assessment imposing tax on the under
reported sales, together with a letter advising that a penal action including prosecution might
be taken against Mrs. Johnson.

In her defence, Mrs. Johnson claimed ignorance and acknowledged that she is not a tax
expert and does not fully understand the Hong Kong tax rules and solely relied on the accounts
clerk to handle all accounting and tax matters. Mrs. Johnson intends to object and file an appeal
relating to the additional assessment issued by the IRD by engaging a professional tax advisor
who will act as her authorised representative.

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OVERVIEW

In Chapter 1, we learned about the principle of a territorial tax system adopted by the Hong
Kong Special Administrative Region (HKSAR) government. This is an important concept in
understanding the imposition of tax on income arising in or derived from Hong Kong and
outside of Hong Kong.

In this chapter, we will focus our attention in understanding the importance of Hong
Kong tax administration that is carried out by the IRD, including taxpayer’s filing obligation,
employer’s reporting responsibilities and how to deal with different types of tax assessments.

In addition, it is equally important for taxpayers to understand their legal rights in

situations where they do not agree with IRD assessments. Taxpayers and/or their authorised
representatives need to understand the objection process in detail, particularly the
timeline imposed for each step, and the use of Tax Reserve Certificates to satisfy tax owing,
notwithstanding that the assessment is under objection.

Last but not least, the IRD has the authority to carry out field audit and investigation on
selected taxpayers where it finds a number of irregularities and non-compliance. Such an
audit is generally time-consuming, intrusive and disruptive to the company’s operation and
employees. Taxpayers are encouraged to maintain contemporaneous documentation and be
compliant at all times with the prevailing tax laws and practice in order to avoid such tax audits.

2 . 1
HONG KONG INLAND REVENUE
DEPARTMENT OVERVIEW AND STRUCTURE

Generally, the Hong Kong Inland Revenue Department (IRD) is committed to provide the
following services to taxpayers:

• Collecting revenue efficiently and cost-effectively;

• Providing courteous and effective service to the taxpaying public;

• Promoting compliance through rigorous enforcement of law, education and publicity

programmes, enabling staff to acquire the necessary knowledge, skills and attitude so
that they can contribute their best to the achievement of the IRD’s vision.

An overview of the organisational structure of the IRD is shown in Exhibit 2.1.

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Commissioner

Deputy Commissioner Deputy Commissioner

Admin
(Technical) (Operation)

Unit 1 Unit 2 Commissioner’s Unit 3 Unit 4 Headquarters

Assessment Assessment Unit Collection/ Field Audit and Unit
and Review (Salaries Tax, Inspection/ Investigation
(Profits Tax – Profits Tax – Estate Duty*/
Corporation Sole proprietorships, Stamp Duty/
and Property Tax – Sole Business
Partnerships) Owners and Registration
Personal
Assessment)

*Estate Duty was abolished in respect of deaths that occurred on or after 11 February 2006.

EXHIBIT 2.1 Overview of the IRD structure. (Source: Inland Revenue Department, Hong Kong.)

2.1.1 Administration of the Inland Revenue Department

The Commissioner of Inland Revenue (the Commissioner or CIR) is responsible for the
administration of various ordinances and the Rules and Regulations made under these
ordinances, including:

• Betting Duty Ordinance (Cap.108);

• Estate Duty Ordinance (Cap.111);

• Inland Revenue Ordinance (Cap.112);

• Stamp Duty Ordinance (Cap.117);

• Tax Reserve Certificate Ordinance (Cap.289);

• Business Registration Ordinance (Cap.310); and

• Hotel Accommodation Tax Ordinance (Cap.348).

For the purpose of this chapter, we will focus our attention on the tax administration by the
IRD relating to the imposition of tax on property, profits and earnings as provided under the
Inland Revenue Ordinance (IRO) Cap.112.

As indicated in Chapter 1 of this module, other than the IRO, the Commissioner may issue
Departmental Interpretation and Practice Notes (DIPNs) and Stamp Office Interpretation and
Practice Notes (SOIPNs) from time to time to clarify the IRD’s technical positions in certain
circumstances. Just like any other interpretation bulletins, DIPNs and SOIPNs do not have the
same statutory right as the IRO itself. These are merely the IRD’s method of application of the
relevant statutes in a given set of facts and pattern.

The Legislative Council of Hong Kong is vested with constitutional authority to enact
legislation to raise taxes. From time to time, the government consults with stakeholders and
the private sector to consider tax legislation. Hong Kong also frequently consults with the
Organisation for Economic Cooperation and Development (OECD) on tax reform with a view to
ensuring that Hong Kong is compliant with international tax norms.

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2.1.1.1 Duties and Powers of Inland Revenue Department Officers

In addition to the imposition, collection and administration of taxes, IRD officers have been
delegated authorities under various sections of the IRO and Stamp Duty Ordinance (SDO) to
collect relevant information from taxpayers.

The IRD’s duties and powers are summarised in Exhibit 2.2.

Section Power of the IRD Exercised by

51(1) To request returns (property tax, salaries tax, profits tax and Assessor
composite tax return) from any person.
51(3) To request fuller and further returns from any person. Assessor
51(4)(a) To request full information or documents in possession from any Assessor/Inspector
person (including third parties).
51(4)(b) To request any person to attend an interview and answer questions Assistant
(including third parties). Commissioner
51(4AA) To exercise the same power under s.51(4) to collect information Same as ss.51(4)(a)
concerning tax of a foreign territory for the purpose of exchange of and (b)
tax information under a double taxation arrangement.
51(4A) To request information from any person (including any person, Assessor/Assistant
or any employee of any person, who was party to the property Commissioner
transaction; any person, or any employee of any person, who has
acted for any party to the property transaction; any person who
either paid or received any consideration, brokerage, commission
or fee; and any person, or any employee of any person, who was
concerned in passing of any consideration, brokerage, commission
or fee, or in the clearing or collection of any cheque or other
instrument of exchange) relating to property transactions or to
request any person to attend at a time and place and answer
questions relating to property transactions. Privilege from disclosure*
constitutes no excuse for non-disclosure.
51A To request a statement of assets and liabilities from any person for Commissioner
a period not earlier than seven years before the commencement or a Deputy
of the year of assessment in which the request is given, with the Commissioner
consent of the Board of Review.
51B To apply for a search warrant from a magistrate to search for and Chief assessor or
take possession of any books, records, accounts or documents. above authorised by
CIR in writing
51B(1AA) To exercise the same power under s.51B to issue search warrants for Same as s.51B
information concerning tax of a foreign territory for the purpose of
exchange of tax information under a double taxation arrangement.
52(1) To request information from any officer in the employment of the Commissioner
government or of a public body.
52(2) To request returns from employers. Assessor
* When a document that contains communication between a client and his or her legal counsel is marked ‘Privileged’,
such document is treated as confidential and protected from disclosure to any third party, including the IRD, except
with the client’s consent. However, the taxpayer has the burden of proof to ensure that such privilege has not been
compromised prior to the IRD’s request.
EXHIBIT 2.2 Key provisions of the IRO relating to the IRD’s authority in administering tax laws in
Hong Kong

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2.1.1.2 Secrecy Provisions Under the Inland Revenue Ordinance

Pursuant to s.4 of the IRO, all staff members of the IRD have the statutory duties to keep
taxpayers’ information, which they come across while performing their duties, confidential.
They are prohibited from disclosing any information to persons other than the taxpayers
themselves or their authorised representatives.

However, pursuant to s.49(5) of the IRO, the obligation as to secrecy under s.4 of the IRO
shall not prevent the disclosure of information to any authorised officer of the government
of the treaty country with which Hong Kong has concluded a comprehensive double taxation
agreement (CDTA), where the information is required to be disclosed under the Exchange of
Information arrangements (DIPN No. 7 (Revised) – para. 12).

2.1.1.3 Board of Inland Revenue

The Board of Inland Revenue (BIR) is established in accordance with s.3 of the IRO. It is made up
of the Financial Secretary and four other members appointed by the Chief Executive, of whom
not more than one shall be an official in the employment of the government. The appointed
member shall hold office until he shall resign or be removed from office by the Chief Executive.

BIR operates independently of the IRD and has a secretary who is the Deputy
Commissioner of Inland Revenue.

There are three key functions of the IRD’s operation as outlined by BIR:

1. To determine the relevant information and disclosure in the returns to be used for
property tax, salaries tax, profits tax and personal assessment or the form of the returns.

2. To determine the annual allowance rates on machinery and plant.

3. To determine the procedures relating to appeals, refunds and relief application,

including other miscellaneous matters which the IRD has been authorised.

Generally, BIR may issue directives or rules for carrying out the provisions of the IRO and
for the ascertainment and determination of any class of income or profits as and when it is
deemed relevant and appropriate.

2.1.1.4 Inland Revenue Rules Used to Compute the Profits of a Hong Kong Branch
In Chapter 1, we learned that Hong Kong adopts a territorial system of taxation. Under such
tax regime, profits tax will be charged only on profits arising in or derived from Hong Kong
from a trade, business or profession carried on by a person in Hong Kong. Profits tax is not
applicable to profits that are sourced outside of Hong Kong.

Under s.85, in order to carry out the various provisions under the IRO, the BIR has been given
the power to make rules (commonly known as Inland Revenue Rules or IRR) in order to determine
the most reasonable method of ascertaining any class of income or profits. All such rules made
by the BIR shall be submitted to the Chief Executive and be approved by the Legislative Council.

Currently, the following Inland Revenue Rules are in effect:

• IRR Rule 1 – Citation.

• IRR Rule 2 – Rates of tax depreciation.

• IRR Rule 2A – General apportionment method for expenses incurred in relation to s.16
(chargeable profits) of the IRO.

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• IRR Rule 2B – Disallowance on interest expenses incurred in relation to the purchase of

shares in a corporation that is chargeable to Part IV of the IRO (i.e. profits tax).

• IRR Rule 2C – Disallowance of a proportion of expenses attributable to the supervision

and management of investment portfolio.

• IRR Rule 2D – Rights of objection and appeal.

• IRR Rule 3 – Methods of determining the Hong Kong branch profit of a financial
institution whose head office is outside Hong Kong.

• IRR Rule 4 – (Repealed).

• IRR Rule 5 – Methods of determining the Hong Kong branch profits of a person other
than a financial institution, whose head office is outside Hong Kong.

In DIPN No. 21 (Revised), the IRD has issued a comprehensive guidance and interpretation
relating to the locality of profits under the territorial tax regime in Hong Kong. Students
are advised to read DIPN No. 21 (Revised) in conjunction with Chapter 1 and Chapter 3 of
this module.

The territorial principle does not generally distinguish between residents and non-residents.
A company may be incorporated and a tax resident in Hong Kong, but if the profits are derived
outside of Hong Kong, it is not liable to pay any Hong Kong profits tax on those profits. Similarly,
if a non-resident entity derives profits from Hong Kong through the activities of its branch or
permanent establishment in Hong Kong, it will be liable to pay profits tax in Hong Kong.

If a foreign person has a permanent establishment (PE) in Hong Kong (see section 2.1.1.5 for
discussion on definition of PE), such as a Hong Kong branch, but its financial statements do not
disclose the true profits arising in Hong Kong, IRR Rule 5, para. 2(a)–(d) sets out a general method
of determining the Hong Kong-sourced profits of such PE using the methods below. S.50AAK
provides that the allocation of profits between a head office and a PE must be made on an arm’s
length basis – that is, on the same basis as one would expect to find with respect to the same
supplies of goods and/or services as between two independent persons acting commercially.

Methods to determine Hong Kong-sourced profits according to IRR Rule 5:

• Method 1: Actual profits method

True Hong Kong-sourced profits as disclosed in the accounts. Such a method is

generally applied when there is a high degree of accuracy and reliability on the
financial statements prepared by the taxpayer. For example, the taxpayer has set
up a separate ledger to account for all the activities of the Hong Kong branch or
permanent establishment, including source documents and other contemporaneous
documentation to the satisfaction of the IRD.

• Method 2: Worldwide profit margin method

HK Turnover
HK sourced profits Worldwide profits
Worldwide Turnover

• Method 3: Percentage of turnover method

° A fair percentage of the Hong Kong turnover, as determined by the assessor.

° Applies when it is impracticable or inequitable to adopt methods 1 and 2.

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2.1.1.5 Difference Between Permanent Establishment Definition Under the Inland

Revenue Ordinance and that Under Double Taxation Agreements/Arrangements
Permanent Establishment Definition Under the Inland Revenue Ordinance
On 13 July 2018, the Hong Kong SAR government gazetted Inland Revenue (Amendment) (No. 6)
Ordinance 2018 (The Amendment Ordinance). The Amendment Ordinance included provisions
to refine the definition of what constitutes a PE in Hong Kong for entities resident in non-
double taxation agreement (DTA) partner jurisdictions. The definition can be found in Schedule
17G of the IRO.

On 19 July 2019, the IRD issued DIPN No. 60, which clarifies the concept of PE in Hong Kong
and the methodology for attributing profits to Hong Kong PEs.

While the issue of whether a double taxation agreement (DTA) territory resident person has
a PE in Hong Kong is to be determined in accordance with the relevant provisions under the
relevant DTA, the PE status of a non-DTA territory resident person is to be determined under
Schedule 17G of the IRO. This includes the following:

• A place of management;

• A branch;

• An office;

• A factory;

• A workshop;

• A mine, an oil or gas well, a quarry or any other place of extraction of natural resources;

• A building site or construction or installation project is a PE of an enterprise (subject

enterprise) only if:

° The subject enterprise has carried on activities at the site or project for a period of
more than 12 months; or

° All of the following apply:

□ The subject enterprise has carried on activities at the site or project for a period
that exceeds, or two or more periods that in the aggregate exceed, 30 days;

□ Connected activities have been carried on at the site or project by one or more
closely related enterprises of the subject enterprise for one or more different
periods that each exceeds 30 days; and

□ All the periods referred to in subparagraphs (i) and (ii) in the aggregate exceed
12 months.

Agents can be a PE of an enterprise if they have, and habitually exercise, authority to

conclude contracts on behalf of an enterprise, the definition of contract conluding activities
is extended to include a principal role leading to the conclusion of contracts without material
modification by the non-resident principal. However, independent agents who act for an
enterprise in the ordinary course of their business do not constitute a PE of that enterprise.

In essence, a PE is formed when the commercial presence of a non-resident person in

a given jurisdiction meets the threshold of taxability. A PE is not, however, constituted by
activities that are preparatory and/or auxiliary in character and so do not amount to the
carrying on of a person’s business in Hong Kong.

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The scope and interpretation of the new PE definition is much wider than before. In
particular, when a non-resident has a fixed place of business in Hong Kong, the safe harbour
for non-existence of a PE is now dependent on the characterisation of the activities as
‘preparatory and auxiliary’ rather on the ‘form’ of the fixed place of business. In other words,
substance over form prevails. It is the activities carried out by the non-resident in Hong Kong
that will be the focus of the IRD instead of the legal form of its presence in Hong Kong.

According to DIPN No. 60, subject to the complementary function test, if either set of
the following conditions is met, the enterprise will not be regarded as having a permanent
establishment in Hong Kong.

The 1st set of conditions

(a) The activity carried on for the enterprise through the place consists solely of one of the
following:

(i) The use of facilities solely for the purpose of storage, display or delivery of goods
or merchandise belonging to the enterprise;
(ii) The maintenance of a stock of goods or merchandise belonging to the enterprise
solely for the purpose of storage, display or delivery;
(iii) The maintenance of a stock of goods or merchandise belonging to the enterprise
solely for the purpose of processing by another enterprise;

(iv) The maintenance of a fixed place of business solely for the purpose of purchasing
goods or merchandise, or collecting information, for the enterprise;

(v) The maintenance of a fixed place of business solely for the purpose of carrying on
any other activity for the enterprise; and

(b) In relation the business of the enterprise as a whole, the activity is of a preparatory or
auxiliary character.

The 2nd set of conditions

(a) The activities carried on for the enterprise through the place consist solely of
any combination of the activities mentioned in subparagraph (a) of the 1st set of
conditions; and

(b) The overall activity of the place resulting from the combination of the activities is of a
preparatory or auxiliary character.

Permanent Establishment Definition Under Double Taxation Agreements/Arrangements

In the ever-increasing cross-border trades between various countries, it is important that the
international tax system remains fair and equitable. As such, the relevant taxing authorities
in each country would rely on their respective tax treaties, also known as double taxation
agreements (DTAs), which are in force to apply the taxation rules on non-residents doing
business in their jurisdiction.

Such DTAs help to avoid double taxation of income and property and provide clear division
on the right of taxation between the contracting countries, ensure taxpayers’ equal rights and
prevent erosion of tax revenues through illegal means.

Whether a resident person of a DTA territory has a PE in Hong Kong or otherwise, would be
determined by the provision of each relevant treaty.

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The DTAs contain a PE definition that has been widely adopted in many jurisdictions as the
threshold that triggers income tax exposure of non-resident (NR) companies on active business
income under a treaty.

Under the DTAs signed between Hong Kong and different countries, a fixed place of
business generally is one of the following:

• A place of management;

• A branch;

• An office;

• A factory;

• A workshop;

• A mine, an oil or gas well, a quarry or any other place of extraction of natural resources;

• A building site or construction or installation project that lasts more than 6–12 months
(the duration varies for different DTAs);

• A dependent agent who has, and habitually exercises, an authority to conclude

contracts on behalf of the principle (agency); or

• Provision of services (for the same or a connected project) for more than 6 months (the
duration varies for different DTAs) in any 12-month period.

This is illustrated in Exhibit 2.3.

Fixed place

Agency PE Construction site

Service

EXHIBIT 2.3 PE definition for fixed place of business

Issues arising from a taxation of a PE in Hong Kong is illustrated in Exhibit 2.4.

HK IRO and guidance DTA provision and OECD rules

Threshold for tax exposure Threshold for tax exposure
• Whether carrying on a trade or business • Whether PE is established in Hong Kong?
in Hong Kong?
Quantification of Profits Subject to Tax Quantification of Profits Subject to Tax
in Hong Kong in Hong Kong
• Only Hong Kong-sourced profits are taxable • Only profits attributable to PE in Hong Kong
• Methods specified in IRR 5 are taxable
• Adopted the OECD principle and guidelines • Follow OECD transfer pricing principle and
unless it is inconsistent with the IRO provision profit attribution rules

EXHIBIT 2.4 Issues arising from taxation of a PE

Chapter 8 should be referred to for a comprehensive discussion on the taxation of
non-residents.

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Key Learning Point

Taxpayers should be aware of the powers of the IRD in requesting information, either
directly from taxpayers or third parties, in order to issue estimated tax assessments. For
non-residents with a PE in Hong Kong, the IRD adopts various methods to quantify the
Hong Kong-sourced profits under different scenarios.

2.1.2 Board of Review (Inland Revenue Ordinance)

Pursuant to s.65 of the IRO, the Board of Review (commonly known as BOR) is an independent
statutory body constituted to operate as Hong Kong’s tax tribunal of first instance. Its
primary function is to hear and determine tax appeals where the taxpayer disagrees with the
Commissioner’s determination after a valid objection has been filed.

S.65(1) of the IRO provides that a Board of Review is required to consist of a chairperson
and 10 deputy chairpersons, who are required to be persons with legal training and experience,
and not more than 150 other members, to be appointed by the Chief Executive. At present, the
BOR is composed of one chairperson, 8 deputy chairpersons and 64 members. These numbers
may change from year to year.

Generally, one of the primary functions of the BOR is to conduct hearings on tax appeals
that have been lodged with the Commissioner. During such hearings, the BOR should have at
least three members present, including the chairperson or deputy chairperson, where they will
make such determination as part of the hearing process. A decision is normally made based
on majority votes. However, where there is a deadlock, the member presiding the hearing is
entitled to a casting vote, in addition to his or her original vote, in order to resolve a deadlock.

Once the appeal has been heard by the BOR, the presiding chairperson is required to
provide the BOR’s decision in writing. Where the Commissioner or the appellant disagrees with
the BOR’s determination, the BOR is required to state a case on question of law for further
deliberation by the Court of First Instance.

Taxpayers should note that the BOR’s decision is final with regards to that particular case
only. So if other taxpayers are trying to rely on a case decided by the BOR, the outcome may be
different should there be different facts and assumptions made. In addition, the decision made
by the BOR on a particular case is not binding on other BORs of Review cases. However, a case
that has been decided by a higher court such as Court of Final Appeal is binding to all lower
courts except where a court is able to determine that the previous decided case is obscure or
not consistent with a fundamental principle of the law, among other things.

2.1.2.1 Functions and Procedures

When a taxpayer disagrees with the assessment issued by the Commissioner, he or she has the
right to file an objection against such an assessment within the stipulated time period, which is
usually one month as required under s.64(1).

In the event that the taxpayer disagrees with the Commissioner’s determination of its
objection, the taxpayer (also known as the appellant) may lodge an appeal to the BOR within
one month from the date of issuance of the Commissioner’s determination as required
under s.66.

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The notice of appeal must be accompanied by a copy of the Commissioner’s written

determination and statement of the grounds of appeal.

2.1.2.2 Notice of Hearing
On receipt of a notice of appeal, the clerk is required to fix a time for the hearing of the
appeal and give 14 days’ notice to the appellant and the Commissioner. At any time before the
hearing of an appeal, the appellant may withdraw the appeal by notice in writing addressed
to the clerk; or the appellant and the Commissioner may reach a settlement on the amount
at which the appellant is liable to be assessed. Where a settlement of an appeal is reached,
the terms of the settlement is required to be adjusted accordingly in writing and signed by the
appellant and the  Commissioner. The settlement is required to be submitted to the BOR for
endorsement.

2.1.2.3 Delivery of Board of Review Decisions

After hearing an appeal, the BOR is required to deliver the decision in writing. The BOR may
confirm, reduce, increase or annul the assessment appealed against or may remit the case to
the Commissioner for re-assessment.

Where the BOR does not reduce or annul such assessment and believes that the appeal
has been conducted with intent to frustrate or abuse the process, the BOR may, at its sole
discretion, order the appellant to pay as costs of the BOR a sum not exceeding HK$25,000 that
is required to be added to the tax charged.

2.1.2.4 Appeal to the Decision of the Board

Where a party is aggrieved by the Board’s decision on a question of law, it may make an
application for leave to appeal the decision of the Board to the Court of First Instance of
the High Court (s.69 of the IRO) or leapfrog the appeal to the Court of Appeal (subject to the
conditions set forth in s.69A of the IRO).

Such application for leave must be:

1. Made in writing setting out the grounds of the appeal, identifying and stating precisely
the question of law involved in each ground;

2. Accompanied with a copy of the decision of the Board against which leave to appeal
is sought;

3. As concise as is practicable and avoid repeating matters already set out in the decision
of the Board;

4. Signed by counsel and solicitors if it has been prepared by them, or by the applicants
themselves if they have not engaged legal representative; and

5. Lodged with a registrar of the High Court and served on the other party (i.e. the
appellant or the Commissioner as the case may be) within one month after the date on
which the Board’s decision is made or (if the Board’s decision is notified to the appellant
or the Commissioner by notice in writing) the date of communication by which the
Board’s decision is notified.

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Knowledge Check Questions

Question 1
Mr. Chia works as a field auditor with the IRD. While conducting an audit into the business
of Birdnest Trading (HK) Company (Birdnest), Mr. Chia came across the payroll records
of Birdnest executives. Mr. Chia informed his wife and distant relatives in Singapore
on how much these executives were paid annually. Identify which of the following
statements is true.
A It is acceptable for Mr. Chia to share such information with his wife and distant relatives
in Singapore since they do not know these executives personally.
B Mr. Chia believes such information is not confidential so he is permitted to share
with others.
C Mr. Chia is permitted to share such information with his wife and relatives since they
have promised to keep it confidential at all times.
D Mr. Chia is only permitted to share such information with the taxpayers or their
authorised representatives.

Question 2
Identify which of the following constitutes a PE in Hong Kong under the DTA definition.
A A frequent traveller to Hong Kong who always stays in the same hotel while
in Hong Kong
B A non-resident businessperson who visits Hong Kong four times per year to meet with
customers and suppliers in Hong Kong. Each visit lasts for five business days
C A purchasing manager from a German company who visits Hong Kong regularly to solicit
orders and sign purchase contracts with customers while in Hong Kong
D An engineer from China who visits Hong Kong regularly to attend trade conferences

2 . 2
OBLIGATIONS OF A TAXPAYER AND
OTHER PARTIES

It is the duty of every person who carries on a business in Hong Kong, or derives income
from Hong Kong, to file a complete and accurate tax return. The IRD would initially rely on
a taxpayer’s tax returns in order to raise the tax assessment. Therefore, the taxpayer is
responsible for maintaining proper and complete records in respect of businesses and other
income-earning activities. The taxpayer may be required to furnish returns and provide
information or documents within a reasonable time.

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2.2.1 The Taxpayer’s Obligations

Generally, every person who carries on business in Hong Kong and is chargeable to tax must
inform the Commissioner no later than four months from the end of the basis period for that
particular year of assessment. For example, ABC HK Ltd, a newspaper publishing company, was
incorporated on 1 April 2018 and has its first year end to 31 March 2019. ABC HK Ltd generates
sales and advertising revenue from the sale of its newspapers. In this case, ABC HK Ltd is
required to inform the Commissioner in writing no later than 31 July 2019 that it is chargeable
to Hong Kong tax. This would facilitate the Commissioner in issuing the relevant profits tax
return to ABC HK Ltd on a timely basis.

In addition to furnishing the return correctly and in time, such person is required to keep
proper business records (in either English or Chinese) and retain them for seven years from the
transaction date. This would facilitate the IRD to ascertain such a person’s assessable profits
in the event of a tax audit. Failure to do so would result in a fine of up to HK$100,000. This
requirement of keeping proper business records can be found under s.51C.

The meaning of ‘records’ is defined under s.51C(3) and (4), which includes the following:

• Books of account that shows income and expenditures;

• Supporting documents like invoices, receipts, bank statements;

• Assets and liabilities of the business;

• Daily records of all cash inflow and outflow relating to the business;

• Updated list of debtors and creditors; and

• Inventory balances at year end.

In this age of modern technology, most businesses keep their business records in an
electronic format. However, the IRD still accepts paper-based method in retaining business
records provided they are legible and well organised.

With regards to property owners who own land and buildings in Hong Kong and generate
rental income from such property, they are also required to keep proper business records in
accordance with s.51D(1) for at least seven years from the completion date of the transaction,
unless they have received approval in writing from the Commissioner that such records need
not be preserved.

The obligations of a taxpayer under the IRO are shown in Exhibit 2.5.

Section Obligation Penalty Penalty that may be imposed by

provision courts for non-compliance
51(1) To complete returns within the 80 (1) A fine at level 3 and a further fine not
time limit as requested in the and (2) exceeding 300% of tax undercharged or
notice from an assessor in writing. would have been undercharged.
(If there is no prosecution, the
Commissioner, or a Deputy Commissioner,
may raise an additional tax assessment
(not exceeding 300% of tax undercharged
or would have been undercharged) under
s.82A. Alternatively, the Commissioner may
compound the offence.)

EXHIBIT 2.5 Common examples of obligations of taxpayers and penalties for non-compliance

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Section Obligation Penalty Penalty that may be imposed by

provision courts for non-compliance
51(2) To notify the Commissioner in 80(2) A fine at level 3 and a further fine not
writing of his or her chargeability exceeding 300% of tax undercharged or
for tax not later than four would have been undercharged.
months after the end of the (If there is no prosecution, the
basis period in which the income Commissioner, or a Deputy Commissioner,
was derived. may raise an additional tax assessment
(not exceeding 300% of tax undercharged
or would have been undercharged) under
s.82A. Alternatively, the Commissioner
may compound the offence.)
51(3) To furnish a fuller or further 80(1) A fine at level 3 and court order for
return as may be requested. compliance within the time specified in
the order.
(Alternatively, the Commissioner may
compound the offence.)
51(6) To notify the Commissioner in 80(1) A fine at level 3 and court order for
writing, of his or her cessation compliance within the time specified in
of income, within one month of the order.
such cessation. (Alternatively, the Commissioner may
compound the offence.)
51(7) To notify the Commissioner in 80(1) A fine at level 3 and court order for
writing, of his or her departure compliance within the time specified in
from Hong Kong for any period the order.
exceeding one month, not later (Alternatively, the Commissioner may
than one month before the compound the offence.)
expected date of departure.
51(8) To notify the Commissioner in 80(1) A fine at level 3 and court order for
writing of his or her change of compliance within the time specified in
address within one month of the order.
such change. (Alternatively, the Commissioner may
compound the offence.)
51C To keep record of business 80(1A) A fine at level 6 and court order for
income and expenditure for a compliance within the time specified in
period not less than seven years. the order.
(Alternatively, the Commissioner may
compound the offence.)
51D To keep record of property 80(1) A fine at level 3 and court order for
income for a period not less compliance within the time specified in
than seven years. the order.
(Alternatively, the Commissioner may
compound the offence.)

EXHIBIT 2.5 Common examples of obligations of taxpayers and penalties for non-compliance

(Continued)

2.2.2 The Employer’s Obligations

Under the IRO, employers are required to keep payroll records of their employees and report
remuneration paid to each employee within a designated time.

Employers have to maintain payroll records of their employees and keep these records for
at least seven years.

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On hiring, employers have to maintain a record of all employees, such as:

• Personal particulars (e.g. name, address, identity card number, marital status);

• Nature of employment (e.g. full-time or part-time);

• Capacity in which employed (e.g. shop manager, clerk, director);

• Amount of cash remuneration (including remuneration paid overseas);

• Non-cash and fringe benefits (e.g. share award, share option, quarters);

• Employer’s contributions to the Mandatory Provident Fund (MPF) or its equivalent;

• Employee’s contributions to the MPF or its equivalent;

• Employment contract and amendments to terms of employment; and

• Period of employment.

Employees should inform their employers of any changes of personal particulars such as
change of address, marital status, and etc.

During the course of employment, employers have to inform the IRD on the following:

• Any change in the employee’s personal particulars;

• Any change in the employee’s terms of employment; and

• The Hong Kong identity card number of the employees (who did not have an HKID Card
at the time of employment).

The obligations of an employer under the IRO are shown in Exhibit 2.6.

Section Obligation Penalty Penalty that may be

imposed by courts
for non-compliance
52(2) To furnish an employer’s return within the time 80(1) A fine at level 3 and court
limit as requested in the notice from an assessor order for compliance
in writing. within the time specified
in the order.
52(4) To notify the Commissioner in writing of the 80(1) Same as above.
commencement of employment of an employee
chargeable to tax not later than three months after
the date of commencement of employment.
52(5) To notify the Commissioner in writing of the 80(1) Same as above.
cessation of employment of an employee
chargeable to tax not later than one month before
the expected date of cessation of employment.
52(6) To notify the Commissioner in writing of the 80(1) Same as above.
departure of an employee chargeable to tax from
Hong Kong for more than one month not later than
one month before the expected date of departure.
52(7) To withhold payment of money to the employee, 80(1) Same as above.
who has ceased or is about to cease to employ in
Hong Kong and is leaving Hong Kong, for a period
of one month from the date of serving a notice to
the Commissioner under s.52(6).

EXHIBIT 2.6 Obligations and penalties for employers

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2.2.2.1 Reporting of Remuneration Paid to Employees to the IRD

For the purpose of salaries tax assessment, employers need to report the remuneration
paid to employees to the IRD, within one month from the date of issue, by submitting annual
Employer’s Returns (BIR56A and IR56B).

Further details on what types of income, in addition to an employee’s remuneration, are

included in salaries tax assessment can be found in Chapter 4.

1. Continuous employment

It is the obligation of an employer to report employees’ remuneration on the Employer’s

Return (BIR56A and IR56B).

2. New employment

For a new employee, an employer is required to furnish Form IR56E to the IRD within three
months, with particulars of such employee, for the purpose of salaries tax assessment.

3. Termination of service (or death)

In the event of death or termination of service of an employee, an employer has the

obligation to notify the IRD by submitting Form IR56F, not later than one month before
the employment cessation date or upon the death of an employee.

4. Employee leaving Hong Kong for good or for a substantial period of time

Where an employee intends to leave Hong Kong permanently or for a substantial

period of time, the employer is required to notify the IRD by submitting Form IR56G, at
least one month before the expected date of departure.

This does not apply to persons who are required to leave Hong Kong frequently
in the course of their employment, business or profession. Therefore, it is the
responsibility of the employers to determine whether the employee leaving their
employment intends to leave Hong Kong permanently or otherwise.

For employees who leave Hong Kong, upon leaving their employment the employer
is required to withhold any payments of money to the employee for a period of one
month from the date on which the notification was given, or until a ‘letter of release’ is
received from the IRD, whichever is earlier.

For ease of learning, this can be summarised as in Exhibit 2.7.

Employment Form to Statutory period Reference in Remarks

condition complete for notification Inland Revenue
Ordinance (IRO)
Commencement IR56E Within three months s.52(4) Both IR56E and IR56B
of employment after the date of are required for the
commencement of commencement year
employment
Still under IR56B Within one s.52(2) Must be submitted
employment as month from the annually together
at 31 March date of issue with a BIR56A

EXHIBIT 2.7 Summary of statutory obligations of an employer to report remuneration paid to

an employee

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Employment Form to Statutory period Reference in Remarks

condition complete for notification Inland Revenue
Ordinance (IRO)
Cessation of IR56F Not later than s.52(5) IR56B for the
employment one month cessation year is
before cessation not required
Departure IR56G Not later than s.52(6) and s.52(7) IR56B for the
from Hong Kong one month before cessation year is
departure and to not required
withhold money for
tax clearance

EXHIBIT 2.7 Summary of statutory obligations of an employer to report remuneration paid to

an employee (Continued)

Apply and Analyse 1

Mr. Cheung owns and operates Goldenshoe HK Ltd, which is a retail store in Hong Kong
selling sports shoes. Due to the expansion of the business, Mr. Cheung decides to hire
additional sales staff. During the same year, Mr. Tan, who has worked at the store for the
past 40 years, has decided to retire at the end of September 2018 and will visit his family in
mainland China thereafter.

Analysis

In addition to keeping the proper business records regarding his employees, Mr. Cheung
needs to be aware of his reporting obligations as an employer to the IRD, with regards to
the new hires as well as the retired employee (Mr. Tan).

Mr. Cheung is also required to file an annual employer’s return in respect of each
employee every year.

With respect to Mr. Tan, Mr. Cheung is also required to file a cessation notice to the IRD
not later than one month before Mr. Tan’s retirement and to withhold any money payable
to Mr. Tan for one month from the date on which Mr. Cheung gave the notice to the IRD,
unless written consent from the IRD is received.

2.2.2.2 Payments to Non-incorporated Service Providers

For small and medium businesses, it is generally a common practice that they do not have
many employees in order to control the overhead costs, but instead rely on the support and
services provided by service providers who are unincorporated persons. In such a situation,
there is a requirement for the business to report the payments made to such service providers
by using Form IR56M upon request. Examples of such unincorporated persons are consultants,
agents, brokers, subcontractors and freelance artists or performers.

In order to maintain the cost effectiveness of this reporting requirement, the IRD requires
such businesses to report the payment made to such persons under the following circumstances:

• For subcontractors, payment in excess of HK$200,000 per annum; or

• For consultants, agents, brokers, subcontractors and freelance artists or performers,

payment in excess of HK$25,000 per annum.

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The reporting period is from 1 April to 31 March of the following year. However, if a
business’ financial period does not end on 31 March, it is required to prorate the amount paid
for the period from 1 April to 31 March of the following year to be in line with an individual’s
year of assessment.

Key Learning Point

When an individual is carrying on a business in Hong Kong, either through an incorporated
company or otherwise, it is important to understand the reporting obligations as an
employer with respect to hiring new employees as well as those employees who decide to
retire or leave their current employment. Employers are expected to keep proper business
records of employees and their business.

2.2.3 Returns
Pursuant to s.51(1) of the IRO, an assessor may give notice to any person in writing, requesting
that person, within a reasonable time stated in the notice (normally one month), to furnish a
return that may be specified by the Board of Inland Revenue for:

• Property tax, salaries tax or profits tax; or

• Property tax, salaries tax and profits tax (i.e. a composite tax return).

Those are the profits tax return, property tax return and composite tax return – individuals.

Normally, the IRD will issue tax returns to taxpayers in April every year. After the taxpayers
complete and file the tax returns with the supporting documents, the IRD would issue a
notice of assessment (NOA) showing the amounts of tax assessed, tax payable or refund.
Notwithstanding that the IRD may issue a NOA which is in line with the tax return filed by
taxpayers, the IRD may select cases at a later date to conduct desk audit, field audit, an
in-depth investigation. This is the Assess First Audit Later (AFAL) system used by the IRD. These
will be discussed in more detail in this and the following sections.

For the purpose of this section, we will focus our attention on profits tax returns relating to
corporations, unincorporated business or sole proprietorships.

Taxpayers should note that it is a serious offence to submit an incorrect return without any
reasonable excuse. The person who is an authorised signatory to the tax return has to declare
that all the information contained in the return is true, correct and complete to the best of their
knowledge.

2.2.3.1 The Taxpayer’s Return

There are three types of Profits tax return forms. These are:

1. Profits tax return – Corporations (BIR51);

2. Profits tax return – Persons other than corporations (BIR52); and

3. Profits tax return – In respect of non-resident persons (BIR54).

Taxpayers are required to submit a complete tax return by providing accurate

information and documents as prescribed in the returns, including the notes and instructions
accompanying the returns.

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For corporations, the documents required are:

1. A certified copy of the Statement of Financial Position, the Auditor’s Report where
required by Hong Kong or foreign law (or has otherwise been prepared) and the
Statement of Profit or Loss and Other Comprehensive Income (sometimes loosely
called an income statement or profit or loss statement) in respect of the basis period;

2. A tax computation with supporting schedules showing how the amount of assessable
profits (or adjusted loss) has been arrived at; and

3. Other documents and information as specified in the Notes and Instructions.

Where a corporate taxpayer falls under the following situations, audited accounts are not
required to be prepared:

• Where statutory audit is not required in the country where the company is incorporated
and there has been no audit performed previously;

• The company is dormant as defined under the relevant Companies Ordinance (s.5, 447,
611 and 633); or

• The company is being or has been liquidated.

The profits tax returns (Form BIR 51 and Form BIR 52) require the taxpayers to provide
the taxpayer’s particulars, its tax data and financial data as well as details of the tax
representatives, and etc. The return should be signed by the taxpayer’s authorised person.

For unincorporated businesses or sole proprietorship, the documents required are:

1. A certified copy of the Statement of Financial Position/Balance Sheet and the Statement
of Comprehensive Income/Profit and Loss Account in respect of the basis period;

2. A tax computation with supporting schedules showing how the amount of assessable
profits (or adjusted loss) has been arrived at; and

3. Other documents and information as specified in the Notes and Instructions.

A sole proprietor carrying on a business in Hong Kong has to file a tax return (Form BIR 60)
for every year of assessment.

Concession for Small Corporations and Businesses

A concession has been granted to small corporations and businesses to allow them not to
submit the supporting documents above when filing their returns. However, it is important to
note that these documents must still be prepared before completion of the return and may be
called for by the IRD in appropriate circumstances.

A ‘small corporation or business’ is where total gross income does not exceed HK$2 million
for the basis period of a year of assessment, including but not limited to:

• All types of income, including sales and other ordinary business income;

• Sales income from closely connected persons;

• Proceeds from sale of capital assets; and

• Other non-taxable income whether it is derived from the principal business activity or
otherwise.

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Apply and Analyse 2

Based on the Opening Case, we now have been advised that Mrs. Johnson started her
business on 1 October 2015 and her first set of accounts was made up to 30 June 2016.
As it was her first year of operation, Mrs. Johnson’s business only generated a total gross
income of HK$500,000. In order to save administration costs, Mrs. Johnson intended to
file the tax return on her own, but she was unsure of her tax filing obligations. You are a
certified public accountant (CPA) and happen to be her good friend. Mrs. Johnson has now
asked you for advice regarding her tax filing obligation.

Analysis

There are a number of issues to consider:

1. Which type of form to use as a sole proprietor?

2. What is the first year of assessment?

3. What are the documents that must accompany the tax return? Are there any
exemptions from filing these supplementary documents?

In this case, Mrs. Johnson has to file Form BIR 60 as a sole proprietor. Since it was her
first year of assessment, the IRD generally issues the first tax return about 18 months after
the registration of the business. Mrs. Johnson should expect to receive her first tax return
on or around 31 March 2017. However, if Mrs. Johnson has assessable profits during her
first year of assessment, she is required to notify the IRD within four months after the end
of the basis period for that year of assessment.

Based on the preceding information, Mrs. Johnson’s first year of assessment is

2016/17, which relates to the basis period of 1 October 2015 to 30 June 2016. Assuming
Mrs. Johnson has assessable profits in the year of assessment 2016/17, she would be
required to notify the IRD by 31 October 2016.

Generally, for unincorporated businesses or sole proprietorship, the documents that

need to be submitted are:

1. A certified copy of the Statement of Financial Position/Balance Sheet and the

Statement of Comprehensive Income/Profit and Loss Account in respect of the
basis period;

2. A tax computation with supporting schedules showing how the amount of

assessable profits (or adjusted loss) has been arrived at; and

3. Other documents and information as specified in the Notes and Instructions.

However, since Mrs. Johnson’s total gross income for year of assessment 2016/17
is less than HK$2 million, she is exempted from the requirements above, but is advised
to keep all the business records in the event that the IRD requests to examine those
documents (s.51C of the IRO refers).

2.2.3.2 The Employer’s Return

As mentioned in Section 2.2.2, a company carrying on business in Hong Kong is obliged to file
Form IR56B (known as Employer’s Return of Remuneration and Pensions) for all its employees,

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irrespective of whether the employee rendered services in or outside Hong Kong, so long as
their total income exceeded the limit as laid down in Note 1(a) of Notes and Instructions for
forms BIR56A and IR56B.

Form BIR56A is a disclosure and declaration form by the authorised representative of the
company that hires employees working in Hong Kong. When submitting to the IRD, this form is
accompanied by Form IR56B, which provides the personal information and relevant details of
each employee’s compensation package for that particular year of assessment.

Sample copies of Form BIR56A and IR56B with notes can be found at https://www.ird.gov.hk/
eng/pdf/bir56a_completion_e.pdf and https://www.ird.gov.hk/eng/pdf/ir56b_completion_e.pdf
respectively.

2.2.4 Obligations of Other Parties Under the Inland Revenue Ordinance

We will discuss the obligations of an agent, trustee, executor and tax advisor in this section.

2.2.4.1 Obligations of an Agent
Pursuant to s.2 of the IRO, an agent, in relation to a non-resident person or to a partnership in
which any partner is a non-resident person, includes:

1. The agent, attorney, factor, receiver or manager in Hong Kong of such person or
partnership; and

2. Any person in Hong Kong through whom such person or partnership is in receipt of any
profits or income arising in or derived from Hong Kong.

It is important to note that the statutory definition of an ‘agent’ is broader than it is in

commercial law. Notwithstanding that the agent has received profits or otherwise, where such
profits arose from, or are derived from Hong Kong, by a non-resident, any tax owing may be
recovered out of the assets of the non-resident or from the agent. Therefore, the agent is
required to withhold from the assets sufficient money to pay the tax.
The resident person, also known as the withholding agent, who pays or credits such sums is
required at the time that he or she makes the payment or credit to deduct from those sums an
amount sufficient to meet the tax due.

2.2.4.2 Obligations of a Trustee
Pursuant to s.2 of the IRO, a trustee includes any trustee, guardian, curator, manager or other
person having the direction, control or management of any property on behalf of any person,
but does not include an executor. Persons who are not normally trustees at law may therefore
fall within the scope of this definitional provision.

Some of the examples of a trustee’s obligations are:

• Holds the legal title to the trust property;

• Administers and deals with the trust property for the benefit of the beneficiaries,
including property tax issues;

• Report the account information and the financial activity for the year in respect of each
reportable account for the purpose of AEOI (automatic exchange of information).

Pursuant to s.53 of the IRO, where an incapacitated or non-resident person is required

to act or perform certain actions as required by or under this ordinance, a trustee has to be

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appointed, and such act or performance must be done by the trustee of such incapacitated
person or by the agent of such non-resident person, as the case may be.

It is important to note that ‘incapacitated person’ means ‘any minor, lunatic, idiot or person
of unsound mind’ (s.2 – in other words, anyone who is not sui juris at law).

2.2.4.3 Obligations of an Executor
Pursuant to s.54 of the IRO, the executor of a deceased taxpayer’s estate is obliged to handle
the deceased’s tax affairs. S.2.1 of the IRO defines ‘executor’ as ‘any executor, administrator
or other person administering the estate of a deceased person and includes a trustee acting
under a trust created by the last will of the author of the trust’.

The executor of a deceased taxpayer has obligations to:

• Manage the tax affairs of the deceased taxpayer, including the submission of tax returns;

• Provide relevant information as requested by the IRD; and

• Pay tax bills in a timely manner.

The executor is required to submit the deceased’s tax return (Form BIR60) relating to
salaries income or profits from a sole proprietorship business earned prior to death.

For the purpose of this chapter, we will outline the filing obligation of the executor relating
to salaries income, income from sole proprietorship and partnership prior to the death of
the taxpayer:

• Reporting salaries income earned before death

In the tax return for the year of death, where the deceased taxpayer received
employment income, including any accrued amount such as accumulated leave pay
and year-end bonus that were not received at the time of death, the executor has the
obligation to include all such income in the deceased’s final tax return for the period
from 1 April of the relevant year to the date of death of the deceased.

• Reporting profits earned before death

° Sole proprietorship business

The profits/losses of a sole proprietorship business are to be reported in the Tax

Return – Individuals form.

If the deceased operated a sole proprietorship business, the business would be

regarded as ceased on death. The executor should declare the assessable profits
and supply other relevant information for the period from the commencement of
the latest accounting period to the date of death of the deceased in the deceased’s
Tax Return – Individuals form.

Where there is a successor to the business, the successor would be treated as

operating a new business by the same business name. The successor should apply
for a new business registration certificate as soon as possible. The IRD will issue a
tax return to the successor in due course in the usual manner.

° Partnership business

The profits/losses of a partnership business should be reported by the precedent

partner in a Profits tax return (BIR52). Pursuant to s.2 of the IRO, ‘precedent partner’

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is the one first named in the partnership agreement. If there is no agreement, he

or she will be the first named in the usual partnership name or in any statutory
document such as the Business Registration Certificate.

A partnership business will not cease on the death of a partner and the
deceased partner is merely treated as having retired from the partnership. The
Business Registration Office has to be informed of such change of partners within
one month.

If the executor does not wish to elect for personal assessment on behalf
of the deceased taxpayer, there is no need to furnish any information relating
to the deceased’s share of profits in any partnerships in the deceased’s Tax
Return – Individuals form.

If personal assessment is elected on behalf of the deceased in the deceased’s

tax return, the executor should ‘check the box’ in Part 6(1) of the BIR60 to signify the
election. When the deceased’s share of profits/losses is ascertained, that amount
as well as the deceased’s income from other sources will be aggregated to compute
the personal assessment tax. Further details on personal assessment, elections and
tax implications can be found in Chapter 4.

2.2.4.4 Obligations of Tax Advisor

The Hong Kong domestic and international tax environments are changing rapidly as a result of
coordinated efforts by governments around the world to prevent the erosion of their respective
tax revenues. Such initiatives include the BEPS (Base Erosion and Profit Shifting) legislation in
Hong Kong – The Inland Revenue (Amendment) (No. 6) Ordinance 2018 gazetted on 13 July 2018.

In view of the developing tax landscape, both in Hong Kong and around the world, it is
important for taxpayers in Hong Kong to ensure that they are able to meet their tax reporting
obligations in accordance with the prevailing Hong Kong IRO, including but not limited to the
various DIPNs issued by the IRD.

In this regard, it is common for taxpayers, particularly those involved in complex

transactions, either domestically or internationally, to engage the services of a licenced
professional tax advisor. Such an advisor could either be an individual, small boutique CPA firm
or international CPA firm.

Although each may differ on the types of services offered, each has common
responsibilities and obligations to ensure that clients report their tax affairs accurately, timely
and in accordance with the prevailing tax legislations.

In addition, from time to time, tax advisors are also involved in providing tax planning
strategies as requested by their clients in order to operate their business in the most tax efficient
manner. To this extent, there are sufficient commercial reasons that drive certain tax minimisation
strategies without having any intention to evade taxes. The IRD generally would accept the
implementation of such transactions provided that relevant supporting documents are made
available when requested and the IRD is satisfied that they were not tax motivated transactions.

Where a tax advisor has been appointed as the authorised representative by a taxpayer in
the event of a tax audit, the advisor would be required to cooperate fully with the information
requested by the IRD and to provide such documentation in a timely manner, particularly
where the relevant year of assessment is going to be statute-barred.

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2.2.4.5 Formal Request for Information Under s.51(4)

Pursuant to s.51(4) of the IRO, the assessor has a broad range of power to obtain full
information from any person under this ordinance, including the taxpayer if the assessor
believes that such person may hold certain information or documents that would assist the
assessor in determining the tax liability of a person.

The letter issued by the assessor for the purpose of collecting the required information is
called a formal notice. Generally, such a notice is issued when a person fails to answer or supply
information in relation to the assessor’s letter within the specified time limit. If a person does
not comply with a formal notice, the IRD may commence prosecution proceedings against him
or her. Examples of such information include books of accounts, customer and supplier trade
lists, inventory lists, cash vouchers, bank statements and other legal documents as appropriate.

In the event that the taxpayer does not provide the required information to the assessor on
a timely basis, an estimated assessment may be issued by the assessor instead of commencing
prosecution proceedings, which can be time-consuming and costly for both parties.

Knowledge Check Questions

Question 4
In view of Mrs. Johnson’s growing business where the gross income exceeded HK$2 million,
her tax advisor advised her to incorporate her sole proprietor business into a corporation
in order to limit her legal liability. Once the business is incorporated, Mrs. Johnson is not
sure which of the following documents must accompany a corporation’s tax return in the
first year.
(I) An audited financial statement in respect of the basis period.
(II) A tax computation with supporting schedules showing how the amount of assessable
profits (or adjusted loss) has been arrived at.
(III) Other documents and information as specified in the Notes and Instructions.

Identify which statement below is correct.

A Since this is the first year where the sole proprietorship is converted into a corporation,
only II and III are required.
B Only I and II are required.
C All are required.
D Only II is required.

Question 5
Mr. Tang informed Mrs. Johnson on 30 April 2018 that he planned to retire on 30 June
2018. Identify Mrs. Johnson’s reporting obligation to the IRD.
A Mrs. Johnson should inform the IRD no later than one month prior to 30 June 2018 by
filing Form IR56B.
B Mrs. Johnson should inform the IRD as soon as Mr. Tang advised her about his plan to
retire from his employment, but she is not required to submit any form to the IRD.
C Mrs. Johnson should file Form IR56F no later than 30 May 2018.
D Mrs. Johnson should file both Form IR56B and IR56F no later than 30 May 2018.

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2 . 3
ASSESSMENTS AND PAYMENT

In April 2001, the IRD introduced a new assessment system called ‘Assess First, Audit Later’ or
commonly known as AFAL, which essentially allows the IRD to use its computer programme to
screen tax returns and process any assessments thereof.

Under the AFAL system, the IRD would not review the tax returns immediately. Instead, if
the tax returns fulfil certain preset conditions set out under the AFAL programme, the IRD will
issue Profits Tax Assessments/Statements of Loss to the taxpayers first. In addition, these tax
returns may be selected for desk audit/field audit/investigation at a later date.

2.3.1 Time Limit to Raise Assessment

Under s.59(1) of the IRO, an assessor is required to assess every person (who is in the opinion
of an assessor chargeable with tax under the IRO) as soon as the time limited by the notice
requiring them to furnish a return under s.51(1) (i.e. Returns and Information to be furnished)
has expired.

Notwithstanding the time limitation, an assessor is given the authority and discretion
to raise an assessment or additional assessment if he or she is of the view that the relevant
person is about to depart from Hong Kong or believes it is appropriate to do so.

Under s.60(1) of the IRO, an assessor may raise an assessment or an additional assessment:

• Within the year of assessment;

• Within six years after the year of assessment; or

• Within ten years after the year of assessment if the non assessment or under
assessment is due to fraud or wilful evasion.

In the case that a taxpayer sustained a loss in a year of assessment instead of having an
assessable profit, the loss could be carried forward and set off against the future assessable
profits from the same trade, profession or business for subsequent years of assessment.
The IRD will issue a statement of loss in this case to show the aggregate amount of loss
carried forward.

Since a statement of loss is not considered as an assessment, the above six-year time
limit does not apply to issuance or revision of a statement of loss. Technically, a tax loss year
remains open (i.e. subject to review by the IRD) until the sixth year after the first year in which
the taxpayer has an assessable profit after utilising all the tax losses brought forward.

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In the case of a deceased taxpayer, s.54(b) of the IRO provides that when a person died
before 11 February 2006 no assessment or additional assessment can be raised after:

• One year from the date of death; or

• One year from the date of filing any affidavit required under the Estate Duty Ordinance;

Whichever is the later.

Pursuant to s.54(b) of the IRO, no assessment or additional assessment can be issued after
the expiry of three years immediately after that year of assessment relating to a person who
dies on or after 11 February 2006.

Where the statute of limitation has expired (i.e. time-barred), in normal circumstances no
assessment will be raised by the IRD under s.60. For example, no additional assessment for
2013/14 can be raised on an ordinary taxpayer after 31 March 2020. However, it should be
noted that there is no such time limit for assessment raised under s.59.

2.3.2 Notice of Assessment and Demand for Payment

Pursuant to s.62(1), the Commissioner has the right to issue a notice of assessment (NOA) to
taxpayers after the IRD has ascertained the amount to be assessed on the taxpayers. Generally,
the NOA issued will indicate the amount assessed, tax charged and due date for payment which
taxpayers are required to pay.

For taxpayers with significant assessable income in the current year of assessment, the
IRD generally would issue a demand of provisional tax that is based on the assessable income
of the preceding year of assessment. A sample of the demand of provisional tax is shown in
illustrative example 2.

Generally, the tax payment is payable in two instalments which usually fall between
November of the year in which the return is issued and April of the following year. These due
dates are specified in an assessment notice that are determined by the Commissioner.

A system of provisional tax payments applies whereby estimated tax payments are made
during the current year. In most cases, 100% of the final tax for the current year of assessment
plus 75% of the provisional tax for the next year of assessment are payable on the first due
date and the balance of 25% of the provisional tax is payable on the second due date on the
basis that the 75% provisional tax is settled on or before the first due date. The provisional tax
for the current year of assessment already paid in the previous year is credited against the
final profits tax assessed for the current year of assessment, which is determined after filing of
the return.

For example, for a company with an accounting year-end date of 31 December, the NOA to
the company for a given tax year is usually issued in November of the year in which the return
is issued. The tax payments (to be paid in two instalments) are usually due in January and April
of the next year.

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Illustrative Example 1
For salaries tax purposes, the IRD issued a tax return to Mr. Cheung for the year of
assessment 2018/19 in May 2019 to report his net chargeable income of HK$800,000 for
the year ended 31 March 2019.

Sometime in September 2019, the IRD issued a notice of assessment demanding

payment of:

• Final tax for 2018/19; and

• 2019/20 provisional tax computed by reference to his net chargeable income of

HK$800,000 for 2018/19.

Mr. Cheung is allowed to pay the 2019/20 provisional tax by two instalments. The
purpose of the provisional tax payment system is to ensure that tax is not paid on
unearned income.

The first instalment is calculated at 100% of the amount of 2018/19 final tax and 75%
of the amount of 2019/20 provisional tax when such payment will fall due during the
period January to March 2020. The remaining 25% of the 2019/20 provisional tax will be
due for payment as the second instalment during the April to June 2020 period.

In other words, by the time Mr. Cheung is required to pay the 75% of 2019/20
provisional tax, he has already earned 75% of his income (i.e. for the months of April to
December 2019) for the year ending 31 March 2020. Similarly, when Mr. Cheung pays the
remaining 25% of the 2019/20 provisional tax, he has earned the remaining 25% of his
income (i.e. for the months of January to March 2020). Please see the below timeline for
greater clarity.

YA 2018/19 YA 2019/20
Net CI = HK$800,000

1 April 2018 31 March 2019 31 December 2019 31 March 2020 30 June 2020

Issue assessment Payment Payment

2018/19 2018/19 25% of
Final Tax and Final Tax and 75% 2019/20
2019/20 of 2019/20 Provisional Tax
Provisional Tax Provisional Tax

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Apply and Analyse 3

Peter has worked for ABC Hong Kong Ltd for many years. He received his 2017/18
composite tax return dated 2 May 2018, but as he was very busy with his work, he
forgot to file the return. On 18 September 2018, Peter received an estimated salaries tax
assessment for the year of assessment 2017/18.

Analysis

In this example, taxpayers should note the power of the assessor in raising an estimated
assessment in the absence of a tax return and other circumstances that are described
as follows.

Peter is required to file his tax return within one month from the issuance date of
the tax return (i.e. no later than 2 June 2018). Since he did not file his 2017/18 tax return,
the assessor has the authority to issue an estimated assessment on him.

Below are the circumstances under which an assessor can raise an estimated
assessment on a taxpayer:

1. Returns are not furnished by the taxpayer and the assessor believes that the
taxpayer is chargeable to tax under the Inland Revenue Ordinance (s.59(3)).

2. The taxpayer has filed the tax returns but they are not accepted by the assessor
(s.59(2b)).

There are situations where taxpayer has furnished such a return but it may be
considered insufficient to establish the tax payable based on the information given
or the assessor may be in disagreement with certain aspects of the return.

The assessor may issue an estimated assessment based on the information

available or by virtue of their past experience or by comparing with other similar
taxpayers.

3. The assessor is of the view that business accounts or books have not been
satisfactorily kept (s.59(4)).

When the assessor is of the opinion that the accounts or books maintained
by a trade or business are inadequate such that the returns are unreliable, the
assessor may assess the profits or income of such trade or business on the basis
of the usual rate of net profit on turnover of such trade or business. The usual rate
of net profit on turnover may be that prescribed by the Board of Inland Revenue
for particular classes of trade or business or an estimated rate as thought fit by
the assessor.

2.3.3 Payment of Taxes

Taxpayers can pay tax on or before the due date by various methods such as:

• Cash or cheque to the Collection Offices of the IRD or post offices;

• Tone phones;

• Internet (via the PPS system: http://www.ppshk.com/);

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• Bank automated teller machines (ATMs); and

• e-TAX accounts.

Notwithstanding the preceding options, the IRD often encourages taxpayers to use a tax
reserve certificate (TRC) for payment of tax to minimise their tax liabilities.

Presently, there are two types of TRCs:

1. The ordinary TRCs; and

2. The TRCs for ‘Conditional Standover Order’ (issued under objection cases).

Ordinary TRCs are now issued only in electronic form. Alternatively, TRCs for ‘Conditional
Standover Order’ are issued only in paper form.

Generally, when a taxpayer is objecting to an assessment raised by the IRD, a specified

amount of TRC may be purchased as a way of satisfying the potential tax liability as directed
by the CIR so that the tax in dispute can be held over conditionally. The sum purchased
will be applied to settle the tax in dispute or repaid to the taxpayer depending on the final
determination of the objection or appeal. Simple interest will be paid only in respect of the
capital sum eventually repaid to the taxpayer.

Knowledge Check Question

Question 6
Identify which of the statements below is correct.
A An assessor may raise an assessment or additional assessment at any time after the
taxpayer has filed the tax return for a specific year of assessment.
B An assessor does not have the right to raise an additional assessment when the
corporation has filed a tax return showing a tax loss.
C An assessor has the right to raise an assessment or additional assessment at any
time deemed appropriate when he or she believes there is an understatement of
assessable profit.
D An assessor has the right to raise an assessment or additional assessment within ten
years after the year of assessment if the non assessment or under assessment is due to
fraud or wilful evasion.

2 . 4
OBJECTION, HOLDOVER, APPEAL AND ERROR
OR OMISSION CLAIM

Upon receipt of the notice of assessment, taxpayers are advised to verify the amount of income
assessed, profits assessed, allowances and deductions allowed and the assessor’s note (if any)
to understand the basis of the assessment and the reasons of disallowing taxpayers’ claim for
allowances, deductions or inclusion of income.

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If taxpayers disagree with an assessment raised by the assessor, they may lodge an
objection with the Commissioner (s.64(1)).

The IRD has issued DIPN No. 6 (Revised), which outlines the objections and appeal process
where taxpayers do not agree with the IRD’s assessment. This process is outlined in the
following sections.

2.4.1 Objection Process

The notice of objection is required to:

• Be in writing;

• State precisely the grounds for the objection; and

• Be received by the Commissioner within one month after the issuance date of the
notice of assessment.

The Commissioner may consider accepting a late objection if the delay is caused by:

• Sickness;

• Absence from Hong Kong; or

• Other reasonable grounds.

Such reasons for the late objection should be clearly stated in the notice of objection or
Form IR831 accompanied by documentary proof as and when required by the Commissioner to
support the reasons for the late objections.

To object to an estimated assessment raised under s.59(3), a valid return has to be

filed together with the notice of objection within one month after the date of the estimated
assessment.

The taxpayer has the burden of proof to show that the assessment is incorrect or excessive.

On receipt of a valid notice of objection, the Commissioner is required to consider the same
and within a reasonable time may confirm, reduce, increase or annul the assessment to which
an objection was raised.

2.4.2 Holdover of Tax Payment Under an Objection

The general rule is that tax appeals in Hong Kong are to proceed on a ‘pay first, argue later’
basis. That means that a taxpayer disputing an assessment to tax is ordinarily required to pay
the tax demanded before the dispute is adjudicated, that is, according to the original due date
stated on the assessment. The Commissioner may, however, hold over the tax under objection
under s.71 of the IRO.

Conditional holdover is typically granted when the Commissioner considers the taxpayer’s
case to be relatively weak: the condition to the holdover is usually the purchase of tax reserve
certificates (TRC) in the amount of the tax demanded or some lesser amount agreed by the
taxpayer; otherwise, the taxpayer will be required to obtain a bank guarantee. In practice,
obtaining a bank guarantee is difficult and the fees charged by banks are usually high. In
most cases, the taxpayers have to purchase a TRC as they are unable to obtain a banker’s
undertaking, especially within the short period of time specified in the Conditional Standover

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Order. If the taxpayer’s appeal is successful, the TRC will be redeemed with nominal interest to
the taxpayer.

Unconditional holdover will generally be granted where the Commissioner is satisfied

that the taxpayer’s case is very strong on its merits and enables the taxpayer to progress the
dispute without first having to pay in the full amount of tax claimed by the Commissioner.

If, however, no TRC were purchased, any tax subsequently assessed payable by the
Commissioner, Board or higher court will be payable by the taxpayer plus interest at the
prevailing court rate (i.e. the judgement interest rate). Exhibit 2.8 shows a summary of the
holdover consideration by the Commissioner.

Conditional holdover Unconditional holdover

Taxpayer has a weak case or little merit in his or Taxpayer has a strong case and the likelihood of
her grounds for objection. succeeding in his or her objection is high.
Taxpayer is required to purchase TRCs or provide Taxpayer is not required to purchase TRCs or
a banker’s guarantee or undertaking. settle the tax owing until a revised notice of
assessment is issued by the Commissioner.
Taxpayer will earn interest on the TRCs if he or Taxpayer has to pay interest on the tax owing at a
she is successful in his or her objections and tax rate specified by the chief justice if he or she loses
assessed is discharged (around 0.25% p.a.). the case (around 8% p.a.).

EXHIBIT 2.8 Holdover considerations

2.4.3 Holdover of Provisional Tax Payment

As discussed in section 2.3.2, provisional tax is calculated based on the current year assessment
amount, taxpayer may apply in writing for a partial or complete holdover of provisional tax in
circumstances as in Exhibit 2.9.

Property tax Salaries tax Profits tax

N/A Entitlement to further allowances N/A
under Part 5 of the IRO.
Assessable value of the property Net chargeable income for Assessable profit for the
for the year is likely to be less the year is likely to be less year is likely to be less than
than 90% of the provisional than 90% of the provisional 90% of the provisional
amount assessed. amount assessed. amount assessed.
N/A N/A A loss brought forward has
been omitted or is incorrect.
Cessation of income Cessation of income chargeable Cessation of trade, profession
from property. to salaries tax. or business.
Election for personal assessment N/A Election for personal
has been made that is likely to assessment has been made
reduce the tax liability. that is likely to reduce the tax
liability.
An objection has been lodged An objection has been lodged An objection has been lodged
against the final assessment against the final assessment against the final assessment
upon which the provisional upon which the provisional upon which the provisional
assessment is based. assessment is based. assessment is based.

EXHIBIT 2.9 Circumstances for partial or complete holdover

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It should be noted that an application to hold over provisional tax must be lodged with the
Commissioner on time, that is, not later than:

• 28 days before the due date for payment of the provisional tax; or

• 14 days after the date of issue of the notice of assessment; or

Whichever is the later. There is no provision in the IRO allowing for late application of holdover.

Upon receipt of a valid holdover application, the IRD will adjust the amount of provisional
tax demanded in accordance with the information provided by the taxpayer and other available
information and issue the taxpayer with a revised notice of payment of provisional tax.

Key Learning Point

Generally, taxpayers are likely to encounter situations where they do not agree with
the assessments issued by the IRD. Therefore, it is imperative that taxpayers or their
authorised representatives understand the role of the Board of Review, documentation to
be submitted when filing objections and the appeal procedures where there is a dispute
regarding the Board of Review’s decision.

Illustrative Example 2
Mrs. Ho retired on 30 June 2019. Shortly after her retirement, she received her salaries
tax assessment on 18 September 2019 for the year of assessment 2018/19. This is
shown below:

HK$
Assessable income 1,032,000

2018/19 final tax payable 135,000

Less: 2018/19 provisional tax paid (108,000)
27,000
2019/20 provisional tax payable 135,000
Total tax payable 162,000
Payable in two instalments:
By 13 January 2020 128,250
By 13 April 2020 33,750

Since Mrs. Ho retired on 30 June 2019 and assuming she has no other sources
of taxable income derived from Hong Kong, she may apply to hold over part of the
provisional salaries tax in respect of 2019/20 as it is likely her assessable income for
2019/20 will be less than 90% of the amount assessed to provisional tax.

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Illustrative Example 2 (continued)

Mrs. Ho is required to file the application for holdover in writing and submit to the
Commissioner 28 days before the due date for payment of her 2019/20 provisional tax.

If no holdover of provisional salaries tax is made, Mrs. Ho is required to pay the tax as
stated in the notice of assessment. However, in the event that her actual 2019/20 salaries
tax liability is lower, any excess provisional salaries tax paid will be refunded.

2.4.4 Tax Appeal Process

The tax appeal process is summarised in Exhibit 2.10.

Court of Final Appeal

s.69

Court of Appeal

s.69

Court of First Instance

s.69

s.69A
Board of Review

s.66

s.67
Taxpayer

EXHIBIT 2.10 Overview of the tax

appeal process

After the taxpayer has filed a valid objection, the IRD may request additional information
from taxpayers and process the objection. Then, the IRD may propose a revision of assessment
in settlement of the objection. In case that no agreement can be reached, the objection will
be referred to the Commissioner for his determination. In the event that a taxpayer does not
agree with such determination, he or she has the right to file an appeal to the BOR subject to
certain time limitation.

Hearings before the BOR can be relatively informal because they are not governed by the
rules of civil procedure applicable to hearings in open court. In practice, however, hearings
before the Board tend to follow the same procedures as court hearings.

S.68(4) provides that the burden of proof is on the taxpayer to show that the assessment
is excessive or incorrect. This is not to be construed as an especially heavy burden; in effect,
it requires no more than the taxpayer substantiating their his or her (D31/87 2 IRBRD 409
at 410). The Board is the primary fact-finding tribunal: that means it is charged with finding the
underlying facts and applying the provisions of the IRO to those facts. After hearing the appeal,

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the Board may confirm, reduce, increase or annul the assessment under appeal. Where the
Board does not reduce or annul the assessment, the appellant may be ordered to pay as costs
of the Board a sum not exceeding HK$25,000, which shall be added to the tax charged (DIPN
No. 6, para. 50).

If either the taxpayer or the CIR disagrees with a decision of the Board of Review, each
may apply to the Court of First Instance (CFI) or the Court of Appeal (COA) for leave to appeal
the decision. Under s.69(3)(e), the CFI would grant leave only if it involves a question of law in
the proposed appeal and the proposed appeal has either a reasonable prospect of success
(which does not necessarily mean that it will succeed or will likely succeed, but merely that the
appellant has a reasonably arguable case – see CIR v Pong Fai (2017) 1 HKLRD 1275) or there is
some other reason in the interests of justice why the proposed appeal should be heard.

If the CFI refuses to grant leave to appeal, the taxpayer or the CIR may make further
application to the COA for leave to appeal. If the COA grants leave to appeal, the case will be
heard by the COA.

If the COA also refuses to grant leave to appeal, its decision will be final and no further
application may be made to appeal against the Board’s decision.

In the event where a taxpayer or his or her counsel believes there has been an incorrect
administrative procedure in the application of the tax legislation, judicial review may be
considered as an option of challenging the decision made by the CIR or BOR. It is important
to note that a judicial review is not the same as an appeal process. Judicial reviews cannot be
invoked as an alternative to a substantive appeal on a point of law: It is not a substitute for the
usual route of appeal in challenging an assessment. A judicial review instead focusses on the
procedure to decide whether it has been applied correctly or not.

The preceding appeal process is summarised in Exhibit 2.11.

IRO key Relevant Time limit Process

sections authoritative
body
66 BOR – Board of Within one month Documents to be submitted to BOR
Review from the date of • Notice of appeal in writing;
the Commissioner’s
• Copy of CIR’s determination;
determination, or
such further period • Reasons for objection; and
BOR may allow. • Statements of facts and grounds of appeal.
67 CFI – Court of Within 21 days after Request to transfer the case to the CFI can
First Instance the date the notice of be made either by taxpayer or CIR, with the
appeal is received by written consent of the other party.
the clerk to the Board.
69 CFI – Court of Within one month Application for leave to appeal to be made in
First Instance from the date of the writing to the CFI that involves a question of
Board’s decision. law and served on the other party.
69A COA – Court of Within one month Application for leave to appeal to be made in
Appeal from the date of the writing to the COA that involves a question of
Board’s decision. law and served on the other party.

EXHIBIT 2.11 Tax appeal process summary

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Key Learning Point

Tax appeal is an important tool for taxpayers to dispute tax assessments raised by the
IRD in an independent forum setting. However, since it is a judicial process, taxpayers or
their authorised representatives have to keep in mind the appropriate courts that will hear
their appeals, timeline and documentation that has to accompany each stage of the appeal
process.

2.4.5 Error or Omission Claim

S.70 provides the conditions under which an assessment is treated as final and conclusive.
However, in the event that an error or omission has been made in the calculation of
net assessable income or profits, the IRO provides an exception to reopen such an
assessment pursuant to s.70A. The purpose of s.70A is to provide a remedy for unreasonable
financial hardship, if any, which may have arisen from the errors or mistakes either on the part
of the taxpayer or the assessor.

In order for an assessment to be reopened under s.70A, the following conditions must be
fulfilled:

1. It is established to the satisfaction of an assessor that the tax charged for that year of
assessment is excessive by reason of an error or omission in any return or statement
submitted in respect thereof, or by reason of any arithmetical error or omission in the
calculation of the amount of the net assessable value, assessable income or profits
assessed or in the amount of the tax charged.

2. The affected taxpayer made an application within six years after the end of the year of
assessment or within six months from the date on which the Notice of Assessment was
served, whichever is the later.

However, if the assessment issued has been made in accordance with the accepted
treatment or practice prevailing at the time the return was made, such an assessment cannot
be reopened and corrected under s.70A.

What constitutes a prevailing practice is a question of fact. If an assessor refuses to correct

an assessment under s.70A, the taxpayer may object to such notice of refusal in the same
manner as an objection against a Notice of Assessment.

Although its legislative intent is to mitigate the harshness of the finality provisions in s.70
of the IRO, s.70A tends to be construed rather restrictively. In Extramoney Ltd v CIR (1997)
2 HKC 38, the court approved the dictionary definition of ‘error’, namely, ‘something incorrectly
done through ignorance or inadvertence; a mistake’.

Further, the court held that the burden is on the taxpayer to show that the assessment
was excessive by reason of an error or omission within the terms of s.70A. A deliberate act or
omission on the part of the taxpayer could not be an error. Merely because another course
of action subsequently becomes apparently more advantageous from a tax perspective
does not mean that it is open for the taxpayer to reopen the assessment under s.70A on the
basis of error.

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Compare also Moulin Global Eyecare Holdings Ltd (in Liquidation) v CIR (2014) 17 HKCFAR 218.
In this case, the directors of the company in liquidation had deliberately overstated profits
as part of a fraud, and the IRD had assessed such non-existent profits to tax. The liquidators
sought to recover the excess profits tax from the IRD. In dismissing the liquidators’ appeal, the
Court of Final Appeal concluded that the fraud had been perpetrated actively by the directors;
it was not an inadvertent error or mistake, but deliberate deception.

Some of the key issues arising from the preceding court case are as follows:

• ‘Error’: something done inadvertently, not a deliberate act.

• Directors falsified the accounts and overpaid profits tax of HK$89 million when in fact
the company sustained heavy losses.

• Appeal dismissed by the Court of Final Appeal:

° The conduct of the fraudulent directors was attributed to the taxpayer; the
company was deemed to have knowledge about the false accounts and incorrect
returns. Therefore, there is no valid and reasonable excuse for late objection.

° Submission of incorrect tax returns was a deliberate act and not an error within the
meaning of s.70A.

Key Learning Point

Taxpayers understand the importance of filing a correct and complete tax returns.
However, it is also equally important for taxpayers or their authorised representatives to
understand their legal rights in the objection process and the use of TRCs where holdover
payment is requested. Taxpayers should be aware of the conditions when an assessment
that was final and conclusive can be reopened pursuant to s.70A of the IRO.

Knowledge Check Question

Question 7
Identify which of the following are grounds for lodging a correction of error or omission
claim under s.70A of the IRO.
(I) A wrong estimate of the assessable income made by the assessor in the absence
of a return.
(II) An arithmetical error made by the assessor in calculating the assessable income.
(III) An assessment made in accordance with a prevailing practice that has now changed.
(IV) An omission to claim a professional membership subscription in the tax return.

A I, II and III
B II, III and IV
C I and III only
D II and IV only

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2 . 5
OFFENCES AND PENALTIES OVERVIEW

When a taxpayer does not comply with the requirements under the IRO, the taxpayer is
considered to have committed an offence, which usually results in a fine, penalty or both,
including imprisonment. However, where the taxpayer is able to provide valid proof or reasons
for non-compliance, such fines and penalties may be avoided or reduced.

Below are some common examples of offences under the IRO:

• Failure to file a tax return within a specified time limit.

• Failure to inform the IRD of the chargeability of tax within four months from the end of
year of assessment if the taxpayer does not receive a tax return.

• Deliberately understate profits or overstate expenses to minimise tax liability.

• Deliberately provide false information or prevent the IRD from getting access to
relevant information in tax evasion cases.

• Failure to keep sufficient business records within the statute limitation period.

Where a taxpayer is engaged in a blatant wilful tax evasion, the IRD may view such activity
to be criminal in nature and prosecute against the offender accordingly under s.82 instead of
imposing an s.82A penalty. However, if a taxpayer believes that there was no intent to engage
in wilful tax evasion activities and has reasonable excuse to explain the offence as claimed
by the IRD, he or she should forward detailed written representation to the IRD and request
respectfully for a lenient treatment.

A reasonable excuse depends on each fact and circumstance relevant to each taxpayer.
Generally, the most common test for a reasonable excuse would be what an average person
with reasonable skill and knowledge would do in managing his or her tax affairs. For example,
a sole proprietor who does not have a high education and carries on a small business activity
would be given a more lenient treatment by the IRD when he or she makes a mistake on
his or her tax return. Alternatively, a large multinational company that can afford to hire
professional tax advisors would unlikely be given a lenient treatment when errors or incorrect
returns are made.

There are many Hong Kong court cases that demonstrate the meaning of reasonable
excuse and actions taken by the IRD.

Exhibit 2.12 shows some of the excuses that have been rejected by the Board of Review as
being not reasonable.

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Reason Case reference

Ignorance of law D79/89
Limited education, illiteracy, linguistic difficulties D1/83, D24/84, D40/88, D46/89, D50/93
with Chinese and English
Domestic pressure D15/83
Business pressure D43/89, D67/90
Incompetent staff D46/89, D47/90

EXHIBIT 2.12 Excuses rejected by the Board of Review as not reasonable

For offences that do not affect the amount of tax charged, the court may grant an order to
instruct the defaulter to comply within a specified time together with a fine. However, where
the said offences affect the amount of tax charged, a penalty together with a fine of up to 300%
of the tax undercharged may be imposed on the tax offender.

There are six levels of fines specified in Schedule 8 of the Criminal Procedure Ordinance as
in Exhibit 2.13.

Level Fine
HK$
1 2,000
2 5,000
3 10,000
4 25,000
5 50,000
6 100,000

EXHIBIT 2.13 Levels of fines

Apply and Analyse 4

Mr. Pang owns a luxury retail watch shop in Causeway Bay, Hong Kong. A number of his
customers are from Mainland China, Japan and Korea. As part of his marketing strategy in
2018, he asked his part-time bookkeeper and long-time family friend, Mrs. Chia, to prepare
two separate profit and loss accounts to capture the sales made to Hong Kong and
overseas customers. Mrs. Chia is also responsible for preparing the business’s tax returns
that Mr. Pang signs as the authorised signatory every year.

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Apply and Analyse 4 (continued)

For the year of assessment 2018/19, Mrs. Chia advised Mr. Pang that the sales revenue
derived from overseas customers should be treated as offshore income and are not
subject to Hong Kong profits tax. The advice was in fact not correct. Since Mr. Pang is not
a tax expert, he relies solely on the advice of Mrs. Chia whom he has complete trust and
confidence.

Analysis

Illiteracy and ignorance of the law are not acceptable defences in a criminal prosecution.
If a taxpayer has demonstrated his or her best efforts to rely on professional advice and
the technical filing position is different than the IRD’s, the taxpayer may have a reasonable
excuse that there is no wilful intention or conduct to under report income.

Blind reliance on staff with no professional qualifications to render tax advice without
taking reasonable steps to verify the accuracy of the advice would not be accepted as a
reasonable excuse by the IRD.

It is unlikely that in Mr. Pang’s case the IRD would accept his explanation as a
reasonable excuse unless he has further proof that professional opinion had been sought.
In the event of any doubt, the full details of the transaction should have been disclosed in
the return and drawn to the attention of the IRD.

Any person who without reasonable excuse makes an incorrect return by omitting or
understating his or her taxable income is guilty of an offence (s.80(2)). The Commissioner
of Inland Revenue (CIR) may institute proceedings in the court, which may impose a fine
of HK$10,000 plus treble the amount of tax that has, or would have, been undercharged
as a result of the omission or understatement. The CIR may also compound the offence
(s.80(5)).

The IRO contains a number of penalty provisions dealing with a taxpayer’s failure to
submit a tax return, including filing an incorrect return. These are set out in ss.80, 82 and 82A
of the IRO.

Under s.80, a person who without reasonable excuses fails to make a return, make an
incorrect return, etc, could be prosecuted. If there is a wilful intent to evade or assist any other
person to evade tax, prosecution could be brought under s.82. In addition, the Commissioner
may also impose an ‘administrative’ penalty under s.82A by charging additional tax instead of
prosecuting such person under s.80(2) or s.82(1).

These are summarised in Exhibit 2.14.

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Section Provision Penalty and

comments
80(1) 1. Any person who, without reasonable excuse: Fine at level 3. Involves
a. Fails to comply with the requirements of a notice given civil proceedings.
under the following sections:
S.51(3) – provide assessor with a complete return;
S.51A(1) – provide Commissioner with statement of
assets and liabilities, and so on;
S.52(1) – provide Commissioner with information to
be supplied by officials of the government or of any
public body;
S.52(2) – provide employer’s return as requested
by assessor;
S.64(2) – provide Commissioner with further information
or books or documents relating to a determination of an
objection; or
b. Fails to respond to a summons issued under the
following sections:
S.64(2) – where a summons has been issued to any person
who, in the opinion of the Commissioner, has possession
of the relevant books and records and is in a position to
give evidence under oath or otherwise, respecting the
assessment that is the subject of the objection;
S.68(6) – where a summons has been issued to any person
who, in the opinion of the Board of Review, is in a position
to give evidence, under oath or otherwise, respecting the
appeal and be examined by the Board of Review; or, fails
to answer any questions put to them by the Commissioner
or the Board of Review at the hearing; or
c. Fails to comply with the following sections:
S.5(2)(c) – to inform the Commissioner in writing within
30 days after the event that there is a change in the
ownership or use of the land and/or buildings or in other
situations affecting such exemption for corporations that
previously were exempted from property tax;
S.51(6) – to inform the Commissioner in writing within
one month from the date such person ceases to derive
chargeable income;
S.51(7) – to inform the Commissioner in writing of the
expected date of departure and return to Hong Kong,
where such person chargeable to salaries tax, profits tax
or personal assessment is departing Hong Kong for any
period exceeding one month, no later than one month
before the expected date of departure;
S.51(8) – to inform the Commissioner in writing within
one month with details of the change where such person
who is chargeable to tax changes his or her address;
S.51D(1) – to keep proper rent records for not less than
seven years after the completion of the transactions,
acts or operations to which they relate, unless the
Commissioner directs otherwise or upon the dissolution
of a corporation;

EXHIBIT 2.14 Penalty provisions under the IRO

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Section Provision Penalty and

comments
S.52(4) – to provide the Commissioner with an
employer’s return on commencement of employment
not later than three months after the date of
commencement of employment;
S.52(5) – employer to inform the Commissioner in
writing relating to cessation of employment of his or her
employee not later than one month before the expected
date of cessation of employment;
S.52(6) – employer is required to give notice in writing to
the Commissioner no later than one months from the date
of his or her employee’s departure where such employee
intends to leave Hong Kong for more than one month;
S.52(7) – except with the written consent of the
Commissioner, employer is required to withhold
payment due to the employee who has ceased or is
about to cease employment in Hong Kong and intends
to leave Hong Kong for a period of one month from
the date of servicing a notice to the Commissioner as
required under s.52(6);
S.76(3) – the debtor of the tax defaulter is required to
give notice in writing to the Commissioner and provide
all facts as to non-compliance under s.76(1) relating to
the deduction of tax from payment due to the defaulter.
Such notice must be given to the Commissioner within
14 days of the expiration of the 30-day period from the
date of notice issued under s.76(1).
80(1A) Any person who, without reasonable excuse, fails to comply Fine at Level 6.
with the requirements of s.51C commits an offence and is
liable on conviction to a fine at level 6 and the court may
order the person convicted within a time specified in order to
perform the act which they have failed to do.
80(1AA) Without prejudice to the generality of the term ‘reasonable
excuse’ under s.80(1) relating to the employer’s obligations under
ss.52(4), (5), (6) or (7),where a person deemed to be an employer
by operation of s.9A may have a defence if he or she shows that:
a. He or she did not comply with those requirements
because he or she relied on a statement in
writing, both
(i) By that individual; and
(ii) In the form specified under s.80(1AC); and
b. It was reasonable for them to rely on the statement.
80(1AB) A person who knowingly or recklessly makes a statement of Fine at Level 3.
the kind referred to in s.80(1AA)(a) that in a material respect is
false or misleading commits an offence.
80(2) Any person who, without reasonable excuse: Level 3 fine and not
a. Makes an incorrect return by omitting or understating greater or equal to
anything in respect of he or she is required to 300% of tax under-
make a return; assessed or should have
been assessed.
b. Makes an incorrect statement in connection with a
claim for any deduction or allowance;
c. Gives any incorrect information in relation to any
matter or thing affecting his or her own liability for tax
or the liability of any other person;

EXHIBIT 2.14 Penalty provisions under the IRO (Continued)

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Section Provision Penalty and

comments
d. Fails to comply with the requirements of a notice
given to him or her under s.51(1) or s.51(2A) (i.e. fails
to submit a return by the due date); or
e. Fails to comply with s.51(2) (i.e. to inform the
Commissioner of his or her chargeability to tax).
80(2A) In the case of an offence under s.80(2)(d), the court may order
the person convicted to comply with the requirements of the
notice given to him or her under s.51(1) or s.51(2A) within such
time as may be specified in the order.
80(2B) Any person who does not comply with an order of the court Fine at Level 4.
under s.80(1) or s.80(2A) or s.51(4B)(b) commits an offence.
80(2C) Any person who does not comply with an order of the court Fine at Level 6.
under s.80(1A) commits an offence.
80(2D) Any person who, without reasonable excuse, gives incorrect Fine at Level 3.
information in relation to any matter that affects his or her
or another person’s liability to a foreign tax covered by an
exchange of information article under a double taxation
arrangement commits an offence.
80(3) No person shall be liable to any penalty under this section
unless the complaint concerning such offence was made in the
year of assessment in respect of or during which the offence
was committed or within six years after the expiration thereof.
80(5) The Commissioner may compound any offence under s.80 and
may before judgement stay or compound any proceedings
thereunder.
82(1) Any person who wilfully with intent to evade or to assist any
and (1A) other person to evade tax
a. Omits from a return any sum that should be
included;
b. Makes any false statement or entry in any return;
c. Makes any false statement in connection with a claim
for any deduction or allowance;
d. Signs any statement or return furnished without
reasonable grounds for believing the same to be true;
e. Gives any false answer whether verbally or in
writing to any question, or request for information,
asked or made;
f. Prepares, maintains or authorises the preparation or
maintenance of any false books of account or other
records or falsifies or authorises the falsification of
any books of account or records; or
g. Makes use of or authorises the use of any fraud, art or
contrivance, commits an offence.

EXHIBIT 2.14 Penalty provisions under the IRO (Continued)

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Section Provision Penalty and

comments
Penalty on summary conviction A fine at level 3 and
• A further fine of
three times the
tax undercharged
or the tax that
would have been
undercharged; and
• Imprisonment for
six months.
Penalty on indictment • A fine at level 5; and
• A further fine of
three times the
tax undercharged
or the tax that
would have been
undercharged; and
• Imprisonment for
three years.
82(2) The Commissioner may compound any offence under s.82 and
may before judgement stay or compound any proceedings
thereunder.
82A(1) Any person who, without reasonable excuse:
a. Makes an incorrect return by omitting or understating
anything in respect of which he or she is required to
make a return;
b. Makes an incorrect statement in connection with a
claim for any deduction or allowance;
c. Gives any incorrect information in relation to any
matter or thing affecting his or her own liability to tax
or the liability of any other person;
d. Fails to comply with the requirements of a notice
given to him or her under s.51(1) or s.51(2A) (i.e. fails
to submit a return by the due date); or
e. Fails to comply with s.51(2) (i.e. fails to inform the
Commissioner of is or her chargeability for tax).
Provided that no prosecution under s.80(2) or s.82(1) has
been instituted in respect of the same facts, shall be liable to
be assessed under s.82A to additional tax of an amount not
exceeding treble the amount of tax that:
(i) Has been undercharged as a result of such incorrect
return, statement or information, or would have
been so undercharged if the return, statement or
information had been accepted as correct; or
(ii) Has been undercharged as a result of the failure
to comply with a notice under s.51(1) (i.e. return of
property tax, salaries tax, profits tax or composite tax
return) or s.51(2A) (i.e. personal assessment return)
or failure to comply with s.51(2) (i.e. fails to notify the
Commissioner of his or her chargeability for tax), or
which would have been undercharged if such failure
had not been detected.

EXHIBIT 2.14 Penalty provisions under the IRO (Continued)

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Section Provision Penalty and

comments
82A(2) Additional tax shall be payable in addition to any amount of
tax payable under an assessment or an additional assessment
under s.60.
82A(3) An assessment to additional tax may be made only by
the Commissioner personally or a Deputy Commissioner
personally.
82A(4) Before making an assessment to additional tax, the
Commissioner or a Deputy Commissioner, as the case may
be, shall:
a. Give notice to the person that he or she proposes to
assess additional tax and should:
(i) Inform such a person of the alleged incorrect
return, incorrect statement or incorrect
information or alleged failure to comply with
s.51(1), s.51(2A) or s.51(2);
(ii) Inform the person that he or she has the right to
submit written representations;
(iii) Specify the date, which shall not be earlier than
21 days from the date of service of the notice,
by which representations of the person must
be received.
b. Consider and take into account any representations
made from or on behalf of the person.
The IRD’s policies on penalties under s.82A can be found on its website at http://www.ird.gov.hk/eng/pol/ppo.htm.

EXHIBIT 2.14 Penalty provisions under the IRO (Continued)

Knowledge Check Question

Question 8
Some of Mr. Pang’s overseas customers paid for the luxury watches in cash as they
enjoyed a higher discount that Mr. Pang offered them. Mrs. Chia wanted to help Mr. Pang
to reduce his income tax liability and advised him to exclude the cash sales from his
tax return. Mr. Pang agreed and believed that Mrs. Chia would be solely responsible for
preparing a complete tax return on his behalf although he is the authorised signatory.
Identify which of the statements below is true.
A Mr. Pang believed that he did not commit any fraud nor demonstrate wilful intent to
evade taxes as his responsibility was limited to signing the tax return only.
B Mrs. Chia did not think that there was anything wrong to exclude cash sales from the
tax return since there was a low risk that the IRD would find out in the absence of any
sales receipts.
C The above constitutes an offence under ss.82(1) and (1A) of the IRO for which both Mr.
Pang and Mrs. Chia are liable.
D The IRD is unlikely to penalise Mr. Pang since he has hired an accountant to prepare his
tax return.

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2 . 6
FIELD AUDIT AND INVESTIGATION SCOPE
AND OBJECTIVES

The Field Audit and Investigation Unit of the IRD is responsible for conducting field audits
and investigations on businesses and individuals with a view to combating tax evasion and
avoidance. Back tax is assessed and penalties are generally imposed where discrepancies
are detected.

2.6.1 Field Audit and Investigation Essential Issues

2.6.1.1 Field Audit
The IRD set up a Field Audit Group in June 1991 to conduct field audits of taxpayers’
businesses. In April 2000, the present Field Audit and Investigation Unit was formed through
the merger of the Field Audit Group and the Investigation Unit. Field audit action is normally
initiated when irregularities or indications of non-compliance with the requirements of the
ordinance are detected.

A field audit is conducted on both corporations and unincorporated businesses. The work

of field auditors includes site visits to business premises and examination of accounting
records of taxpayers in order to ascertain that correct tax returns have been prepared and
submitted.

These site visits provide a more thorough understanding of business operations and hence
facilitates the detection of cases where tax evasion or avoidance is involved. At the same time,
it gives the IRD’s enforcement activities a more visible presence and consequently encourages
the lodgement of correct tax returns.

The general purpose of field audits and investigations is to secure maximum possible
voluntary compliance using a balanced programme of audit and investigation.

The three main objectives are:

1. To recover back taxes;

2. To provide a deterrent to tax evasion by the imposition of penalties, either administratively

or through the institution of prosecution action; and

3. To educate taxpayers on the need to file proper and correct returns.

2.6.1.2 Investigation
Investigation officers are responsible for conducting in-depth investigations where tax evasion
is suspected and taking penal action (including prosecution proceedings in appropriate cases)
to create a deterrent to tax evasion.

The IRD adopts the ‘assess first, audit later’ (AFAL) approach as its assessment mechanism
on tax returns and other supplementary information submitted by taxpayers while at the
same time fully utilises advanced technology in selecting cases for post-assessment audit and
investigation.

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Some of the common reasons for being selected for tax audit and investigation are
as follows:

• A heavily qualified audit opinion on the taxpayer’s financial statement.

• Business transactions mainly settled in cash.

• An unreasonably low turnover or profit margin as compared with other businesses in

the same industry.

• A history of failure to submit tax return on time in past years.

• Failure to maintain sufficient business records.

• Significant cross-border related party transactions.

• A company continues to operate on a going concern basis despite recurring losses.

• Profits significantly declined after undergoing internal group structuring.

• Financing from unknown sources to acquire valuable assets or injected a large amount
of capital into the business.

• Other cases referred by other government departments or reported by informers.

General procedures in tax audit and investigation are summarised in Exhibit 2.15.

Instruction to
Case selection Notification to taxpayer
taxpayer/representatives

Additional/protective Gathering of records Initial interview

assessment and information (fact finding)

Settlement agreement Recovery of taxes

EXHIBIT 2.15 General procedures in tax audit and investigation

2.6.2 Settlement Methods

There are many different situations where understatements of profits may occur and reported
by taxpayers. Some may be due to different methods of valuation such as inventories, different
points of view on what items are deductible or not, differing assessments of whether gains
are capital or trading in nature or omission of transactions whether intentionally or otherwise.
Therefore, it is not practicable to apply one single settlement method in computing the amount
of profits that are understated in all field audit and investigation cases.

The method of evasion may, for example, vary from a simple undervaluation of stock to a
complex scheme involving the creation of false accounting entries and supporting vouchers. In
practice, the following methods are some of the common ones used by the IRD to quantify the
amount of understated profits.

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A key element in determining the appropriate method of quantification to be used is the

reliability of the taxpayer’s books and records. If they are reliable, a ‘direct’ approach can be
used, whereas if they are incomplete or unreliable, an ‘indirect’ method will be applied.

2.6.2.1 Direct Method – Complete Books and Records Available

The direct method should be used where taxpayers keep proper books and records. S.51C
of the IRO provides the details, what are regarded as ‘records’, for taxation purposes and
specifies the minimum records that must be maintained by a taxpayer to enable business
transactions to be traced, explained and verified.

In such circumstances, determining the correctness of the income reported by the taxpayer
and the expenses charged in the accounts is not difficult. As a result, transactions that are not
reflected in the accounts can be easily identified by a reconciliation of the amounts reported in
the tax return with the entries recorded in the books.

In the event that there is a discrepancy between the tax returns and source documents,
including but not limited to accounting books and records, taxpayers should prepare revised
financial statements on the basis of the complete books and records. These statements
together with the complete books and records should then be submitted to the field auditor or
investigator for verification.

2.6.2.2 Indirect Method – Incomplete Books and Records Available

The indirect method should be used where taxpayers do not keep proper books and records.
It is often not possible to construct revised accounts using traditional accounting methods to
create proper double entries.

In such cases, the back-duty assessments generally have to be based on indirect methods.
Indirect methods are based on an investigation of the taxpayer’s personal affairs. There is no
single ‘best’ indirect method of quantification; the method used depends on the circumstances
of the case.

Some of the common indirect methods used are:

• The Assets Betterment Statement method;

• The Bank Deposits method;

• The Business Economics (Percentage Computation) method; and

• The Projection method.

Each of the methods above is discussed in the following text.

Assets Betterment Statement Method

Preparation of an Assets Betterment Statement (ABS) is generally the most comprehensive
indirect means of quantifying an understatement of profits where the books and records in
respect of a period are inadequate or are not available. The method may also be applied to
quantify understated employment income in salaries tax cases. A specimen format of an ABS
from DIPN No. 11 can be found in Appendix 2.A at the end of this chapter.

The essential function of an ABS is to disclose the correct taxable profits or income of a
person by adding all disallowable expenditure to the person’s yearly asset increase (i.e. the
excess of net assets in any one year over the previous year). Receipts that are of a capital

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nature or otherwise not assessable are deducted from the sum of these items to arrive at
the betterment profits (adjustments are also made in respect of any applicable depreciation
allowances or balancing charges if necessary).

This can be summarised using the formula:

Betterment Profits Increase in Net Assets Disallowable Expe

enditures Non-taxable Receipts

Bank Deposits Method

The Bank Deposits method is a means of ascertaining gross receipts. It can be used where it is
established in the course of the analysis that most of the taxpayer’s income is deposited into
bank accounts. It is important when adopting this method to ensure that coverage extends
to all bank accounts in which business receipts have been deposited, including those held by
nominees of the taxpayer. The specimen format for this method (from DIPN No. 11) can be
found in Appendix 2.B at the end of this chapter.

In the case of wholly or partly cash trade businesses, preparation of a monthly summary
of the bank deposits is useful to help ascertain if there are any other bank accounts that have
not been detected (e.g. when there are marked fluctuations in monthly deposits). If there
is a significant decrease in the amount of cash deposits or if cash deposits are found to be
missing in a certain part of the period under review, the income for the year concerned may be
projected.

It is required to make adjustments for the amount of cash receipts directly used
for payment of business and personal expenses. With regard to the corresponding
expenses, if the amounts charged in the accounts have been understated, adjustments for
expenses underclaimed should also be made to ascertain the correct profits. To quantify
the understatement of gross profits, it is generally acceptable to apply the ‘average’ or
‘representative’ gross profit ratio to the total bank deposits , while always bearing in mind to
exclude those deposits that are entirely assessable (e.g. rebates, commission, sale of scrap,
etc.) However, unidentified deposits are usually included on the assumption that they are
ordinary business receipts.

In G Deacon & Sons v CIR (1952) 33 TC 66, assessments to include unexplained bank deposits
as taxable profits were upheld based on circumstantial evidence. A format for determining
taxable profits using the bank deposits method from DIPN No. 11 is shown in Appendix 2.C at
the end of this chapter.

Business Economics (Percentage Computation) Method

According to DIPN No. 11, this method involves the application of percentages or ratios
(considered typical of business operations similar to those of the taxpayer) to particular known
amounts, for the purpose of computing the amounts required to determine the taxpayer’s
assessable profits.

For example, by reference to similar businesses or situations, appropriate percentages

can be identified to help determine the taxpayer’s sales, cost of sales, gross profits or even net
profit. Likewise, by the application of typical percentages to established figures, individual items
of income or expenses may be ascertained.

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In some cases, these percentages may be determined by examination or analysis of

the taxpayer’s accounts or records. Gross profit ratio may be determined by comparing
purchase invoices to sales invoices and by analysing price lists and other similar data. A large
representative sample should be selected on a random basis. In addition, any change in the
taxpayer’s operations or business environment (e.g. changes in the strategy, product lines,
trend, location or major customers and suppliers of the business) should be taken into account
when calculating the average gross profit ratio.

Illustrative Example 3

Gross profit on sales (adapted from DIPN No. 11)

HK$
Net sales (based on taxpayer’s financial records) 500,000
% of gross profit (average) 30%

Gross profit as computed 150,000

Less: Gross profit per financial accounts (50,000)
Additional profits to be assessed (variance) 100,000

Illustrative Example 4

Percentage on cost (markup) (adapted from DIPN No. 11)

HK$
Cost of goods sold (based on taxpayer’s financial records) 300,000
Taxpayer’s average markup of 30% on cost 90,000
Sales as computed 390,000
Less: Sales per financial accounts (350,000)
Additional profits to be assessed (variance) 40,000

Projection Method
Where other, more accurate methods are not available to determine the assessable profits of
a taxpayer, the IRD may rely on the projection method as a way to expedite the settlement of a
field audit or investigation.

For example, the IRD may use a taxpayer’s assessable profits that have been correctly
determined for a particular year of assessment and use this information to estimate the
assessable profits for years of assessment that the IRD believes have been understated.

One of the key assumptions in using this method is that the basis of projection should
be reasonable and can be supported by reliable primary data. Any changes in the taxpayer’s
operation or business environment should also be taken into account.

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Illustrative Example 5
Omission of sales revenue (adapted from DIPN No. 11).

Omitted sales based on projection of sales, deposited in the private bank accounts of a
director, were added back to the profit of the audit year.

Sales omitted in other years were obtained by extrapolating from the percentage of
sales omitted in the audit year.

Illustrative Example 6
Over-claimed expenses based on projection (adapted from DIPN No. 11).

Salaries payable to relatives of the director and entertainment expenses were charged
in the accounts of the audit year.

No services had been provided by the relatives and the accrued salaries were never
paid while the entertainment expenses were the private expenses of the director.

The proportion of salaries and entertainment expenses, which had been denied
deduction, was computed and the results were extrapolated to other years since sums of
the same nature were similarly charged in the accounts.

2.6.3 Assessments and Recovery of Taxes

2.6.3.1 Assessment and Additional Assessment
Under s.59(2)(a) of the IRO, where a person has furnished a return under s.51, the assessor
may ‘accept the return and make an assessment accordingly’. Post-assessment audits and
investigations are used to identify possible unassessed or underassessed cases. The selection
of cases for assessment is either based on risk areas or by random checking.

In field audits and investigations, it is necessary that additional assessments will be issued
after clarifying with the taxpayers. All in-time years are considered if circumstances warrant.
Court judgements have confirmed the power of the assessor to raise assessments under s.60
of the IRO in field audits and investigations.

In Lam Soon Trademark Ltd v CIR (2004) 6 HKTC 768, the presiding judge Bokhary at the
Court of Final Appeal observed that the assessor’s duty to make assessment is laid down in
s.59 and the duty is to assess every person who is in the assessor’s opinion chargeable with tax
under the ordinance. Bokhary PJ further ruled that the additional assessments raised after a tax
audit were justified in terms of s.59 even when the taxpayer was originally assessed in respect
of the same profits on another basis.

2.6.3.2 Protective Assessment
A field audit or investigation can be a time-consuming exercise and could possibly take
more than a year to complete. In Re Chia Tai Conti-Hong Kong Ltd, 6 HKTC 688, the judge Yam
recognised that, in a complex tax audit case, further investigation and requests for information

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would be required after information and documents have been provided by the taxpayer. It is
often necessary for assessors to raise estimated assessments under either s.59(2)(b) or s.59(3)
during the course of investigation in order to protect the revenue, especially in the following
circumstances:

(a) To meet the six-year time limit for raising back-year assessments under s.60 of the IRO;

(b) In deceased cases (under s.54(c) of the IRO, where the person died on or after
11 February 2006, no assessments in respect of a period prior to their death shall be
made after the expiry of three years immediately after that year of assessment);

(c) Where the taxpayer is about to leave Hong Kong; or

(d) Where there are indications that the taxpayer is delaying the investigation process.

Based on the assessor’s judgement in respect of the information available to the assessor,
estimated assessments may be raised on a person under alternative heads of charge
(e.g. in their personal capacity, as a trustee and as an agent) as a protective measure.

Nina T. H. Wang v CIR (1991) 3 HKTC 483 endorsed the practice of making estimated
assessments in a situation where the assessor may have insufficient information to do
otherwise. As per the judgement in Mok Tsze Fung v CIR (1962) 1 HKTC 166, the assessor is
not obliged to disclose the basis of the assessment. If the taxpayer considers it appropriate,
the taxpayer should lodge a notice of objection to a protective assessment in order to keep
the matter open and accordingly protect their interests. An assessor may not, however,
assess the same income to tax twice and require the taxpayer to pay tax with respect to both
alternative assessments (Dairyfarm Establishment & The Dairy Farm Company Limited v CIR (2018)
HKCFI 2245).

As previously mentioned, it is in the taxpayer’s interests to take the initiative and have the
representative prepare revised financial statements with a view to facilitating finalisation of the
field audit or investigation. However, it should be stressed that the representative is expected
to reply promptly to any query from the field auditor or investigator in the interim and not
defer replying until after revised financial statements are completed.

2.6.3.3 Recovery of Taxes in Default

Tax should be paid on or before the due date as stipulated in the notice of assessment. If tax is
not paid by the due date, tax is deemed to be in default. When this happens, the IRD will take
immediate actions to secure tax payment and recover the tax from the tax defaulters.

Part 12 of the IRO deals with payment and recovery of taxes in default. The IRD is
empowered under the following provisions in its effort to recover taxes in default:

1. S.71 – recovery of tax in default;

2. S.76 – recovery of tax from debtor of the taxpayer; and

3. S.77 – recovery of tax from persons leaving Hong Kong.

Pursuant to s.76, taxpayers should note that the IRD may take legal actions against a
tax defaulter and issue recovery notices to third parties who owe money to the defaulter,
requiring them to pay the outstanding tax. This would include the defaulter’s employers, banks,
or debtors.

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In addition, the IRD may also apply to court for a Departure Prevention Direction (DPD) to
stop the defaulter from leaving Hong Kong where applicable, in accordance with s.77.

Recovery Actions Taken by the IRD

There are several recovery actions that are taken by the IRD:

• Imposition of surcharges on tax in default:

° 5% will be imposed on the total amount of tax in default, including the second
instalment amount that will be immediately due if the first instalment is not paid by
the due date.

° 10% will be further imposed on all unpaid amounts (including 5% surcharge) after
the expiry of six months from the due date.

• Issue of recovery notice to third parties, including the employer, banker,

tenant, debtor and customer, and others, who owe or hold money due to the
defaulting taxpayer:

° Recovery notices to third parties are normally issued if the tax inclusive of any
surcharge imposed remains unsettled.

° The person to whom a recovery notice is issued must pay money, if any, not
exceeding the amount of tax in default held on account of the defaulter to the IRD
within a stipulated time. Failure to do so will render the person personally liable for
the whole of the tax that he or she was required to pay.

° If the third party is an employer, the employer should follow the requirements
under s.32(3) of the Employment Ordinance (Cap.57) when deducting the wages
for payment of tax to the IRD, that is, the total of all deductions, including other
deducted item(s) made in one wage period shall not exceed one half of the wages
payable in that period except under some specified circumstances.

• Institution of recovery proceedings in the District Court:

° The IRD may institute debt recovery proceedings before the District Court to
recover tax from a defaulting taxpayer, irrespective of the quantum of tax
claimed. The defaulter will be liable to the court fee, fixed costs and interest
on the judgement sum from the date of commencement of proceedings to the
date of full settlement in addition to the outstanding tax due upon entry of
judgement.

° If the outstanding judgement debt remains unsettled, the IRD will issue a writ
of fieri facias to levy execution against the movable property of the defaulter,
or apply for a charging order on the immovable property belonging to the
defaulter. In warranted cases, bankruptcy/liquidation proceedings will be initiated
and pursued.

• Application to the District Court for Departure Prevention Direction:

°° If a person has not paid all tax assessed on them and they intend to depart, or have
departed, Hong Kong to reside elsewhere, the Commissioner may apply to the
District Court for a DPD to prevent the person from departing Hong Kong.

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Knowledge Check Question

Question 9
Identify which of the following regarding the reasons for being selected for tax audit and
investigation is true.
A An unqualified audit opinion on the taxpayer’s financial statement
B Business transactions are mainly settled in credit cards and personal cheques
C Significant cross-border related party transactions
D Significant financing from major overseas financial institution

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SUMMARY

• Taxpayers should not underestimate the powers of the IRD as provided under ss.51 and 52 of
the IRO, including the related subsections, in requesting information from taxpayers and any
other person whom the assessor considers may be in possession or control of information or
documents in regard to any matter that may affect any liability, responsibility or obligation of
any person under the IRO.

• Based on the territorial tax system in Hong Kong, a non-resident entity that derives profits
from Hong Kong through the activities of its branch or permanent establishment in Hong
Kong will be liable to profits tax in Hong Kong. According to the Inland Revenue Rule 5, there
are three methods commonly adopted by the IRD in order to determine such taxpayer’s
assessable profits. These are:

1. Actual Profit method;

2. Worldwide Profit Margin method; and

3. Percentage of Turnover method.

• Notwithstanding that there are two definitions of permanent establishment (PE) under the
IRO (Schedule 17G) and the Double Tax Agreement (DTA), the IRD, in practice, has applied
substance over form in determining whether a non-resident has a PE in Hong Kong. It is the
nature of the activities rather than the legal form of its presence in Hong Kong that will be
scrutinised by the IRD.

• It is important for taxpayers to understand the correct types of forms (BIR 51, 52, 54 and
60) when submitting tax returns to the IRD, including the relevant documents that should
accompany those tax returns. Notwithstanding the concessions for small corporations and
businesses, they are advised to keep all relevant supporting documents in the event that the
IRD requests these.

• Employers must take note of their reporting obligations to the IRD relating to their employees
and the relevant forms to be filed within the statutory notification period.

• New Hires (Form IR56E) – three months from commencement of employment.

• Continuous employment (BIR 56A and IR56B) – within one month from the issue date of
the return, annually.

• Cessation of employment (termination or death) (IR56F) – not later than one month before
cessation or upon the death of the employee.

• Departure from Hong Kong (IR56G) – one month prior to departure (exception applies).

• Taxpayers should note that the assessor reserves the right to issue an assessment or an
additional assessment pursuant to s.60(1) of the IRO:

° Within the year of assessment;

° Within six years after the expiration of that year of assessment; or

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° Within ten years after the expiration of that year of assessment if the non-assessment or
underassessment is due to fraud or wilful evasion.

• When a taxpayer disagrees with the assessments raised by the IRD, there is a specific process
in which an objection can be lodged. Specifically, the notice of objection has to:

° Be in writing;

° State precisely the grounds for the objection; and

° Be received by the Commissioner within one month after the issuance date of the notice
of assessment.

• Taxpayers and/or their authorised representatives should be familiar with the tax appeal
process that is governed under ss.66, 67, 69 and 69A of the IRO. Taxpayers may also explore
the benefits of using tax reserve certificates (TRC) as part of their tax payment plan.

• There are three main objectives of the IRD’s Field Audit and Investigation Unit:

1. To recover back taxes;

2. To provide a deterrent to tax evasion by the imposition of penalties, either

administratively or through the institution of prosecution action; and

3. To educate taxpayers on the need to file proper and correct returns.

• In the event that the IRD discovers there is an understatement of profits, there are two
methods generally used by the IRD. These are the direct and indirect methods.

1. Direct method involves the reconciliation between the financial statements and source
documents. Where necessary, the IRD may request the taxpayer to prepare a revised
financial statement prior to issuing an additional assessment.

2. Some of the common indirect methods used are:

°° Assets Betterment Statement method;

°° The Bank Deposits method;

°° The Business Economics (Percentage Computation) method; and

°° The Projection method.

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MIND MAP

HONG KONG INLAND REVENUE DEPARTMENT OBJECTION, HOLDOVER, APPEAL AND ERROR
(IRD) OVERVIEW AND STRUCTURE OR OMISSION CLAIM
Principles of HK taxation is based on territorial Objection process
basis, no capital gains tax Holdover of tax payment under an objection
Administration of the IRD and tax Ordinances Holdover of provisional tax payment
(IRO – profits tax, salaries tax and property tax)
Tax appeal process
The application of DIPNs
ADMINISTRATION
OF THE TAX

ASSESSMENTS AND PAYMENT

Time limit to raise assessment
Notice of assessment and demand for payment
Payment of taxes

KEEPING OF BUSINESS RECORDS RETURNS

Taxpayers are required to keep proper business Types of returns (BIR51, 52 and 60)
records that are legible and provide support Power of IRD under s.51(1) to request taxpayers
to the tax returns. to furnish a return
Time limit to keep business records OBLIGATIONS OF Documents to be filed for a proper tax return
TAXPAYERS (audited accounts, supporting schedules,
other information as outlined in the Notes
PAYMENT OF TAX and Instructions)
Cash
Cheque
TRC (Tax Reserve Certificate)
Internet/Online payment
Telephone banking
Pre-authorised tax payment service

NATURE OF OFFENCE PENALTIES

S.51 – failure to provide returns and information S.80(1) – no reasonable excuse, does not involve
to IRD (assessor, commissioner) underpayment of tax
S.52 – failure to provide information to be S.80(2) – no reasonable excuse, involve
furnished by officials and employers PENALTIES underpayment of tax
S.51C – failure to keep business records for not AND OFFENCES S.82(1) – wilful intent to evade tax, involve
less than seven years underpayment of tax
S.51D – failure to keep property rental records S.82A – no reasonable excuse, administrative
for not less than seven years penalty, involve underpayment of tax

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COMMON ISSUES IRD SETTLEMENT METHODS

Heavily qualified audit opinion Direct method – based on complete books
Mainly cash transactions and records
Significantly low sales revenue or profit margin Indirect methods – based on incomplete books
as compared to other comparables and records
• Assets betterment statement method
Poor tax track record FIELD AUDIT AND • Bank deposit method
Profits significantly reduced after internal INVESTIGATION • Business economics (percentage computation)
restructuring method
• Projection method
EFFICIENT TAX AUDIT MANAGEMENT
Understand the scope of tax audit
• Which year of assessments?
• Any statute limitation apply to the years of
assessment under audit?
• Does it relate to profits tax, personal tax,
property tax audits?
Co-operate fully with the field auditor and
understand taxpayers’ rights
Provide written responses in a timely manner

APPENDIX
2.A Asset Betterment Statement

Specimen format of Assets Betterment Statement

Mr. ABC Trading as ABC & Co1
Schedule Accounting Year End2 Year Year Year
No.3
‘X’ ‘X + 1’ ‘X + 2’
(HK$) (HK$) (HK$)
ASSETS
Cash at bank
Cash in hand
Landed properties
Net business assets (at cost) of sole proprietorship
business(es)
Investment in partnership business(es)
• Capital
• Current accounts/Loans
Investment in private companies
• Share capital
• Current accounts/Loans
Quoted shares
Motor cars
Personal advances and loans _______ _______ _______
Total Assets _______ _______ _______

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Specimen format of Assets Betterment Statement

Mr. ABC Trading as ABC & Co1
Schedule Accounting Year End2 Year Year Year
No.3
‘X’ ‘X + 1’ ‘X + 2’
(HK$) (HK$) (HK$)
LIABILITIES
Personal loans and advances
Mortgaged loans for properties _______ _______ _______
Total Liabilities _______ _______ _______
Net Assets _______ _______ _______
Increase (decrease) in net assets (A) _______ _______
(when compared to the previous year)

Note

1. If the person carries on more than one business, the ABS should show the assets and liabilities of all his or her
businesses.
2. The position should be compiled in respect of each of the year of assessment under review.
3. Fill in the schedule no. and attach schedules in support. Schedules should be compiled for the individual items
where necessary.

Schedule
No.
ADD:
Inadmissible items adjusted in returns and tax computations of sole proprietorship
business(es), excluding proprietor’s salaries
Taxes paid
Legal expenses and stamp duties on acquisition of properties
Decoration expenses on properties
Rates on residence and rental properties
Loss on sale of shares
Loss on sale of properties
Loss on sale of business investments
Remittance outwards
Interest payments of private nature
Overseas private trips
Private and living expenses (estimated)
Unidentified withdrawals from bank accounts
Unidentified withdrawals from current accounts with
business investment _______ _______
(B) _______ _______

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Schedule
No.
DEDUCT:
Profit on sale of properties
Profit on sale of business investment
Profit on sale of shares
Employment income
Rental income
Bank interest
Dividends
Remittance inwards
Depreciation allowances adjusted in tax computations
Distributions from partnership business(es)
Profits (Loss) of other sole proprietorship business(es)
returned/assessed _______ _______
(C) _______ _______
BETTERMENT PROFITS* (A) + (B) – (C) _______ _______
LESS:
Profits (Loss) Returned/Assessed of ABC & Co. _______ _______
DISCREPANCIES _______ _______

* Note – The betterment profits will be used to compute the final assessable profits or losses in respect of the
business(es) under review.

(Source: DIPN No. 11.)

2.B Bank Deposit Method

Specimen Format of Bank Deposits Method

Mr. XYZ trading as XYZ & Co1
Schedule Bank Name and A/C No. Year Year
(See Attached)
‘X’ ‘X + 1’ Total
(HK$) (HK$) (HK$)
1 Summary of bank account analyses ending on
the accounting date2
Total Deposits
2 Less: Interbank Transfer or Deposits
3 Returned Cheques
Sales of Capital Assets
Rental Income
Other Non-business Deposits _______ _______ _______

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Specimen Format of Bank Deposits Method

Mr. XYZ trading as XYZ & Co1
Schedule Bank Name and A/C No. Year Year
(See Attached)
‘X’ ‘X + 1’ Total
(HK$) (HK$) (HK$)
Adjusted Total Deposits
Add: Unbanked Deposits for Expenses
(Estimated)
Add: Debtors’ Closing Balances _______ _______ _______
Less: Debtors’ Opening Balances _______ _______ _______
Less: Reported Turnover _______ _______ _______
Unexplained Deposits
(Additional Profits) _______ _______ _______

Note

1. A separate schedule should be compiled for each business under review.

2. Summary should be prepared for each of the year of assessment under review.

(Source: DIPN No. 11.)

2.C Format for Determining Taxable Profits Using the Bank Deposits Method

Schedule 1 : Total Deposits of Bank Accounts

Bank Name & A/C No.1 ____________________________

Year ‘X’ Year ‘X + 1’

Month Cash Cheque Others 2
Cash Cheque Others2 Total
(HK$) (HK$) (HK$) (HK$) (HK$) (HK$) (HK$)
April
May
June
July
August
September
October
November
December
January
February
March

Note
1. The summary of all the bank accounts should be prepared. One table should be prepared for each bank account.
2. Others include items such as Letters of Credit (L/C), Credit as Advised (Cr. Adv.), Telegraphic Transfer (T/T), Transfer,
and so on.

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Schedule 2 : Interbank Transfer or Deposits

Bank Name & A/C No.1 ____________________________

Year ‘X’ Year ‘X + 1’

Date Source2 Cheque Transfer Cash Cheque Transfer Cash Total
(HK$) (HK$) (HK$) (HK$) (HK$) (HK$) (HK$)

Note

1. A separate schedule should be prepared for each of the bank accounts.

2. Fill in the withdrawal bank account No.

Schedule 3 : Returned Cheques

Bank Name & A/C No.1 ____________________________

Date Year ‘X’ Year ‘X + 1’ Total

(HK$) (HK$) (HK$)

Note

1. A separate schedule should be prepared for each of the bank accounts.

(Source: DIPN No. 11.)

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Notwithstanding that Mr. Chia’s spouse and relatives do not know
Birdnest’s executives personally or otherwise, this is an irrelevant factor in the context
of the secrecy provision under the IRO, unless they are appointed as the authorised
representatives of Birdnest’s executives.
Answer B is incorrect. Just because Mr. Chia believes such information is not confidential,
does not mean he is permitted to share it with others. It is irrelevant to the context of the
secrecy provision under the IRO.
Answer C is incorrect. As with the statement in option A, notwithstanding that Mr. Chia’s
wife and relatives have promised to keep such information confidential, this is also an
irrelevant factor in the context of the secrecy provision under the IRO.

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Answer D is correct. Pursuant to s.4 of the IRO, all staff of the IRD have the statutory duty
to keep taxpayers’ information confidential that they come across while performing their
duties. They are prohibited from disclosing any information to persons other than the
taxpayers themselves or their authorised representatives, subject to the application of any
information exchange agreement binding the IRD, such as an exchange of information
article in a DTA, or a Tax Information Exchange Agreement.

Question 2
Answer A is incorrect. The fact that a regular visitor to Hong Kong stays in the same
hotel for every visit does not make the hotel (or their room) a fixed place of business. It
is common for corporate travellers to book an international hotel chain while traveling
overseas in accordance with their corporate travel policy.
Answer B is incorrect. Even though the businessperson meets with customers and
suppliers while in Hong Kong, there is insufficient information that he or she is negotiating
and signing contracts while in Hong Kong.
Answer C is correct. Under the DTA, the definition of PE includes a dependent agent who
has, and habitually exercises, an authority to conclude contracts on behalf of the principal
(agency). There are two factors to consider:
(a) The activity must be undertaken by a dependent agent of the overseas principal.
In this case, the purchasing manager is an employee of the German company.
Therefore, he is deemed to be a dependent agent of the German company (i.e. the
principal) who solicits purchase orders on the principal’s behalf.

(b) The purchasing manager regularly solicits/negotiates and signs purchase contract
with suppliers while physically in Hong Kong. Note that ‘habitually’ implies some
element of recurrence. One-off transactions, with nothing more, would not qualify.

Answer D is incorrect. Attending a trade conference in Hong Kong does not in itself create
a taxable presence or PE in Hong Kong. This is likely an activity of a preparatory or auxiliary
character.

Question 3
Answer A is incorrect. At the hearing, the taxpayer (appellant) should submit either an
unsworn submission or evidence on oath, not both of them.
Answer B is incorrect. If the appellant makes an unsworn submission, he or she will not be
cross-examined by the representatives of the Commissioner.
Answer C is incorrect. The Board is required to hand down its decision in writing.
Answer D is correct. Although there are other conditions that have to be met when
applying for leave against the Board’s decision, the condition outlined in D is true.

Question 4
Answer A is incorrect. Such submissions will be treated as an incomplete tax return by the
IRD as I is also required.
Answer B is incorrect. Such submissions will be treated as an incomplete tax return by the
IRD as III is also required.

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Answer C is correct. Whether it is the corporation’s tax return for the first or subsequent
year, a corporation has the obligation to submit the documents outlined in I, II and III to be
regarded as having submitted a complete tax return.
Answer D is incorrect. Such submissions will be treated as an incomplete tax return by the
IRD as I and III are also required.

Question 5
Answer A is incorrect. Mrs. Johnson should use the correct Form IR56F instead of IR56B.
Answer B is incorrect. Although Mrs. Johnson may have informed the IRD about Mr. Tang’s
cessation of employment, such notification must be accompanied by the appropriate Form
IR56F to be considered valid.
Answer C is correct. Mrs. Johnson is required to file form IR56F to the IRD at least one
month before the cessation date. Form IR56B (Continuous employment) is not required to
be filed to the IRD in the year of cessation.
Answer D is incorrect. Form IR56B is not required to be submitted to the IRD in the year of
cessation of employment.

Question 6
Answer A is incorrect. The timeline for an assessor to raise an assessment or additional
assessment is provided under s.60(1) of the IRO. In respect of a deceased person, the
timeline to raise such an assessment is provided under s.54(b) of the IRO.
Answer B is incorrect. Notwithstanding that a company may have filed a loss tax return,
the assessor may raise an assessment or additional assessment in the event that he or she
disagrees with certain deductions claimed or exclusion of certain income by the taxpayer
and such adjustments result in a taxable income by the company.
Answer C is incorrect. Although the statement is generally true, the assessor has to
observe the timeline as provided under s.60(1) or s.54(b) when raising an assessment or
additional assessment.
Answer D is correct. This is one of the timelines outlined under s.60(1).

Question 7
There are two conditions that must be satisfied under s.70A:
(a) It is established to the satisfaction of an assessor that the assessment is excessive
due to an error or omission in a return or statement or that there is an arithmetical
error or omission in the calculation of the assessable income or profits or tax
charged; and

(b) An application is made within six years after the end of the year of assessment or
within six months after the date on which the Notice of Assessment was served,
whichever is the later.

Both statements in II and IV satisfy the above conditions.

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Statement I is not correct since the assessor had not committed any error or arithmetical
error simply because their estimated assessment did not coincide with a figure they would
have reached had other information been available to them (Sun Yau Investment Co Ltd v
CIR (1984) 2 HKTC 17).
Statement III is not a valid reason for a taxpayer to reopen an assessment which is
final and conclusive if the IRD has applied the tax laws correctly in accordance with the
prevailing IRO or practice at the time the assessment was issued.
Therefore, answer D is correct.

Question 8
Answer A is incorrect. Mr. Pang was guilty of an offence under s.82(1)(d) of the IRO when
he signed the tax return without reasonable grounds for believing the same to be true.
Answer B is incorrect. Mrs. Chia committed an offence under s.82(1)(f) of the IRO when she
prepared an incorrect tax return by intentionally omitting the cash sales from overseas
customers.
Answer C is correct. Both Mr. Pang and Mrs. Chia are guilty of an offence under s.82(1) and
(1A) of the IRO.
Answer D is incorrect. Blind reliance on staff who has no professional qualification to
render tax advice without taking reasonable steps to verify the accuracy of their advice
would not be accepted as a reasonable excuse by the IRD.

Question 9
Answer A is incorrect. An unqualified audit opinion on the taxpayer’s financial statement
does not necessarily attract IRD for tax audit and investigation.
Answer B is incorrect. When business largely settles transactions in cash, this may attract
the IRD’s attention to commence a field audit and investigation. Credit cards and personal
cheques are common methods of payment.
Answer C is correct. Significant cross-border transactions, especially payments made to
non-residents that are not supported by proper documentation or using the Hong Kong
entity as a conduit to reduce withholding tax rates, would likely invite queries from the IRD
that may lead to a field audit and investigation.
Answer D is incorrect. Financing from a major overseas bank is generally acceptable by the
IRD provided it is supported by proper loan documents.

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EXAM PRACTICE

QUESTION 1
Summer HK Ltd sells coffee machines in Hong Kong. Due to a change of finance personnel
and relocation of its office, Summer HK Ltd did not have sufficient time to prepare
and finalise its audited accounts for the year ended 31 December 2017. Consequently,
Summer HK Ltd did not file its profits tax return for the year of assessment 2017/18 by the
required due date.

As a result, pursuant to s.59(3) of the IRO, the IRD issued an estimated assessment
showing estimated assessable profits of HK$5 million and tax payable of HK$825,000. The
date of issue of the estimated assessment was 30 November 2018. Based on Summer
HK Ltd’s draft audited accounts, the projected assessable profits for the year would be
HK$3 million and the tax payable HK$495,000.

Required:

(a) Explain the conditions to be satisfied for Summer HK Ltd to lodge a valid objection
against the 2017/18 estimated tax assessment.

(b) In the event that Summer HK Ltd lodges a valid objection against the estimated
assessment, advise the company’s obligation(s) with regard to the payment of tax and
the further action the company may take to suspend the payment of tax in dispute.

QUESTION 2
Central HK Ltd (‘Central’) manufactures winter jackets and sells them in Hong Kong and
overseas markets. It employs a team of 50 staff members for its operation. Mr. Wong,
who is the head of the purchasing division, submitted his resignation on 30 April 2018. His
employment with Central ended with effect from 31 May 2018. After deducting his outstanding
annual leave entitlement, Mr. Wong’s official last day in the office was 15 May 2018.

Mr. Wong advised Central that he would leave Hong Kong on 20 May 2018 to go to
Singapore and visit his sick relatives there. Mr. Wong decided to help with some of the
medical bills and requested Central to remit his final payment (including salary and bonus)
to his bank account in Singapore. Mr. Wong informed Central that he is likely to stay in
Singapore for at least two months and did not indicate whether he would be returning to
Hong Kong thereafter.

During the year of assessment 2018/19, Central also hired two new staff. However,
Central did not report this change in employees to the Inland Revenue Department.

Required:

(a) Describe the general reporting obligations of an employer in respect of the hiring
of new staff and the resignation of existing staff under the IRO and current practice
of the IRD.

(b) With respect to the resignation of Mr. Wong, explain to Central of its reporting
obligations, including the due dates of compliance.

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QUESTION 3
On 28 September 2018, Mr. Chang received his salaries tax assessment for the year of
assessment 2017/18. This assessment showed the following:

HK$
Assessable income 1,000,000

2017/18 final tax payable 140,000

Less: 2017/18 provisional tax paid (100,000)
40,000
2018/19 provisional tax payable 140,000
Total tax payable 180,000
Payable in two instalments:
By 15 January 2019 145,000
By 15 April 2019 35,000

Mr. Chang went into retirement in August 2018. He believes that he is not required to
pay the whole or part of the provisional tax for 2018/19 as assessed.

Required:

Explain to Mr. Chang of his options if he does not want to pay the whole or part of the
provisional tax for the year of assessment 2018/19.

QUESTION 4
Based on the Opening Case of this chapter, you have been hired by Mrs. Johnson as her
authorised representative to deal with her tax matters. You are required to explain the
following to Mrs. Johnson:

(a) Based on the relevant provisions in the IRO and in the absence of reasonable
excuse, what are the penalty actions that the IRD can take against Mrs. Johnson for
understating her taxable profits. You are also required to explain to Mrs. Johnson what
constitutes fraud and wilful intention.

(b) In her defence against the IRD’s allegations that her errors may constitute fraud and
wilful intention, please explain to Mrs. Johnson whether she has a reasonable excuse to
defend herself against any penalty action that may be imposed in (a) above.

QUESTION 5
With regards to the profits tax return (the ‘return’), please describe the relevant sections
under the Inland Revenue Ordinance, including but not limited to the prevailing practice of
the IRD and explain the implications of the following:

(a) When a taxpayer must file the return;

(b) The types of documents that should accompany a tax return;

(c) The implications for failing to file the return; and

(d) The person who has the legal responsibility to prepare and file the return.

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ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Summer HK Ltd may file a valid objection provided all the conditions below are
satisfied:

(i) The objection letter must be made in writing addressed to the Commissioner of
Inland Revenue (CIR);

(ii) The objection letter must state precisely the grounds of objection, for example, the
estimated profits are excessive, based on the company’s audited account for the
year ended 31 December 2017;

(iii) The objection letter must be received by the CIR within one month after the date of
the notice of assessment, unless an extension of time has been granted by the CIR
based on a reasonable cause which is accepted by the CIR; and

(iv) Where an estimated assessment has been issued in the absence of a proper tax
return, the objection will only be valid if the completed tax return as well as all
supporting documents, such as audited accounts, are submitted together with the
objection.

Therefore, Summer HK Limited must file to the CIR a letter of objection that
should be received by the CIR on or before 31 December 2018 (as 30 December
2018 is a Sunday) with the signed audited accounts and other relevant supporting
documents.

(b) Notwithstanding that Summer HK Ltd has filed a valid objection, it is still required to
pay the tax as assessed on or before the payment due date. However, the taxpayer
may apply for a holdover of the ‘tax in dispute’ pending the decision or settlement of
the objection. The CIR may agree to a conditional or unconditional holdover of the tax
in dispute. A conditional holdover can take various forms at the discretion of the CIR,
as follows:

(i) Summer HK Ltd is required to purchase a tax reserve certificate (TRC) equivalent
to the amount of the tax held over. In the event the tax becomes payable finally,
the TRC will be accepted as settlement of the tax payable but no interest will
accrue on the TRC. The TRC may be redeemed in cash with interest, or replaced
with a new TRC not earmarked for objection only, if the tax is ultimately held to be
not payable.

(ii) In the event that Summer HK Ltd does not have financial resources to purchase a
TRC (e.g. low cash balance or no credit facility), the CIR may require Summer HK Ltd
to provide a banker’s undertaking. The bank should undertake to pay the tax plus
interest, if the tax held over becomes payable upon settlement of the objection.

In the case of an unconditional holdover, the tax in dispute will not be payable
until the objection is determined. Generally, such a holdover is approved where the
objection is likely to be allowed due to certain reasons (e.g. an estimated assessment is
likely to be nullified following a proper return being lodged or a mistake has been made
by the assessor), or where a highly contentious tax or legal issue is involved.

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However, in the event that the tax does ultimately become payable, Summer HK Ltd
will be required to pay interest for the period from the later of the original due date or
the date of the holdover notice to the date that the objection is determined.

Based on the draft audited accounts and profits tax computation, the company’s
assessable profits are less than the estimated assessable profits as computed by
the IRD, therefore it is likely that the objection would be accepted and unconditional
holdover would be granted for the tax in dispute of HK$330,000 (i.e. HK$825,000 −
HK$495,000).

Summer HK Ltd should expect to receive a notice from the IRD confirming the
amount agreed to be held over, the balance of the tax that is payable and the due date
of payment. If the assessable profits per the return of HK$3 million are accepted, a
revised assessment will be issued to supersede the earlier estimated assessment and
Summer HK Ltd will be obliged to pay the tax due accordingly.

QUESTION 2
(a) Pursuant to s.52(4) of the IRO, an employer has the obligation to report to the IRD
within three months from employment commencement date of the newly employed
employee who is likely to be chargeable to salaries tax in Hong Kong, stating the full
name and address of the individual, the date of commencement and the terms of
employment.

Pursuant to s.52(2) of the IRO, the employer is also required to file an annual
employer’s return in respect of each employee every year.

In addition, when an employee resigns from employment in Hong Kong, the

employer is required to notify the IRD in writing not later than one month before the
cessation of such employment, pursuant to s.52(5) of the IRO. In practice, the official
effective date of resignation is taken as the date of cessation. In certain circumstances,
a shorter period of notice may be accepted if the employer only becomes aware of the
cessation in less than one month before the effective date

In a situation where an employee is about to leave Hong Kong for a period of longer
than one month, other than for business purposes that is connected to their Hong Kong
employment, the employer is required to notify the IRD of such departure, including
the expected date of departure, not later than one month before the expected date of
departure (s.52(6)). Shorter notice may be accepted in reasonable circumstances.

Lastly, pursuant to s.52(7) of the IRO, the employer is also required to withhold any
money payable to the departing employee for one month from the date on which the
employer gave notice of departure from Hong Kong to the IRD, unless written consent
from the IRD is received (s.52(7)).

(b) Mr. Wong

Mr. Wong ceased his employment with Central on 31 May 2018. In this case, Central
is required to file the cessation notice to the IRD by 30 April 2018. However, since Mr.
Wong only gave his notice of resignation to Central on 30 April 2018, the IRD is likely to
accept a shorter notice period under such circumstances. Central is expected to file the
cessation notice to the IRD no later than 31 May 2018 (i.e. effective cessation date of
employment).

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In the absence of any information indicating Mr. Wong’s return date to Hong Kong
and the fact that he intends to stay in Singapore for more than a month, Central is
required to file a notice of such departure to the IRD not later than one month before
the intended departure date of 20 May 2018, that is, 20 April 2018.

On the basis that Central was only notified by Mr. Wong of his resignation on
30 April 2018, the IRD is likely prepared to accept a shorter period of notice, but expects
such notice of cessation of employment and departure from Hong Kong to be filed
before the departure date of 20 May 2018.

Based on the given circumstances, Central is expected to notify the IRD in writing,
both relating to the notice of cessation as well as the departure before 20 May 2018.

With regards to money owing to Mr. Wong, Central is required to withhold the final
payment to him for one month from the date Central filed the mentioned cessation/
departure notice, until the IRD’s written consent is received.

In practice, such consent will be granted after Mr. Wong has cleared all his
Hong Kong tax liabilities or the IRD is satisfied that Mr. Wong has no intention to
depart from Hong Kong for good. The fact that Mr. Wong requested his final payment
to be remitted to his Singapore bank account does not change Central’s obligation as
employer to withhold the relevant payment due to Mr. Wong.

QUESTION 3
Due to Mr. Chang’s retirement in August 2018, he may apply to hold over part of the
provisional salaries tax in respect of 2018/19 since his assessable income for 2018/19
will be, or is likely to be, less than 90% of the amount assessed to provisional tax. The
application for holdover must be made in writing and lodged with the Commissioner before
the due date.

Note that the IRO provides for a two-tier time limit. Mr. Chang must lodge an application
not later than 28 days before the due date for payment of the provisional tax or 14 days
after the date of issue of the notice for payment of provisional tax, whichever is the later.

Therefore, in respect of all or a part of the first instalment of tax, Mr. Chang should lodge
an application for holdover on or before 18 December 2018. Any holdover application in
connection with the second instalment of tax should be lodged on or before 18 March 2019.

If no holdover of provisional salaries tax is made, Mr. Chang is required to pay the
tax at the amount demanded on the date specified. However, should it ultimately be
determined that his 2018/19 salaries tax liability is lower, any excess provisional salaries
tax paid will be offset against the final salaries tax payable for 2018/19 and the excess will
be refunded.

QUESTION 4
(a) Pursuant to s.80(2) of the IRO, any person who submits an incorrect tax return due to
omission or understatement of his or her taxable income without reasonable excuse is
guilty of an offence.

If prosecuted and convicted, Mrs. Johnson may face a maximum penalty of

HK$10,000 (level 3) and a further fine of treble the amount of tax that has or would
have been undercharged as a result of the understatement. The Commissioner may
compound these offences and settle for a monetary penalty under s.80(5).

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In cases of fraud and wilful evasion, a prosecution may be taken (under s.82(1)),
which can lead to imprisonment in addition to the usual fines. However, the burden
of proof lies with the Commissioner and, in practice, it is often difficult to demonstrate
that the taxpayer has engaged in a fraudulent transaction or shown wilful intent to
evade taxes.

Examples of fraud and wilful intention to evade taxes are as follows:

(i) An omission from a return;

(ii) A false entry or statement in a return;

(iii) A false statement in a claim for a deduction or an allowance; and

(iv) Signing a statement or return without reasonable grounds for believing that
it is true.

If no prosecution (under ss.80(2) or 82(1)) has been instituted, the Commissioner

or the Deputy Commissioner may penalise Mrs. Johnson by way of assessment to
additional tax up to a maximum of treble the amount of tax undercharged (s.82A). Mrs.
Johnson has the right to appeal to the Board of Review against the imposition and/or
quantum of any additional tax assessed (s.82B).

(b) The IRD generally does not view the following reasons as ‘reasonable excuse’:

• Ignorance of the law.

• Complete reliance on non-subject matter expert, unlike a professional tax advisor,

without validating the accuracy of the recommendation or advice that would be
expected from a reasonable person.

In Mrs. Johnson’s case, the IRD is unlikely to accept her explanation as a reasonable
excuse unless she has additional proof or corroborating evidence that she has sought
proper professional advice and her errors were purely as a result of oversight without
any intent of fraud or wilful conduct.

In hindsight, if Mrs. Johnson was uncertain as to the proper tax treatment of those
sales revenues, she should have made a full disclosure of the transaction in the return
and drawn the attention of the IRD. This would help to mitigate against any penalty
actions taken against her by the IRD.

QUESTION 5
(a) For Hong Kong tax purposes, there are three types of profits tax return forms that a
taxpayer should be aware of:

(i) Profits Tax Return – Corporations (BIR51);

(ii) Profits Tax Return – Persons Other Than Corporations (BIR52); and

(iii) Profits Tax Return – In Respect of Non-resident Persons (BIR54).

Therefore, any person who carries on business in the form of a corporation,

partnership business or if a non-resident person is chargeable to profits tax in the
name of the Hong Kong resident person, such person should report the profits on
profits tax returns as previously stated, whichever is applicable.

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Generally, Forms BIR51 and 52 are issued on the first working day in April (e.g. 1
April) each year. For a person who carries on a sole proprietor business, Form BIR60 is
required to be completed. This form is generally issued on the first working day in May
unless such person commences or ceases their business activity.

Taxpayers are required to file their respective tax returns within one month from
the date of issue. For sole proprietors of unincorporated businesses, the deadline for
submission is within three months from the date of issue. A further extension of one
month will be given automatically if the return is filed electronically.

However, if a tax representative is engaged by a taxpayer to handle the profits tax

return, the IRD would generally allow an extension of the time to submit the return in
relation to the accounting year end date of the business.

For example, if the taxpayer has a December year end, the authorised tax
representative may apply for an extension up to mid-August of the following year to
submit the return.

For taxpayers who have a year end between 1 January and 31 March, the
authorised tax representative may apply for an extension to mid-November in cases
where taxpayers have assessable profits to report and where taxpayers are in a loss
situation, such due date is further extended to the end of January of the following year.
(b) For corporate taxpayers, other than small corporation, they are required to attach their
audited accounts as supporting documents when filing a profits tax return.

For corporate taxpayers that qualify as a small corporation (e.g. annual gross
income for a basis period is less than HK$2 million in addition to some other conditions
as specified by the IRD), they are not required to attach audited accounts as supporting
documents with their profits tax returns but are still required to keep those documents
and submit them upon request.

With regards to a branch of a foreign corporation doing business in Hong Kong,

it is required to file Hong Kong profits tax return annually and the IRD may require
audited accounts of the foreign corporation to support the Hong Kong branch’s profits
tax return.

(c) Under s.80(2), a person commits an offence, in the absence of reasonable excuse, if
such person fails to file a profits tax return within the time period as required by the
IRD. The maximum penalty is a fine at level 3 (i.e. HK$10,000) plus 300% of the amount
of the tax underpaid or would have been underpaid.

However, instead of instituting a civil proceeding, the Commissioner reserves the

right to raise an additional assessment under s.82A as a form of administrative penalty
and impose up to 300% of the amount of the tax that was either underpaid or would
have been underpaid had the offence not been detected. Depending on the facts
and circumstances of the case, the Commissioner may compound the penalty to a
smaller amount.

The Commissioner may issue an estimated assessment based on estimation of

profits or income with reference to other similar taxpayers operating in a similar
industry and demand tax payment accordingly before a penalty or additional tax
is raised.

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Taxpayers have the right to file an objection if they consider the estimated assessment
is excessive. Such objection has to be filed timely and accompanied by a properly
completed tax return in order to be considered as a valid objection.

(d) Generally, any person who derives profits from Hong Kong or who has received a notice
to file a profits tax return, has the obligation to file a profits tax return within the time
period as stated in the return or such extended time allowed by the IRD. ‘Person’ is
defined under s.2 to include a corporation, partnership, trustee, whether incorporated
or unincorporated, or a body of persons.

Under s.51(1) of the IRO, an assessor has the power to issue a return to any person
and to require him or her to complete and submit the return within a reasonable time.

However, where no notice to file a profits tax return has been received by a person
who derives profits assessable to tax in Hong Kong, such person has the obligation
under s.51(2) to inform the Commissioner in writing within four months after the end of
the basis period for the relevant year of assessment that he or she is assessable to tax
in Hong Kong and request that a tax return be issued for completion.

Taxpayers may prepare and complete the tax return on their own. However, where
the business activity involves certain complex transactions or taxpayers are uncertain of
tax treatments relating to significant transactions, it is recommended that they engage
the assistance of qualified tax representatives to prepare and file the tax return on
their behalf.

Taxpayers should note that the return must be signed by an authorised person and,
in the case of a company, by its authorised officer such as company secretary, general
manager or director (or liquidator in the event of liquidation).

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 Part B
Tax Rules, Principles and
Calculations of Tax Liabilities for
Property Tax, Salaries Tax, Profits
Tax, Personal Assessment and Stamp
Duty in Hong Kong

Chapter 3 Profits Tax

Chapter 4 Salaries Tax
Chapter 5 Property Tax
Chapter 6 Personal Assessment
Chapter 7 Stamp Duty

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 3
Profits Tax

CHAPTER TOPIC LIST

3.1 Profits Tax Overview 3.3.9 Underwriting Income

3.1.1 Scope of Charge 3.3.10 Cross-Border Land
3.1.2 Chargeable Persons Transportation Income
and Tax Rates 3.3.11 Current Developments in
Source Issues
3.2 Trade, Profession or Business
3.3.12 Transfer Pricing
3.2.1 Trade
3.2.2 Profession 3.4 Miscellaneous Income and
3.2.3 Business Exemptions
3.2.4 Permanent Establishments 3.4.1 Sums Specifically Chargeable to
Profits Tax
3.3 Sources of Profits
3.4.2 Concessionary Trading Receipts
3.3.1 Traditional Tests of Sources
Chargeable to Tax at Half of the
of Profits
Profits Tax Rate
3.3.2 Source of Trading Profits
3.4.3 Sums Specifically Exempt from
3.3.3 Source of Manufacturing Profits
Profits Tax
3.3.4 Source of Commissions and
Service Fees 3.5 General Deductions and Specific
3.3.5 Interest Income Deductions
3.3.6 Rental Income 3.5.1 General Deduction Rule
3.3.7 Income from E-Commerce 3.5.2 Deductible Items
3.3.8 Royalties or Licence Fees 3.5.3 Deductible Interest
3.5.4 Deductions Not Allowed

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3.6 Distinction Between Capital and 3.10 Special Transactions and

Revenue Items Businesses
3.6.1 Capital Receipts and 3.10.1 Stock Taken for Own Use
Revenue Receipts (Sharkey v Wernher Principle)
3.6.2 Capital Expenditure and 3.10.2 Stock Borrowing and Lending
Revenue Expenditure Transactions
3.7 Depreciation Allowances 3.10.3 Financial Instruments
3.7.1 Depreciation Allowance for and Foreign Exchange
Machinery or Plant Differences
3.7.2 Industrial Building Allowance 3.10.4 Alternative Bond Schemes
3.7.3 Commercial Building Allowance 3.10.5 Regulatory Capital Securities
3.10.6 Special Classes of Business
3.8 Preparation of the Profits Tax
Computation 3.11 Partnerships and Joint Ventures
3.8.1 Preparing a Profits Tax 3.11.1 Partnerships
Computation 3.11.2 Profits Tax Computation for
3.8.2 Post-cessation Receipts a Partnership Business
and Payments and Pre- 3.11.3 Allocation of Profit/Loss
commencement Payments 3.11.4 Joint Ventures
3.8.3 Effect of Accounting Policies on 3.11.5 Entity Choice for Business
Tax Computations and Tax Purposes
3.8.4 Profits Tax – Prepaid or 3.12 Loss Relief for Individual,
Deferred Revenue Expenses Partnership and Corporation
3.9 Basis Period 3.12.1 Individual
3.9.1 Normal or Continuing Business 3.12.2 Partnership
3.9.2 Commencement of Business 3.12.3 Corporation
3.9.3 Cessation of Business 3.12.4 Cross Set Off
3.9.4 Change of Accounting Date

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 P ro f its T ax

LEARNING OUTCOMES

PRINCIPAL LO: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES FOR
PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT AND STAMP
DUTY IN HONG KONG
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Scope of profits tax charge
LO1: Explain the scope of charge of profits tax
LO2: Explain and apply the criteria for determining whether a person carries on a trade, profession
or business in Hong Kong
LO3: Describe the circumstances under which both profits tax and salaries tax may not apply
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Badges of trade
LO4: Analyse whether a transaction constitutes an adventure in the nature of trade
LO5: Apply the badges of trade in the context of tax cases and recent Board of Review decisions
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Source of profits
LO6: Apply the principles and rules for determining the sources of profits (including the chargeability
of e-commerce transactions)
LO7: Describe and apply the latest developments in tax cases on source issues
LO8: Apply DIPN No. 13, 21 and 39
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Deemed trading receipts
LO9: Apply the rules governing the taxation of deemed trading receipts
LO10: Apply DIPN No. 22 and 49
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Distinction between capital and revenue
items
LO11: Contrast capital and revenue items
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: General deductions and specific deductions
LO12: Apply the rules governing allowable and non-allowable profits tax deductions under the IRO
LO13: Apply DIPN No. 3, 5, 12, 13A, 24, 28, 33, 40 and 49
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Cessation and post-cessation receipts and
payments
LO14: Explain and analyse the tax issues in relation to cessation
LO15: Explain the operation of s.15D of the IRO
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Sharkey v Wernher principle
LO16: Explain and apply the Sharkey v Wernher principle
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Stock borrowing and lending transactions
LO17: Explain the tax implications for stock borrowing and lending transactions
LO18: Apply DIPN No. 26 and 27

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LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Financial instruments and foreign
exchange differences
LO19: Explain the taxation on financial instruments and taxation of foreign exchange differences
LO20: Apply DIPN No. 42
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Exemption for offshore funds and offshore
private equity funds
LO21: Explain and apply the exemption for offshore funds and offshore private equity funds
LO22: E
 xplain the historical background and rationale for the exemption for offshore funds and
offshore private equity funds
LO23: E
 xplain and apply the deeming provision and the ascertainment of the deemed assessable
profits
LO24: Apply DIPN No. 43 and 51
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Alternative bond schemes
LO25: Explain the religious background for alternative bond schemes
LO26: Explain the tax implications for alternative bond schemes
LO27: Apply DIPN No. 50
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Corporate treasury activities
LO28: Explain the profits tax concession to qualifying corporate treasury centres
LO29: E
 xplain the rules governing the deduction of interest payments on money borrowed by a
corporation carrying on in Hong Kong an intra-group financing business
LO30: Apply DIPN No. 52
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Regulatory capital securities
LO31: E
 xplain the profits tax treatments in respect of regulatory capital securities issued by banks to
comply with Basel III capital adequacy requirements
LO32: Apply DIPN No. 53
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Aircraft leasing activities
LO33: E
 xplain the profits tax concession and treatments for qualifying aircraft lessors and qualifying
aircraft leasing managers
LO34: Apply DIPN No. 54
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Special classes of business
LO35: Explain the tax rules governing income from aircrafts and shipping business
LO36: Describe how income from international traffic may be taxed under DTAs and Airline and
Shipping Income Agreements
LO37: Explain the tax rules governing income for different types of insurance companies
LO38: Describe the two different taxation methods for life insurance companies
LO39: Explain the tax rules governing income of clubs and associations
LO40: Explain the differences between clubs and associations with reference to tax cases
LO41: Explain the tax rules governing the income and expenses of financial institutions
LO42: E
 xplain the significance of the Sincere Insurance & Investment Co Ltd case to financial
institutions

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LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Partnerships, joint ventures and allocation
of profit/loss
LO43: Explain the tax rules governing partnerships and joint ventures
LO44: A
 pply the rules relating to partnerships and joint ventures in evaluating the choice of entity for
business purposes and the tax reporting requirements
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Losses
LO45: Explain the treatment of losses
LO46: E
 xplain and apply the mechanism under which the tax loss of a partner under a partnership is
offset against the partner’s other income under personal assessment and vice versa
LO47: Apply DIPN No. 8
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Depreciation allowances: plant and
machinery
LO48: Explain the rules governing the grant of depreciation allowances on plant and machinery
LO49: Calculate the depreciation allowances on plant and machinery
LO50: Apply DIPN No. 7
LO: Describe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Profits tax: Depreciation allowances: industrial
buildings and commercial buildings
LO51: Explain the rules governing the grant of industrial building allowances and commercial building
allowances
LO52: Calculate the industrial building allowances and commercial building allowances
LO53: Apply DIPN No. 2
LO: Calculate the following tax liabilities for transactions, individuals and entities: Profits tax:
Ascertainment of profits tax liability
LO54: D
 etermine the basis period for calculating assessable profits for the years in which a trade,
profession or business commenced or ceased or there is a change in accounting date
LO55: Calculate the assessable profits from a trade, profession or business chargeable to profits tax
LO56: C
 alculate the tax adjustments, the depreciation allowances on plant and machinery, the
industrial building allowances and commercial building allowances
LO57: Calculate the net assessable profits or adjusted losses
LO58: Calculate the profits tax payable, including provisional profits tax
LO59: Interpret the relevance of accounting policies in the context of tax computations
LO60: Apply DIPN No. 1, 20, 34 and 40

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OPENING CASE

GSHM

M r. Taiping King Wong (Mr. Wong) is an entrepreneur who has incorporated a company
in Hong Kong, GSHM Limited (GSHM). The main line of business of GSHM is retailing
high street fashion. GSHM rents office premises both in Kowloon and Hong Kong to sell its
own-brand mid-market clothing, aimed principally at middle-class women in the 25–45 age
bracket. GSHM is supplied by third-party Chinese manufacturers, which produce textiles in
China where labour costs are much lower, and export them to Hong Kong. Because costs
have been increasing in China, GSHM has recently begun outsourcing production to Vietnam.
Mr. Wong personally owns all its brands and designs and cultivates a strong brand identity,
seeking to compete in the same market as H&M and Uniqlo. That structure is, however,
inefficient from a tax perspective. Mr. Wong accordingly decides to transfer all the intellectual
property rights he currently holds to an offshore company, Red Lantern Limited (Red Lantern),
incorporated in the Cayman Islands. Red Lantern licences the intellectual property to GSHM
in exchange for an annual royalty. The operations and activities of GSHM are fairly typical
for a Hong Kong undertaking: In global supply chains, manufacturing, design, retail, and
intellectual property holding operations are often allocated to different jurisdictions to exploit
the comparative advantages of such jurisdictions when it comes to costs, worker skills, and tax
incentives. Effective tax structuring and tax mitigation options are also important to GSHM.

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OVERVIEW

This chapter will provide a comprehensive introduction to profits tax in Hong Kong. Unlike
many other jurisdictions, Hong Kong does not have a general income tax. That means that
income is in general not taxed unless it corresponds to one of the specific taxing schedules
in the Inland Revenue Ordinance (IRO). Profits tax is the most important of those schedules
and charges to tax the Hong Kong source profits (and thus not just the income) of a trade,
profession or business carried on in Hong Kong. That is a deceptively simple formulation. What
constitutes a trade, profession or business has been the subject of extensive judicial debate.
Most importantly, the source principle, which is critical in ascertaining whether profits are
taxable in Hong Kong, has become highly complex and, in certain cases, does not lend itself
well to contemporary transactions. While the general rule is that one looks to what the taxpayer
has done to earn its profits, and where it has done it, discounting antecedent or incidental
matters, it is often difficult to apply that broad guiding principle to a globalised economy based
on financial services such as that of Hong Kong. This chapter will consider in depth the essential
building blocks of profits tax and consider its application in a variety of commercial scenarios,
with both domestic and international elements. You will further be introduced to the specific
deeming provisions that treat certain sums as taxable even when they are not charged to tax
under the general charging provision in s.14 of the IRO, and to concessions and exemptions
that are available to certain taxpayers and certain circumstances. After acquiring a grounding
in the theory of the law underlying the charge to profits tax, you will study the relationship
between law and general principles of accounting, and further apply your knowledge to tax
computation. After completing your study of this chapter, you will have acquired a firm and
comprehensive grounding of the law and practice of profits tax and be ready to apply this to
practical commercial scenarios.

3 . 1
PROFITS TAX OVERVIEW

Unlike many other jurisdictions, Hong Kong does not have a general income tax on individuals
or on corporations. The principal tax on business profits is called ‘profits tax’, which is charged
on assessable profits. Profits are assessable to profits tax if and to the extent that they are the
profits of a trade, profession or business carried on in Hong Kong and are sourced in Hong
Kong. It is essential to understand this is a three-limbed test. In order for a charge to profits
tax to arise:

• First, there must be a person carrying on a trade, profession or business in Hong Kong;

• Second, they must derive Hong Kong source profits; and

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• Third, those profits must be the profits of that trade, profession or business carried on
in Hong Kong. Simply having a trade, profession or business in Hong Kong or deriving
Hong Kong source profits is insufficient.

Each limb must be met for a charge to tax to arise. An alternative way of expressing the
general charging provision is that a person must: (i) carry on a trade, profession or business
in Hong Kong; (ii) derive Hong Kong source profits; (iii) from that trade, profession or business
carried on in Hong Kong.

Although there are exceptions, which we shall consider in detail later in this chapter,
generally speaking, profits sourced from outside of Hong Kong are not taxable in Hong Kong.
As you by now know, Hong Kong has a territorial tax regime: The default position is that only
profits that arise in or are derived from Hong Kong are chargeable to tax. Although on its
face a simple and intuitive regime, the profits tax code can give rise to difficulties both for
enterprises and for practitioners. For example, when is a profit sourced in Hong Kong? Under
which circumstances, if at all, can a profit be said to be sourced in Hong Kong and in another
jurisdiction? What about passive income, such as dividends, interest, and royalties?

In this chapter, you will deepen your theoretical and practical understanding of the charge
to profits tax, the doctrine of source and some of the principal exceptions to the general rule
that only Hong Kong source profits are chargeable to tax. It is assumed that you are familiar
with first principles of profits tax; you should, however, take the time to refresh your memory
of s.14(1) of the IRO.

3.1.1 Scope of Charge

Profits tax is charged on the Hong Kong source profits of a person carrying on a trade,
profession or business in Hong Kong. Note the use of the term ‘profits’. Profits are different
from income or turnover. A profit is a notional unit of account denoting some economic gain.
Generally, a profit is computed by subtracting business expenditure from business income.
The scope of the charge is, as we have indicated, territorial: a company may have extensive
business income from a number of sources, but will only be charged to profits tax on its Hong
Kong source profits, and not its profits sourced offshore. Other jurisdictions, such as Canada
and the United Kingdom, tax on a residence basis: The general charge to income tax in those
jurisdictions provides that a resident person is chargeable on its worldwide income. That is
not the case in Hong Kong; whether a person is resident or otherwise in Hong Kong, it will in
general only be chargeable to tax on its Hong Kong source profits. The concept of tax residence
is therefore of limited importance as regards domestic Hong Kong taxation.

Profits tax is a charge to tax on assessable profits, as defined in the IRO. This is distinct
from any accounting notion of profits; in practice, the two concepts often overlap. The question
of what a taxable profit is always a question of law, as distinct from a question of fact or
accounting. In determining whether a profit is taxable, reference must be made to the terms of
the IRO and the case law on point, and not GAAP or any other applicable accounting standard.

Throughout this chapter, we will refer to ‘assessable profits’. Assessable profits are profits
eligible for taxation under s.14 of the IRO.

Note that gains from the sale of capital assets are expressly excluded from being
chargeable to profits tax in s.14(1) of the IRO. This is significant when we come to discuss the
distinction between trading and investment income below. The distinction between revenue

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and capital is one of the oldest questions in tax law, and we shall consider it in greater detail
when we discuss the deductions regime in ss.16–17 of the IRO.

3.1.2 Chargeable Persons and Tax Rates

S.14 of the IRO provides that profits tax is chargeable on the Hong Kong source profits of a
person carrying on a trade, profession or business in Hong Kong. The key term here is ‘person’.
S.2 of the IRO defines a person as including a corporation, partnership, trustee, or body of
persons. That is a broad definition: essentially, any person or entity capable of carrying on an
economic activity will be treated as a person, albeit not a separate legal person at law, taxable
under the IRO.

The rates of profits tax are set out in Schedules 1, 8, 8A and 8B of the IRO. Corporations
(that is, bodies corporate) are charged at a standard rate of 16.5% of assessable profits, though,
under certain circumstances, the first HK$2 million of assessable profits are charged at half the
corporate rate, being 8.25% (effective from the year of assessment 2018/19 onward). All other
taxable persons are charged to profits tax at the standard rate of 15%, or, where the
two-tiered profits tax rates regime applies, at half the standard rate, being 7.5% on the first
HK$2 million of assessable profits. The two-tiered profits tax rate is available subject to certain
conditions, the most important of which is that in a given group of connected entities only one
such entity can avail itself of the two-tiered profits tax rates regime.

In order to be eligible for the lower rate of profits tax on the first HK$2 million of
assessable profits, the principal condition is that only one person within a set of connected
persons is eligible for the reduced rate (s.14AAC). For example, in a group of companies, only
one company can enjoy the benefit of the reduced rate, even if each other company is also
chargeable to profits tax in Hong Kong. An entity for the purposes of the two-tiered profits tax
rates regime includes natural persons, bodies corporate, partnerships and trusts. If a natural
person carries on more than one sole proprietorship business, the person is taken to be a
separate entity in relation to each sole proprietorship business.

An entity is a connected entity of another entity if:

(a) One of them has control over the other;

(b) Both of them are under the control of the same entity; or

(c) In the case of the first entity being a natural person carrying on a sole proprietorship
business, the other entity is the same person carrying on another sole
proprietorship business.

Generally, an entity has control over another entity if the first-mentioned entity, whether
directly or indirectly through one or more than one other entity;

(a) Owns or controls more than 50% in aggregate of the issued share capital of the
latter entity;

(b) Is entitled to exercise or control the exercise of more than 50% in aggregate of the
voting rights in the latter entity; or

(c) Is entitled to more than 50% in aggregate of the capital or profits of the latter entity.

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Thus, where there is a set of connected entities, only one of those entities can elect for the
concessionary rate. All other entities within that set of connected entities will pay tax at the
standard rate. The reason for this restriction is to prevent aggressive tax structuring through
the fragmentation of a business between a large number of companies, with each availing itself
of the reduced rate of profits tax. This is a paradigmatic example of a specific, as opposed to
general, anti-avoidance provision, designed to prevent aggressive tax structuring. The Inland
Revenue Department (IRD) maintains a helpful FAQ summarising the scope and effect of the
two-tiered profits tax rates regime, which may be accessed by following this link:
https://www.ird.gov.hk/eng/faq/2tr.htm.

Key Learning Point

Profits tax is a charge on the Hong Kong source profits of a trade, profession, or business
carried on in Hong Kong. It is distinct from income tax in many other jurisdictions because
it is only charged on certain profits arising in or derived from Hong Kong.

Knowledge Check Questions

Question 1
Identify which of the following statements best summarises the charge to profits tax.
A Profits tax is a general tax on corporate profits, and is charged on corporations carrying
on a trade or business in Hong Kong.
B Profits tax is a tax on business income and is charged on persons deriving Hong Kong
source profits and carrying on a trade, profession or business in Hong Kong.
C Profits tax is a tax on Hong Kong source income, chargeable in the hands of persons
carrying on a trade or business in Hong Kong, irrespective of their jurisdiction of tax
residence.
D Profits tax is charged on Hong Kong source profits arising from a trade, profession or
business carried on in Hong Kong.

3 . 2
TRADE, PROFESSION OR BUSINESS

This section deals with the first limb of the s.14 charge to profits tax. First, you must consider
whether a person carries on a trade, profession or business in Hong Kong. If no trade,
profession or business is carried on in Hong Kong, the person in question is simply not
chargeable to profits tax under s.14 of the IRO. Any person carrying on a trade, profession or
business in Hong Kong is required to register under s.5 of the Business Registration Ordinance
(Cap.310), which operates as Hong Kong’s de facto tax registration law.

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3.2.1 Trade
Trade is defined in s.2(1) as including every trade and manufacture and every adventure
and concern in the nature of trade. This is a circular definition, so one looks to the case law
for clarification. A trade is an organised activity that is carried on with a view to profit. This
presupposes that there must exist a profit-generating activity that is carried on with some
degree of recurrence and continuity (see, for example, Kowloon Stock Exchange Ltd v CIR (1984)
STC 602 and Simmons v IRC (1980) 2 All ER 798). There are certain elements one would normally
expect to find in trading activities because a trade should be distinguished from an investment.
The gains from an investment, which are capital in nature, are not chargeable to profits tax. In
most cases, trading profits arise from the sale of assets held as trading stock (as opposed to
capital assets) or from the supply of services. In deciding whether a gain derived from the sale
of an asset is a trading or capital sale, the landmark decision in Marson v Morton (1986) 1 WLR
1343 found the following ‘badges of trade’ to be of particular relevance:

• Profit-seeking motive: generally speaking, trading is carried on commercially and with a

view to profit. This may be contrasted with activities that are carried on for pleasure or
on a charitable basis, where no subjective profit-seeking motive is identifiable.

Illustrative Example 1
Mr. Montgomery Withnail QC is an amateur arts collector. He enjoys hanging antique
Chinese scrolls in his apartment on the Peak. One scroll he bought for HK$2 million.
A friend of his subsequently suggested that he might buy the scroll from him for
HK$3 million. Mr. Withnail initially refused but, on reconsideration, agreed to part
with the scroll for the offered sum. Under those circumstances, the gain he derived is
likely not a trading profit. Mr. Withnail simply does not habitually trade in antiques, but
accepted a generous offer on an exceptional basis.

• The subject matter of the transaction: A person acquiring trading stock and realising
this daily at a retail outlet will likely be trading; however, a person buying and disposing
of a building will be less likely to be regarded as trading unless he uses the building
as his stock-in-trade (Marson v Morton (1986) STC 463). It seems that the subjective
intention of a buyer of landed property at the time of its acquisition is especially
important in determining whether it is acquired as a trading asset. This can also be
triggered by one of the following:

°° The nature of the asset (e.g. whether it is used for personal enjoyment, income
yielding, trading, etc.);

°° The quantity of such assets; and

°° The purpose to make inference on the trading intention.

The intention to elect to begin trading can also cause the asset to cease being a capital
asset and become stock-in-trade (Simmons v IRC (1980) 1 WLR 1196). Conversely, in Lee Yee Shing
Jacky & Anor v CIR (2008) 2 HKC 436, the Court of Final Appeal noted that in practice it would

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be rare for persons, especially individuals, to be found to be trading in shares unless they
were professional securities dealers. Otherwise, transactions in shares are to be regarded as
investments or speculation, and not trading.

Illustrative Example 2
Mr. Montague Withnail QC carries on the profession of being a barrister. He has a
holiday home in Sai Kung, which he decides to sell because it is too inconvenient to travel
there, and he now prefers to vacation in Thailand. He accordingly disposes of the home
at a significant profit. That is unlikely to be a trading transaction. The house is not trading
stock in Mr. Withnail’s hands. Conversely, if he sold the house to a professional property
trader, who subsequently resold it to a developer, that would more likely be a trading
transaction, since immovable property is the stock-in-trade of a property trader.

• The number of transactions carried out: repeated or systematic transactions are more
likely to indicate trading activity than isolated or incidental transactions, though in
certain cases an isolated transaction can nonetheless be a trading transaction (Pickford
v Quirke (1927) 13 TC 251). However, repeated transactions do not necessarily have
to be trading transactions. Investments, such as investments in securities, may be
turned over quickly and yet not be regarded as trading disposals (Rangatira Ltd v CIR
(1997) STC 47).

• The length of the period of ownership: Assets turned over quickly will likely be regarded
as having been disposed of in a trading transaction, whereas assets held for long
periods of time are less likely to be held as trading stock.

• The frequency or number of similar transactions by the same person: an iteration of

similar transactions points to a pattern that would indicate a systematic trade (CIR v
Fraser (1942) 24 TC 498).

• Supplementary work on or in connection with the property sold: the more value added
by the person selling an asset (or providing a service), the greater the likelihood that
the person will be found to be trading in that regard. This includes making a good or
service more marketable than it would otherwise be (Cape Brandy Syndicate v CIR (1921)
12 TC 358).

Illustrative Example 3
Mr. Germano Lugaresi is an Italian artisan who is resident in Hong Kong. He acquires
leather from local suppliers from which he crafts designer bags. He sells the bags from his
boutique in Sham Shui Po. Those sales are likely to be sales made in the course of trade.
That is because Mr. Lugaresi has acquired a raw material and subjected it to a process that
has made it more marketable, that is, turned raw leather into a bag.

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• The manner in which the sale of the asset was effected: If a transaction has the
commercial characteristics one would normally associated with a trading activity, it
may thereby be regarded as a trading disposal (CIR v Livingston and Others (1926) 11
TC 538). Contrast situations where the disposal of the asset is opportunistic or outside
the ordinary course of trade, where the transaction in question is unlikely to be
regarded as a trading transaction (Hudson’s Bay Co v Stevens (1909) 5 TC 424).

• The method by which the asset was acquired: Where an asset is inherited or gifted, that
will likely be a prima facie indication of it not being a business asset. The same logic
would apply to an asset initially acquired for personal purposes though that would not
prevent the taxpayer from changing their mind on the mode of utilisation of the asset
(Taylor v Good (1974) STC 148). Conversely, an asset acquired on a market could indicate
that it is held as trading stock.

• The source of financing: Where loan finance is contracted to purchase the asset, this
would suggest that it must at some stage be resold for the loan to be repaid (Wisdom v
Chamberlain (1969) 1 WLR 275) though obviously this does not necessarily apply in the
context of mortgage finance for dwellings.

Illustrative Example 4
Billion Fortune Ltd is a company incorporated in Hong Kong that sells jewellery and other
high-value items. In order to fund the acquisition of trading stock, it contracts frequent
short-term loans on the basis of a facility agreement it has contracted with Dragon
Bank. Its sales are likely to be made in the course of trade because it is contracting loan
finance on apparently commercial terms. The pattern of loan finance and the manner
in which it acquires its stock-in-trade – that is, on the basis of short-term loans with a
view to realise these quickly so as to be able to repay the loan principal – all suggest a
systematic pattern of activity that can readily be identified as trading. Taken in the round,
the taxpayer’s activities suggest property speculation rather than investment in the
acquisition of a purely capital asset.

Where more of the badges of trade are found to apply as a matter of fact, a tenable
argument could be made that the taxpayer is trading. That said, the badges of trade and other
factors are not a checklist. There is no single decisive factor. The specific activities carried on
by the person in question need to be assessed holistically and each case falls to be determined
on its own facts (CIR v Church Body of the Hong Kong Sheng Kung Hui (2016) 1 HKC 1). Whether
a person is found to be carrying on a trade is a mixed question of fact and law. A person can
carry on more than one trade or business for profits tax purposes, and if that is the case, each
such trade would need to be evaluated to determine the extent to which it gives rise to profits
taxable in Hong Kong.

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Illustrative Example 5
Mr. Tang is a professional accountant. On 1 June 2018, Mr. Tang inherited a piece of
land in the New Territories upon the death of his father. On 1 July 2018, he sold it to
a property development company for HK$50 million. He then used the sale proceeds
to buy another piece of land in Yuen Long through a wholly owned limited company,
namely Tang Co Ltd (TCL). TCL levelled the land and constructed drainage. It also
advertised the land for rental and sale. The land is classified as a long-term investment in
TCL’s unaudited financial statements for the year ended 31 December 2018. TCL sold the
land for HK$70 million in December 2019.

Mr. Tang acquired the first piece of land by inheritance rather than by purchase in
the market. His immediate disposal would likely indicate that he was merely realising his
legacy, and the sale would not amount to a trading adventure.

However, TCL did a lot of work to enhance the saleability of the second piece of land.
The fact that TCL advertised it for rental or sale might indicate TCL has no settled intention
to hold the land as a long-term investment. The accounting classification might not be
useful as it is from the unaudited financial statement. The land was disposed within a short
period of time. Therefore, TCL would likely be regarded as carrying on a trade and the
profits would be chargeable to profits tax.

Illustrative Example 6
GSHM carries on the trade of retailing high street fashion. Separately, its board of
directors acquired a commercial property in Lo Wu in June 2014. It was envisaged that
the property would operate as a warehouse, but market conditions were such that the
board of GSHM decided to rent it out instead. It advertised the property for a number
of months, without success, until it ultimately found a tenant in January 2015. The
tenant left in February 2016, and thereafter GSHM used the site as a warehouse where
its storage facilities in Hong Kong were not sufficient to cope with shipments of goods
from its suppliers. In October 2018, GSHM was contacted by a developer, Billion Jumbo
Gold Profit, which offered to purchase the property for redevelopment at a significant
mark-up. Because the board of GSHM decided the company urgently needed liquidity
for working capital, it agreed to the sale. Under those circumstances, the disposal of
the property is unlikely to be treated as a trading disposal for the purposes of s.14 of
the IRO. By reference to the badges of trade and a holistic assessment of the situation,
the subjective motive of GSHM was to acquire the property as a capital asset (that
is, to store its stock-in-trade). There was apparently little work done to increase its
value or marketability, and it was leased to a tenant for over a year and then used as
a warehouse, suggesting that GSHM expected to hold it in the long term. There is no
evidence that GSHM regularly carried out property transactions and the asset was held
for a total of over four years. The circumstances of disposal were opportunistic, and not
in the ordinary course of the business of GSHM. GSHM did not market the property to
the developer; the developer actively courted GSHM. It would follow that, on balance, the
transaction is likely to be regarded as a sale of a capital asset under s.14(1) and therefore
the gains arising therefrom are not chargeable to profits tax.

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3.2.2 Profession
A profession is not defined in the IRO. At common law, a profession involves the idea of an
occupation requiring either purely intellectual skill or of manual skill controlled, as in painting
and sculpture, or surgery, by the intellectual skill of the operator, as distinguished from an
occupation which is substantially the production or sale or arrangements for the production
or sale of commodities. What constitutes a profession may depend on the time period and
socio-cultural context (IRC v Maxse (1919) 1 KB 647).

We can apply the concept of ‘profession’ to determine whether an item of income should
be subject to salaries tax or profits tax. If the income is derived from an employment, it will
be subject to salaries tax. If the income is derived from a profession, it would be subject to
profits tax.

The following four tests are commonly applied to distinguish a profession from an
employment:

1. Degree of control (control test).

2. Provision of own equipment and helper, degree of financial risk, responsibility of

management and investment (economic reality test).

3. Part of the organisation (integration test).

4. An employer is generally required to provide work and the employee is required to

discharge that work (mutuality of obligation test).

Consider that an accountant is in certain circumstances an employee and in others a

professional for the purposes of the IRO. An accountant can be employed as an associate,
manager, or partner in an accountancy firm but can also be a sole practitioner. In the former
case, the accountant is an employee and must abide by the rules of the employment. In the
latter case, the accountant carries on a profession for the purpose of s.14 of the IRO.

Illustrative Example 7
Mr. Wong is hired by W Ltd as a marketing manager, with fixed working hours,
supervised by a director. Mr. Wong does not need to provide his own equipment. He
receives fixed salary plus commission based on W Ltd’s turnover. He is holding a name
card of W Ltd.

In view of the degree of control, level of financial risk and level of integration to W
Ltd, Mr. Wong is having an employment with W Ltd and he is subject to salaries tax on his
income received from W Ltd.

Mr. B and Y Ltd entered into a service contract whereby Mr. B was appointed as a
marketing consultant. He also signed similar service contracts with other companies. He
had no fixed working hours at Y Ltd but needed to submit marketing proposals by due
dates specified by Y Ltd. He had to report to the marketing director of Y Ltd. He hired his
own assistants, rented an office, and incurred various overheads. He held a name card just
showing his own name as a professional marketing consultant.

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Illustrative Example 7 (continued)

Mr. B is not subject to employment type control by Y Ltd. He is subject to financial risk
in view of his own investment in hiring own helpers and renting an office. He is not part
and parcel of Y Ltd. He carried on a profession and is subject to profits tax in respect of his
consultancy fee income from Y Ltd.

3.2.3 Business
The threshold for carrying on a business is much lower than carrying on a trade. A business
is defined broadly in s.2 of the IRO, and includes: an agricultural undertaking, poultry and
pig rearing and the letting or subletting by any corporation to any person of any premises
or portion thereof, and the subletting by any other person of any premises or portion of any
premises held by him under a lease or tenancy other than from the government.

The tax position for letting and subletting of real property is outlined in Exhibit 3.1.

Rental income from corporations Rental income from persons other

than corporations
Letting of The rental income is assessable to both The rental income is assessable to
real property profits tax and property tax. property tax.
   
The corporation can claim exemption The rental income is also assessable to
from property tax under s.5(2)(a) or set profits tax, if the person is carrying on
off property tax paid against profits tax a business of letting. In that case, the
payable under s.25. person can claim to set off the property
tax paid against the profits tax payable
under s.25.
Subletting of Assessable to profits tax Assessable to profits tax
real property

EXHIBIT 3.1 Tax position for letting and subletting of real property

The term ‘business’ is considered to have a wider meaning than that of trade. In practice,
business implies activities of a commercial character.

In Lee Yee Shing and Another v CIR (2008), the Court of Final Appeal held that the words
‘carrying on’ connote a repetition of acts or that the series of acts undertaken by the taxpayer
must be such that they constitute a business. Underlying the term ‘business’ is the fundamental
notion of the exercise of an activity in an organised and coherent way and one which is directed
to an end result.

Because of the circularity of the definition in s.2, some clarification from the case law
on point is necessary. Any commercially gainful use to which a person puts its assets may
in principle be capable of qualifying as the carrying on of a business for the purposes of
s.14, for which see, for example the CIR v Bartica Investment Ltd (1996) 4 HKTC 129, where
simply maintaining bank accounts in Hong Kong for business purposes was found to amount

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to carrying on a business in Hong Kong, and American Leaf Blending Co Sdn Bhd v DGIR
(1978) STC 561. Ultimately, whether a company is carrying on a business is a matter of fact
and degree.

That said, the IRD recognises that the mere receipt of interest by a company does
not constitute the carrying on of a business though anything that goes beyond passive
acquiescence may in principle constitute the carrying on of a business even if punctuated by
occasional periods of relative inactivity.

A case to illustrate the low threshold for being found to be carrying on a business in
Hong Kong is the decision in CIR v Bartica Investment Ltd, where the taxpayer placed deposits
with banks in Hong Kong and the deposits were pledged as security for loans made to other
group companies. The taxpayer also held investments and purchased shares in a company
listed in Hong Kong. The court held that the company carried on a business in Hong Kong in
the broad sense contemplated by the Privy Council in American Leaf Blending: placing deposits
was what the company actually did to turn its assets to account and so amounted to carrying
on a business. Note that Bartica was decided at a time when bank interest was taxable in
Hong Kong. As you will learn in this chapter, that is no longer the case.

Key Learning Point

Trade, profession or business are terms of broad import. Any economic activity carried
on by a person is in principle capable of being, at a minimum, a business. That being said,
gains from the sale of capital assets are, notwithstanding that they may be sales in the
course of business, exempt from profits tax.

3.2.4 Permanent Establishments

A permanent establishment (PE) is a fixed place of business through which the trade or
business of a non-resident person is partially or wholly carried on. PE rules are important
to the application of double taxation agreements (DTAs) to which Hong Kong is party. DTAs
allocate taxing rights between the head office and a PE. Note that a PE is in general the same
legal person as its head office; subsidiaries are only rarely PEs of their parent companies. In
substance, a PE is a separable taxable presence of a non-resident person in a given jurisdiction.
Where a DTA is in force between Hong Kong and another jurisdiction, the relevant definition of
PE in the DTA (usually, Article 5) will prevail.

Conversely, where the jurisdiction in which a person is resident does not have a DTA with
Hong Kong, the commercial presence of that person in Hong Kong must be analysed in the
light of Part 3 of Schedule 17G of the IRO, which sets out the domestic PE regime in Hong Kong
(note that the definition of a PE in the context of a DTA to which Hong Kong is party will prevail
over the domestic definition in the context of that DTA (see Chapter 10). This broadly follows
the definition of a PE found in the OECD Model Convention: There must be a fixed place of
business through which the business of an enterprise is wholly or partially carried on. A fixed

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place of business connotes some fixed, physical premises at the disposal of the enterprise. In
particular, it includes a place of management, a branch, an office, a factory, a workshop, or a
natural resource extraction facility. It does not, however, include activities or operations, which
taken in the round, have a preparatory or auxiliary character. For example, the maintenance
of a showroom, a warehouse, a purchasing office, or an information-gathering centre will not
usually amount to a PE. That is because such activities, though commercially relevant, are not
proximate to the profit-making transactions of the business.

For an enterprise which is a non-DTA territory resident person and have an agent acting
on its behalf in Hong Kong, the agent’s activities in Hong Kong would constitute a PE for the
enterprise if

• The agent habitually concludes contracts on behalf of the enterprise, or plays a

principal role leading to conclusion of contracts that are routinely concluded without
material modification by the enterprise, and

• The contracts are in the name of the enterprise for transferring ownership/right to use
of property, or provision of services

An agent will not be deemed as a PE if it is an independent agent acting in its ordinary

course of business. However, it will not be taken as an independent agent if it acts exclusively
for the enterprise and its closely related enterprises.

S.50AAK provides that to have a PE in Hong Kong necessarily amounts to carrying on

a trade, profession or business in Hong Kong for the purposes of s.14. Nevertheless, the
absence of a Hong Kong PE does not necessarily mean a person does not carry on a trade,
profession or business in Hong Kong. As noted in Section 3.2.3, the threshold for being
found to carry on a business in Hong Kong is low. Accordingly, one can carry on a business
for the purposes of s.14 in Hong Kong and yet not have a Hong Kong PE on the terms of
Schedule 17G.

The IRD’s published policy on the attribution of profits to a PE may be found at DIPN No. 60,
though you should also refer to the extensive published OECD guidance on point, especially
where the application for a DTA is concerned.

Illustrative Example 8
Flower Ltd (FL) is incorporated in Country F, which has not signed any tax treaty with
Hong Kong. All directors’ meetings of FL were held in Country F. FL appointed an agent
in Hong Kong to preliminarily negotiate with its clients in Hong Kong based on FL’s
instruction sent via emails. Upon approval and conclusion of the trading terms by the
directors of FL in Country F, the goods will be delivered to the clients from Country F.

FL did not have a PE in Hong Kong because the agent did not habitually conclude any
contracts on behalf of FL. FL is not subject to Hong Kong profits tax.

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Illustrative Example 9
Grass Ltd (GL) is incorporated in Country G, which has not signed any tax treaty with
Hong Kong. All directors’ meetings of GL were held in Country G. GL appointed an
agent in Hong Kong to negotiate sale contracts with GL’s clients in Hong Kong based on
the trading parameters provided by GL beforehand. The trading parameters provided
sufficient authority and flexibility to the agent to negotiate and conclude the trading
terms. Though the agent concluded all trading terms, it did not sign any sale contract on
behalf of GL. Upon conclusion of the sale terms, the Hong Kong agent would prepare and
email the contract to GL for signature by GL’s directors in Country G. The goods would
then be delivered to the clients from Country G.

GL maintained a PE in Hong Kong as the agent habitually concluded contracts on

behalf of GL. GL would be subject to profits tax in respect of profits derived from goods
sold to Hong Kong clients.

Illustrative Example 10
GSHM is a company incorporated and resident in Hong Kong. Because it sees an
opportunity in the South Korean market, it acquires a sales office and retail premises
in Seoul, which are owned directly by GSHM. Because it retails apparel in South
Korea, GSHM can be said to carry on part of its business of retailing apparel in South
Korea. Accordingly, it will have a PE in South Korea on the terms of Article 5 of the
Hong Kong – Republic of Korea DTA. The business profits attributable to the South
Korean PE will in general be taxable in South Korea, and not in Hong Kong.

Compare the case of Dobermann Machine Tools GmbH (Dobermann), a company

incorporated and resident in Germany, which sets up a showroom in Hong Kong at Asia
Expo to raise awareness in the Far East of its cutting-edge precision instruments. It does
not conclude any sales from its showroom, and the employees sent to operate it do not
have the authority to bind the company in any contracts. In this case, Dobermann likely
does not have a PE in Hong Kong. There is no DTA between Hong Kong and Germany;
accordingly, one refers to the domestic PE rules in Schedule 17G, of which s.5 provides
that having a showroom is, taken with all other activities carried on by that enterprise in
Hong Kong, of a preparatory or auxiliary character and thus does not amount to a PE.
Accordingly, Dobermann does not have a Hong Kong PE though it may still be considered
as carrying on a business in Hong Kong for the purposes of s.14.

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Knowledge Check Questions

Question 2
Identify which of the following is most likely to be a PE in Hong Kong.
A A mobile oil rig in territorial waters.
B An exhibition space to showcase a new brand of luxury electric cars.
C A suite at the Peninsula Hotel utilised from time to time by the chief financial officer of a
multinational corporation to meet with potential business partners.
D A call centre established by a bank to provide customer care in the Greater China region.

Question 3
Identify which of the following does not amount to the carrying on of a trade, profession or
business in Hong Kong.
A Montgomery Withnail QC, an English barrister, moves to Hong Kong to offer his services
to Hong Kong clients advising exclusively on matters of English law.
B Shinji Ikari sells Japanese high fashion from his Harajuko, Japan, workshop to customers
in Hong Kong via the online retail platform ‘Silk Road’.
C Dobermann Industries GmbH, a German aircraft engines manufacturer, establishes a
facility in Yuen Long to manufacture turbine blades.
D Vulture Ltd, a company incorporated in Hong Kong, holds interests in private equity
investments in China, which it occasionally sells to interested buyers.

3 . 3
SOURCES OF PROFITS

This is the second limb of the s.14 charging provision. At this stage, you should have ascertained
whether a trade, profession or business is carried on in Hong Kong. If Hong Kong source profits
are derived from that trade, profession or business, then they will be taxable in Hong Kong
under s.14.

The source of profits is perhaps the most important question in Hong Kong tax law. Profits
sourced from outside of Hong Kong are not in general chargeable to profits tax. Enterprises
therefore often go to great lengths to arrange their affairs so as to give rise to ‘offshore’ rather
than Hong Kong source profits. Source as a concept should not be over-complicated. It is a
commercial and not a technical matter, which must be found on a case-by-case basis. Most
importantly, it must be determined by reference to what exactly it is that the taxpayer has
done. This will vary from trade to trade or from business to business. The source concept
has a strong contextual element, which means it is important for practitioners to understand
the precise economic and commercial characteristics of an enterprise’s business to advise
effectively on whether profits are sourced in Hong Kong or elsewhere. Thus, the answer to the
question of whether profits are sourced in Hong Kong will often be: ‘it depends on what the
taxpayer did to earn its profits’.

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3.3.1 Traditional Tests of Sources of Profits

The question of source has been the subject of frequent debate in common law courts. That is
because many colonies of the British Empire had, like Hong Kong, territorial or semi-territorial
taxing regimes.

In Rhodesia Metals v CoT, Lord Atkin approved the general statement that:

Source means not a legal concept, but something which a practical person would regard as a real
source of income; the ascertaining of the actual source is a hard practical matter of fact.

Those sentiments were echoed by Lord Bridge in CIR v Hang Seng Bank Ltd (1991) 1 AC 306,
which is generally regarded as the landmark revenue law case on the question of source in
Hong Kong:

The broad guiding principle, attested by many authorities, is that one looks to see what the
taxpayer has done to earn the profit in question.

The Judicial Committee of the Privy Council in HK-TVB International Ltd v CIR (1992) 2 AC 397
expanded on the broad guiding principle:

F.L. Smidth & Co v Greenwood (1921) 3 K.B. 593 was cited in the Hang Seng Bank case and their
Lordships do not doubt that Lord Bridge had in mind the judgement of Atkin L.J. in that case and in
particular the passage when he said, at p. 593: ‘I think that the question is, where do the operations
take place from which the profits in substance arise?’

Thus Lord Bridge’s guiding principle could properly be expanded to read ‘one looks to see
what the taxpayer has done to earn the profit in question and where they have done it’

Applying Lord Bridge’s guiding principles, the first question to be determined in this appeal
is what the transactions are which produced the profit to the taxpayer.

Lord Jauncey went on to say:

Although Godfrey J. correctly concluded that the operation of the taxpayer which generated the
taxable profits was one carried on in Hong Kong he went too far in saying that a taxpayer must
establish the existence of a profit-generating operation outside Hong Kong if he is to escape
a charge to tax under s.14. It is clear from the Hang Seng Bank case (1991) 1 AC 306 that in
appropriate circumstances a company carrying on business in Hong Kong can earn profits
which do not arise in order from the colony, notwithstanding the fact that those profits are not
attributable to an independent branch overseas.

CIR v Orion Caribbean Ltd (1997) 1 HKLRD 924 was the last Hong Kong revenue law
appeal adjudicated on the advice of the Privy Council, and in that case, Lord Nolan affirmed
the broad guiding principle doctrine articulated in HK-TVBI, approving in particular the
following passage:

Their Lordships consider that it is a mistake to try to find an analogy between the facts in this
appeal and the example given by Lord Bridge in the Hang Seng Bank case. The circumstances
in that case involving, as they did, buying and selling in well-defined foreign markets were very
different from those in the present and the examples were never intended to be exhaustive of
all situations in which s.14 of the Ordinance might have to be considered. The proper approach
is to ascertain what were the operations which produced the relevant profits and where those
operations took place.

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That is the so-called operations test, which was likewise approved by the Hong Kong Court
of Appeal in Magna Industrial Co Ltd v CIR (1997) 1 HKLRD 173.

In Kwong Mile Services Ltd v CIR (2004) 3 HKLRD 168, the Court of Final Appeal held:

What the Taxpayer did in the Mainland was to assume an underwriting risk. But this was, as we
have seen, an underwriting arrangement of an unusual kind. The assumption of this underwriting
risk did not earn the Taxpayer any premium, fee or other payment. All that the Taxpayer acquired
by assuming this underwriting risk was an opportunity to earn the Profits by its exertions.
What actually earned the Profits for the taxpayer were its exertions in the form of its activities
in marketing the property. And those activities took place in Hong Kong. The source with which
provisions like our s.14 is concerned is, I think, accurately described by Stephen J’s phrase in the
Esquire Nominees case [Esquire Nominees Ltd v FCT (1971–1973) 129 CLR 177] at p. 225, namely
‘a quite proximate source’.

In ING Baring Securities (Hong Kong) Ltd v CIR (2007) 10 HKCFAR 417, Bokhary PJ (as he then
was) opined as follows:

The focus is therefore on establishing the geographical location of the taxpayer’s profit-producing
transactions themselves as distinct from activities antecedent or incidental to those transactions.
Such antecedent activities will often be commercially essential to the operations and profitability
of the taxpayer’s business, but they do not provide the legal test for ascertaining the geographical
source of profits for the purposes of s.14.
Lord Millett supplied the following observation:

Lord Jauncey was plainly not intending to enunciate a different test from that stated by Atkin LJ.
The operations ‘from which the profits in substance arise’ to which Atkin LJ referred must be taken
to be the operations of the taxpayer from which the profits in substance arise; and they arise in
the place where his service is rendered or profit-making activities are carried on. There are thus
two limitations: (i) the operations in question must be the operations of the taxpayer; and (ii) the
relevant operations do not comprise the whole of the taxpayer’s operations but only those which
produce the profit in question.

The above-mentioned decisions concur that in establishing the locality of profits one
looks to what the taxpayer has done to earn its profits, or to the profit-making operations or
transactions, as the case may be, discounting antecedent or incidental matters. What the words
‘done’, ‘operations’, and ‘transactions’ have something in common is that they import a degree
of activity on the part of the taxpayer itself in Hong Kong that gives rise to the profit in question.
That is the plain meaning of those words in their practical, commercial sense.

Thus, determining the source of profits is a hard, practical matter of fact to be judged
as a practical reality. It is, in other words, not a technical matter but a commercial one. The
fundamental test is what were the operations of the taxpayer from which the profits in
substance arise, and they arise in the place where their service was rendered or profit-making
operations were carried on. The test thus has two limitations: (a) the relevant operations must
be the operations of the taxpayers or performed on their behalf and for their account by a
person acting on their instructions; and (b) the relevant operations do not comprise the whole
of the taxpayer’s operations but only those which produced the profits in question, and in
that regard one cannot be distracted by antecedent or incidental matters (ING Baring Securities
(Hong Kong) Ltd v CIR (2008) 1 HKLRD 412). The focus of the source test is, therefore, the

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proximate source of the profits; that is, the operations or transactions that in substance, and as
a matter of commercial reality, gave rise to the profits.

DIPN No. 21 (Revised) is a helpful and publicly accessible guide to the IRD’s policy on the
source of profits, though this document does not have force of law. DIPN No. 21 acknowledges
the broad guiding principle in Hang Seng Bank, but expands on it in asserting the IRD’s assessing
practice. In particular, it adopts positions that are not necessarily clear-cut at law. Notably, the
following is a summary of the IRD’s policy:

(a) The question of locality of profits is a hard, practical matter of fact. No universal
judge-made test will cover every case. Whether profits arise in or are derived
from Hong Kong depends on the nature of the profits and the transactions giving
rise to them.

(b) The ascertainment of the source of profits though a practical, hard matter of fact
requires an accurate legal analysis of the transaction.

(c) The transactions must be looked at separately and the profits of each transaction
considered on their own.

(d) The broad guiding principle is that one looks to see what the taxpayer has done to
earn the profits in question and where they have done it. In other words, the proper
approach is to ascertain what were the operations which produced the relevant profits
and where those operations took place. This is the so-called ‘operations test’.

(e) The operations in question must be the operations of the taxpayer.

(f) The relevant operations do not comprise the whole of the taxpayer’s activities carried
out in the course of their business but only those which produce the profit in question.
It is necessary to appreciate the reality of each case, focusing on effective causes for
earning the profits without being distracted by antecedent or incidental matters.

(g) The distinction between Hong Kong profits and offshore profits is made by reference to
gross profits arising from individual transactions.

(h) In certain situations, where gross profits from an individual transaction arise in different
places, they can be apportioned as arising partly in and partly outside Hong Kong,
though in practice the IRD prefers to apportion on a 50 : 50 basis for certain Mainland
manufacturing operations where there is a sustained element of value addition in
Hong Kong.

(i) The place where day-to-day investment decisions are taken does not generally
determine the locality of profits derived from the realisation of those investments.

(j) It is necessary to examine the operations of the taxpayer even though the taxpayer
may be a company within a group. The source of profits must be attributed to the
operations of the taxpayer which produce them and not to the operations of other
members of the group. The operations of the group should not be looked at on the
question of source. However, in appropriate cases, if a related company is in fact
acting on behalf of the taxpayer, then the activities of the related company will be
considered to see if appropriate weight should be accorded thereto.

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(k) If an arrangement or scheme is implemented in Hong Kong to free transactions from

overseas regulations or overcome trade barriers, this in itself will not mean that the
profits will be sourced outside Hong Kong.

(l) Identifying an agent’s acts with those of its principal, while imposing some unity on the
law applicable to situations where one party represents or acts for another, should not
be taken to an inappropriate degree or taken too literally since this is not conducive to
arriving at the accurate legal analysis.

(m) In brokerage business, it is not necessary that the transaction which produced
the profit was carried out by the taxpayer or their agent in the full legal sense
(i.e. one who enters into a contract on their principal’s behalf creating a contractual
relationship between their principal and a third party). It is sufficient that the
transaction was carried out on the taxpayers’ behalf and for their account by a
person acting on their instructions.

(n) The absence of an overseas permanent establishment of a Hong Kong business does
not, of itself, mean that all of the profits of that business arise in or are derived from
Hong Kong.

(o) The place where the taxpayer’s profits arise is not necessarily the place where they
carry on business. However, in HK-TVB International Limited v CIR (1992) 2 AC 397 Lord
Jauncey said (obiter), ‘it can only be in rare cases that a taxpayer with a principal place
of business in Hong Kong can earn profits which are not chargeable to profits tax’. This
is the so-called ‘rare case’ dictum – it is not binding, but it has been adopted by the IRD
as an integral part of its assessing policy.

Illustrative Example 11
Super Lucky Gold Dragon Ltd (SLGD) is a company incorporated in Hong Kong, which
carries on a letting business. It rents commercial premises situated in Hong Kong
to businesses, including GSHM. Are profits from SLGD’s letting business Hong Kong
source? Applying the operations test and asking the fundamental question of what
it is the taxpayer did to earn its profits, and where it did it, one would find that SLGD
lets out property in Hong Kong. The property in question is Hong Kong immovable
property, which is physically located in Hong Kong. On that basis, the profits of its
letting business will be Hong Kong source. Now let us assume that SLGD carries on
the business of retailing jade jewellery in Hong Kong from shops it leases specifically
for that purpose. The jade jewellery is manufactured in a plant in Guangxi province, in
China. SLGD carries on two trades: it is a manufacturer and a retailer. Its retail profits
are chargeable to tax in Hong Kong because they are the profits of a trade, profession
or business carried on in Hong Kong and are Hong Kong source by virtue of the retail
transactions having been effected in Hong Kong. Conversely, its manufacturing profits
are not Hong Kong source because the manufacturing process takes place outside of
Hong Kong. It would follow that they are not chargeable to profits tax.

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You will recall that the s.14 test is a three-limbed charging provision. The mere fact of
carrying on a trade, profession or business in Hong Kong is not sufficient for a charge to tax to
arise. The final two parts of the three-limbed test in s.14 charging provision are separate and
distinct; the mere fact that a person carries on a trade, profession or business in Hong Kong
does not necessarily mean that it will be taxable in Hong Kong (CIR v The Hong Kong & Whampoa
Dock Co Ltd (1960) 1 HKTC 85) though note the ‘rare case’ dictum.

That being said, in HK-TVB International Ltd v CIR (1992) AC 397, the court held that it can
only be in rare cases that a taxpayer with a principal place of business in Hong Kong can earn
profits, which are not chargeable to profits tax. To illustrate the importance of that distinction,
consider the decision of the Hong Kong Court of Appeal in CIR v The Hong Kong & Whampoa Dock
Co Ltd (1960) 1 HKTC 85. In that case, the taxpayer carried on its trade in Hong Kong. When
a ship ran aground in the South China Sea, the taxpayer was instructed by the shipowner to
raise the stricken vessel. The taxpayer dispatched its own ship, whose master, having inspected
the site of the incident, confirmed that it was viable to raise the vessel. The shipowner agreed,
and the vessel was raised. The IRD sought to assess the taxpayer to profits tax on the profits
derived from that operation. The Court of Appeal held that, although it was common ground
that the taxpayer carried on its business in Hong Kong, the proximate cause of its profits
in the present case was the raising of the stricken vessel, and that operation had occurred
in international waters. Accordingly, the source of the taxpayer’s profits with respect to the
salvage operation was outside of Hong Kong.

Contrast, however, the Privy Council decision in HK-TVB International Ltd (1992) AC 397,
where the court held that it can only be in rare cases that a taxpayer with a principal place of
business in Hong Kong can earn profits which are not chargeable to profits tax. Note that this
comment was made obiter, that is, a comment that is not binding or part of the reasoning of the
decision, but is an observation in passing; it has been influential in the IRD’s practical approach
to taxation in Hong Kong. It is certainly true that as a practical matter it will be difficult to argue
that where all business operations are conducted in Hong Kong, no Hong Kong sourced profits
arise; that being said, the analysis will always be fact-dependent.

There is extensive authority for the proposition that where profits are sourced in two
jurisdictions, an apportionment should be made (see for example CoT v Kirk (1900) AC 588 and
Hang Seng Bank). Despite the case law being clear that a profit may in principle be sourced both
in Hong Kong and in other jurisdiction, necessitating an apportionment of that profit between
the two jurisdictions to determine how much of that profit is chargeable to tax, the IRD prefers
to employ an ‘all-or-nothing’ approach, and in practice refuses to contemplate apportionment
unless it is apportionment on a 50 : 50 basis in certain manufacturing operations, which we will
consider in further detail below.

Illustrative Example 12
GSHM establishes a subsidiary incorporated in Hong Kong, Glorious Exposition Ltd (GEL)
to retail fashion aimed at the Taiwanese market. Because of significant differences in
taste, GEL does not market is products in Hong Kong. It has a Hong Kong head office
where its board of directors meets and where substantive business decisions are made,
but all of its retail facilities are located in Taiwan. It does not have any sales in Hong
Kong. GEL carries on a trade, profession or business in Hong Kong; however, all of its
profits are sourced in Taiwan. Accordingly, it is not taxable in Hong Kong: it has only met
the first and not the second limb of the s.14 charging provision.

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3.3.2 Source of Trading Profits

In merchandise trades and other trades or businesses involving the supply of goods, the profits
of the trader are derived from the fact that it sells (i.e. contractually disposes of) the goods
in question to another person, presumably at a mark-up relative to the cost of acquisition. In
other words, the trader earns its profits by entering into contracts for the supply of goods to a
buyer. If contracts form the essence of the business, then for the purpose of determining the
locality from which the income is derived, one looks no further back than the place where the
contracts are made (Whampoa Dock). Thus, if the profit-making activity consists substantially
of the making of contracts, the place where the contracts are made may be regarded as the
only significant factor (CoT v Cam & Sons Ltd (1936) 36 SR (NSW) 544). It would follow that profits
from buying and reselling of commodities were derived from the place where the contracts of
purchase and sale were effected (Hang Seng Bank).

‘Effected’ in this context does not merely mean legally executed; instead, it is taken to
extend to the process of contract formation generally, and will contemplate all the relevant
operations carried out to earn the profits, including the solicitation of orders, negotiation,
conclusion, trade financing, shipment and performance of the contracts (CIR v Magna
Industrial Co Ltd (1997) HKLRD 171). The IRD takes the view that in a scenario where a trading
company acquires trading stock and then resells this to customers, it will look to the place of
where the contracts for sale and purchase were effected. Where the contracts were in each
case effected in Hong Kong, the profits of the trader will be treated as Hong Kong source
and, by the same logic; where neither is effected in Hong Kong, the profits will be treated
as offshore and so not taxable. Where either contract is effected in Hong Kong, the initial
presumption is that the profits of the trader are fully taxable though in practice greater
weight is usually attached to the contract of sale, which is the contract that in substance gives
rise to the trader’s profits. Sales to customers in Hong Kong will generally be regarded as
uniformly Hong Kong source.

The same principles apply in ascertaining the profits derived from the sale and purchase
of unlisted securities: one will look to see where the contracts for sale and purchase were
effected. Conversely, listed securities may only legally be traded on the exchange on which
they are listed. Accordingly, profits derived from the sale and purchase of listed securities will
be regarded as sourced in the jurisdiction in which the shares in question are listed (Bombay
Presidency and Aden v Chunilal B Mehta (1938) 1 ITR 521).

In ascertaining the locality of the profits of a merchandise trade, the place where the
contract of sale is effected typically has greater weight than the place where the contract of
purchase is effected. Thus, in the case of a buying office, where a trading company carrying
on business outside Hong Kong sets up an office in Hong Kong to acquire merchandise and
to gather information, that office is not involved in any sell-side activities, and the IRD is of the
view that no liability to profits tax should arise merely by virtue of the existence of the buying
office. That conclusion overlaps with the orthodox construction of PE legislation, whereby
offices solely for the gathering of information or for the purchase of goods or merchandise
do not constitute a PE (see, for example, Schedule 17G, s.5(3)). Where the buying functions
are delegated to a subsidiary or agent, and the subsidiary or agent as the case may be is
remunerated for rendering that service, such service income is, however, chargeable to
profits tax.

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A curious case is of re-invoicing centres that are centres that operate in Hong Kong for the
purposes of invoicing trading transactions effected elsewhere, for example, with respect to
merchandise that is not shipped to or from Hong Kong, and which is not sold in Hong Kong.
Commission income or profit that accrues to a re-invoicing centre for services rendered in
Hong Kong is chargeable to profits tax because the general rule is that profits arising from
rendering services are sourced in the jurisdiction where those services are rendered. Here, it is
important to distinguish service income from trading income: True trading income arises from
transactions involving the assumption of commercial risks. Conversely service provision aims to
support such trading operations, rather that constituting part of the operation itself.

Apply and Analyse 1
Atreides GmbH is a company incorporated and resident in Germany, which carries on
the business of selling aircraft engines. Aiming to expand its business presence in the
Far East, it established an office in Hong Kong in January 2019, which performed certain
information-gathering and market research services. After a satisfactory report back to
its corporate headquarters in London, the office was upgraded to a sales office, with full
contract-making authority to sell aircraft engines in September 2019. Atreides did not
manufacture its aircraft engines in Hong Kong but sold them to airlines operating in Hong
Kong via its Hong Kong office. As part of the sales package, Atreides offered after-care
engine maintenance services to all its customers.

Discuss the profits tax implications of this scenario from the perspective of Atreides.

Analysis

There is no DTA between Hong Kong and Germany. It is unlikely that Atreides established
a PE in Hong Kong in January 2019 because the activities then carried on by its office were
clearly defined as being auxiliary and preparatory for the purposes of the domestic PE
rules and so incapable of constituting a PE. When Atreides began selling in Hong Kong, it
likely constituted a PE and certainly was carrying on a trade in Hong Kong for s.14 of the
IRO purposes. The sale and purchase of aircraft engines was apparently effected in Hong
Kong, such that the profits of those transactions would be regarded as Hong Kong source.
Similarly, because the after-sale maintenance service offered by Atreides was rendered in
Hong Kong, profits arising from that service would likely have been Hong Kong source and
so likewise chargeable to profits tax.

3.3.3 Source of Manufacturing Profits

Manufacturing profits are sourced in the jurisdiction where the manufacturing process actually
takes place because what a manufacturer does to realise its profits is manufacture goods.
The value addition – that is, the process for which the manufacturer is paid by the persons
contracting it to carry out the manufacturing operations – takes place where the manufacturing
physically occurs. If a manufacturer in Hong Kong sells its goods to a merchant in Manila, the
payment which it receives is undoubtedly sourced in Manila but the profit on the transaction
arises in and is derived from its manufacturing operation in Hong Kong (HK-TVB International).
Thus, where goods are manufactured in Hong Kong, the profits arising from the sale of such

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goods will be fully taxable because the manufacturing operations, the profit-making activities,
are carried out in Hong Kong. This includes the procurement of raw materials, the employment
of labour, the design of products and the use of machinery and plant. Inversely, where goods
are manufactured elsewhere, and sold in Hong Kong, the relevant profit arising in Hong
Kong will be the profit on sale, that is, the difference between the cost of acquisition of the
manufactured good and its sale price.

In certain circumstances, the IRD accepts a 50 : 50 apportionment of profits between

Hong Kong and another jurisdiction in so-called contract processing cases. Contract
processing is where manufacturing takes place offshore, but the Hong Kong company is
actively involved in elements of the manufacturing process, such as supplying technical
and managerial know-how, quality control, provision of raw materials and machinery to the
offshore processor. In other words, the Hong Kong company adds value to the manufacturing
process, notwithstanding that the process itself takes place outside of Hong Kong. The logic
behind allowing apportionment in a contract processing scenario is, therefore, that the person
carrying on a trade or business in Hong Kong does more than simply acquire the products
of the offshore manufacturer, but actively engages in the manufacturing process itself, such
that, applying the broad guiding principle on the source of profits, it can be said that at least
a portion of those profits arises in or is derived from Hong Kong. There is no sound juridical
basis for this 50 : 50 policy of apportionment, since it does not necessarily reflect the extent of
value addition made in each of Hong Kong and the other jurisdiction, and is, in effect, an IRD
concession. As a technical matter, case law suggests apportionment is possible and necessary
in cases that warrant it, that is, where the profit in question can be said to arise in more than
one jurisdiction.

Contrast import processing, where the manufacturing operations are carried out by a
Mainland entity (or entity located in another manufacturing hub) related to the Hong Kong
company; the Hong Kong company procures and sells raw materials (or other inputs) to the
manufacturer and buys back the finished goods. In effect, this is a species of captive toll
manufacturing. Broken down into its constituent parts, the Hong Kong company engages in
the trading of raw materials and finished goods while the Mainland company manufactures
the finished goods. Each transaction is a true transaction in the commercial sense of the word
because legal title passes from one party to the other. Here, the general rule is that each
set of operations is treated for tax purposes as being the operations of, on the one hand,
the Hong Kong company and, on the other, the manufacturer. In CIR v Datatronic Limited
(2009) 4 HKLRD 675, the Court of Appeal held that the profit-producing transactions were the
purchase of goods from the manufacturer by the taxpayer and the subsequent resale of the
same and that those activities took place in Hong Kong. Thus, the profits were derived from
Hong Kong although the manufacturer was a wholly owned subsidiary of the taxpayer.

A contract processing arrangement must be distinguished from an import processing

arrangement. In import processing, the manufacturing operations are carried out by a separate
legal entity incorporated in the Mainland or another country. The Hong Kong company sells raw
materials to the Mainland or overseas entity and buys back the finished goods from the entity.
The Hong Kong company engages in the trading of raw materials and finished goods while
the Mainland or overseas entity manufactures the finished goods. The legal title to the raw
materials and the finished goods passes to/from the entity. The IRD takes the view that a 50 : 50
apportionment is not available to the Hong Kong company as the company derives profit from
trading rather than manufacturing. There is in this case no element of risk assumption or

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participation in the manufacturing process by the Hong Kong company. It would follow that the
profits of the Hong Kong company would as a matter of fact and law arise from the exercise of
its merchandise trading business as opposed to any manufacturing trade or business, which
would properly be imputed to the Mainland or overseas manufacturer.

The IRD holds the view that profits which accrue to the Hong Kong company from ‘trading
transactions’ carried out in Hong Kong cannot be attributed to the manufacturing operations of
the Mainland entity in the Mainland. The source of the trading profits must be attributed to the
operations of the Hong Kong company which produce them (supported by Consco Trading v CIR
(2004) 1 HKRC 90-132 and Datatronic and C G Lighting v CIR (2011) 2 HKLRD 763).

3.3.4 Source of Commissions and Service Fees

Again, one must apply the broad guiding principle on the locality of profits as summarised
above: See what the taxpayer has done to earn its profits, and where it has done it. The crucial
question is therefore what the taxpayer did to earn its commissions. Management fees or
performance fees that are in substance consideration for services rendered in Hong Kong will
therefore likely be sourced in Hong Kong. Conversely, commissions, albeit received in Hong
Kong, for services rendered abroad should not be sourced in Hong Kong. The source of the
income is the place where the activities of the commission agent are performed, and where
services are rendered in connection with the earning of the commission both in and outside
of Hong Kong, the profits should be apportioned accordingly (CIR v Indosuez WI Carr Securities
Ltd (2002) 1 HKLRD 308). In that regard, the place where principals are located, how they are
identified by the commission agent and the place where incidental or antecedent operations
are effected are in general irrelevant in ascertaining the source of profits arising from
commission income.

Profits from the rendering of services are generally sourced in the jurisdiction where those
services are rendered. Such a conclusion is consistent with the broad guiding principle. If one
asks what it is that the service provider did to earn its profits, the answer to that question is
plainly the rendering of services.

There are cases commission income may arise where a business is carried on in Hong Kong
but the activities which give rise to the commission income are not performed in Hong Kong.
The IRD agrees such commission income is not taxable (see examples in DIPN No. 21).

3.3.5 Interest Income

Interest income may be charged to profits tax either under s.14 or under one of the deeming
provisions in s.15, which we shall consider later. The IRD’s views on the locality of interest
income are set out in DIPN No. 13 (Revised). For persons other than a financial institution
(FI), for simple loans of money, the provision of credit test is generally applied to determine
whether interest income is derived from Hong Kong. The provision of credit test places
emphasis on the place where the sum of money is first made available to the borrower.
However, ‘provision of credit test’ is not applicable where the cases are not simple loans of
money. The Privy Council held in Orion Caribbean Limited v CIR (1997) 4 HKTC 432 that where
the taxpayer earned its profits by borrowing and lending of money in the ordinary course
of business, the proper test to ascertain the source of the profits was the operations test:
one looks to see what the taxpayer has done to earn the profit in question and where he
has done it.

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For interest on trade debts, the source is usually the same as that of the trading profits
(Studebaker Corporation of Australia Limited v Commissioner of Taxation for New South Wales
(1921) 29 CLR 225)

For FIs, interest is chargeable to tax under the deeming provision of s.15(1)(i) if it is derived
‘through or from the FI’s business in Hong Kong’. There are agreed tax treatments of the
income of a FI which are outlined in Section 3.10.6.1.

Apply and Analyse 2
Ace Company Ltd (ACL) is a Hong Kong company, which has been carrying on a financial
advisory business in Hong Kong for years. For the utilisation of excess funds generated
from its existing operations and for the exploration of new overseas customers, ACL has
envisaged the development of money lending activities.

ACL would lend the excess funds generated from its existing operations to selective
borrowers. Specifically, ACL prefers lending its excess funds to overseas borrowers as the
management of ACL took the view that interest income derived from loans advanced to
overseas borrowers is not subject to profits tax.

Analysis

In the case of a simple loan of money, one applies the ‘provision of credit test’. Interest is
regarded as sourced in the place where the principal with respect to which that interest is
payable was first made available to the borrower. The residence of the borrower and the
lender are therefore, to that extent, irrelevant. By contrast, where the taxpayer carries on
the business of borrowing and lending money, or otherwise does so in the ordinary course
of its business, the ‘operations test’ in Orion Caribbean will apply: The interest will, thus,
be treated as sourced in the jurisdiction where the relevant operations through which the
borrowing and lending transactions were conducted were carried on.

For the potential money lending activities, if ACL simply applies its excess fund for
lending and does not carry out any other operation associated to the lending, it may be
regarded as simple loan of money and ‘provision of credit’ test will apply. However, if ACL
has an organised set-up to handle the lending activities and performs extensive lending
activities (such as credit evaluation and rating on borrowers, setting interest rate and
negotiating with borrowers on the loan terms), the IRD may regard ACL as carrying on
money lending business and will apply the operations test to determine the locality of the
interest income.

3.3.6 Rental Income

Profits from the sale of land, real estate, buildings and other immovable property are sourced
in the jurisdiction in which the property is situated (Rhodesia Metals Ltd v CoT (1940) AC 774).
By the same logic, profits derived from rental income arising from the rental of immovable
property in Hong Kong are sourced in Hong Kong. Profits from the leasing of movable property
are generally treated as sourced in the jurisdiction where the property is utilised (CoT v British
Shoe Machinery (SA) (Pty) Limited (1964) 26 SATC 163); compare s.15(1)(d) which deems sums for
the use or the right to use movable property in Hong Kong to be chargeable to profits tax.

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3.3.7 Income from E-Commerce

The IRD’s position with respect to the locality of profits of e-commerce is set out in DIPN
No. 39. The general principle underlying that policy is the so-called ‘neutrality of treatment’:
the ordinance is applied to e-commerce on the same basis as to conventional forms of
business. The IRD considers that no particular business form should have an advantage
or a disadvantage as far as taxation is concerned. This approach is intended not only to be
pragmatic, but also to be consistent with that taken by other developed jurisdictions.

Thus, whether e-commerce amounts to carrying on a trade or business in Hong Kong will
be a mixed question of law to be established by reference to the operations actually carried
out by the undertaking in Hong Kong. Merely keeping a fully automated server (intelligent or
otherwise) in Hong Kong for the purposes of effecting e-commerce transactions or having
Hong Kong based customers is in and of itself insufficient. If, however, the taxpayer has a
substantive commercial presence in Hong Kong, then the profits of e-commerce may be
taxable in Hong Kong to the extent that the taxpayer does not carry on its business elsewhere
even if the e-commerce transactions are routed through an offshore server. Accordingly, a
non-resident e-commerce platform with no business presence in Hong Kong, selling to Hong
Kong customers will not, by itself, be chargeable to profits tax in Hong Kong. The status of an
‘intelligent’ server in Hong Kong capable of performing automated transactions or operations
without human input is more complex. Acknowledging that the PE doctrine must evolve in line
with technological developments, the IRD is of the view in DIPN No. 39 that a wholly automated
presence (e.g. an intelligent server) in Hong Kong may be sufficient to constitute the carrying on
of a trade or business in Hong Kong or otherwise to form a PE. That conclusion appears on its
face to be technically accurate. There is nothing in s.14 that requires human agency for a trade
or business to be carried on.

Turning to the question of the source of profits, the neutrality of treatment principle
should likewise apply. Consequently, and in summary, the IRD’s guidance follows the logic of
the ‘operations test’, that is, one looks to the proximate operations giving rise to the taxpayer’s
profits. Therefore, IRD takes the view that the location of the server alone does not determine
the locality of the profits, and the proper approach is to focus more on the core operations that
have effected the e-commerce transaction to earn the profits in question and the place where
those operations have been carried out, rather than on what has been done electronically.

3.3.8 Royalties or Licence Fees

Generally, royalties are periodic payments made for the use or the right to use intellectual
property, such as a copyright, trademark, scientific formula, or process. Where a person carries
on the trade or business of licensing intellectual property rights, the source of profits arising
from that trade or business will depend on whether the licensor developed the intellectual
property in its own right or otherwise acquired the intellectual property from its developer or
another person with a view to licensing it. If the licensor developed the intellectual property
itself and did so in Hong Kong, the profits included in the royalties payable for the use or the
right to use those intellectual property rights will be Hong Kong sourced (Millin v CIR (1928)
AC 207). If, however, the licensor merely acquired the intellectual property rights, the profits
comprised in the royalties payable to it will be sourced in Hong Kong to the extent the relevant
licence or sub-licence agreement from which the licensor derives its profits is concluded in
Hong Kong (Lam Soon Trademark v CIR (2005) HKLRD 625).

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The IRD’s policy on the source of royalty and licence fees affirms both the ‘broad guiding
principle’ and the ‘operations test’ as summarised above. Also compare ss.15(1)(a)–(bb), which
deem certain sums paid in connection with the use or the right to use intellectual property
rights in Hong Kong or otherwise arising from performances in Hong Kong to be chargeable to
profits tax (see Section 3.4.1 for details).

3.3.9 Underwriting Income

Profits comprised in underwriting income are in substance generated by the underwriter
agreeing to bear a given risk in exchange for consideration (usually a premium). It would
follow that the principal consideration in establishing the locality of underwriting income will
be whether or not the risk under the guarantee or underwriting commitment is to be borne
by a person carrying on an underwriting business in Hong Kong. In instances where the Hong
Kong underwriter has no discretion on the acceptance or rejection of offshore instructions and
undertakes no risk, its underwriting income will be accepted as merely having been booked in
Hong Kong and not assessable to profits tax on that basis.

3.3.10 Cross-Border Land Transportation Income

DIPN No. 21 states the IRD’s policy that normally the place where the passengers or goods
are picked up determines the location of profit. If the contract of carriage does not distinguish
between outward and inward transportation, apportionment of profits between offshore and
onshore sources will not be permitted. Note that profits derived in the Mainland by a Hong
Kong resident enterprise from the operation of ships, aircraft or land transport is exempt from
Mainland taxes under the Mainland/Hong Kong DTA.

Exhibit 3.2 is a helpful memory aid of the IRD’s assessing policy on source extracted from
DIPN No. 21 (Revised).

Income or profits Locality

Rental income from real property. Location of the property.
Profits derived by an owner from Location of the property.
the sale of real estate.
Profits from the purchase and sale Location of the stock exchange where the shares or securities in
of listed shares and other listed question are traded.
securities. Where the purchase and sale took place over-the-counter, the
place where the contracts of purchase and sale are effected.
Profits from the purchase and Place where the contracts of purchase and sale are effected,
sale of unlisted shares and other except financial institutions in instances where s.15(1)(l) applies.
unlisted securities.
Service fee income. Place where the services are performed which give rise to the fees.
It should be noted that in the case of an investment adviser whose
organisation and operations are located only in Hong Kong, profits
derived in respect of the management of the clients’ funds are
considered to have a Hong Kong source. Included in chargeable
sums are not only management fees and performance fees but
also rebates, commissions and discounts received by the adviser
from brokers located in Hong Kong or elsewhere in respect of
securities transactions executed on behalf of clients.

EXHIBIT 3.2 Locality of profits

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Income or profits Locality

Interest earned by persons other Determined on the basis set out in DIPN No. 13 (‘Profits tax –
than financial institutions. Taxation of Interest Received’).
Royalties other than those Place of acquisition and granting of the licence or right of use.
deemed chargeable under s.15(1) Please refer to DIPN No. 49, Part B.
(a), (b) or (ba).
Cross-border land Normally, the place of uplift of the passengers or goods.
transportation income. However, where the contract of carriage does not distinguish
between outward and inward transportation, apportionment
will not be permitted. Article 8 of the Comprehensive Double
Taxation Arrangement with the Mainland is relevant. See relevant
paragraphs in DIPN No. 44 (‘Arrangement between the Mainland
of China and the Hong Kong Special Administrative Region for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with respect to Taxes on Income’).

Source: DIPN No. 21 (Revised), para. 45.

EXHIBIT 3.2 (Continued)

Apply and Analyse 3 – Adapted from HKICPA Module D

September 2001 Exam
Raptor Transportation Ltd (RTL), which was incorporated and based in Hong Kong, started
its coach services between Hong Kong and Zhuhai in January 2018. RTL had ticket offices
in Tsim Sha Tsui, Central and Kwun Tong (collectively named as Hong Kong Offices). The
Hong Kong Offices sold one-way tickets and round-trip tickets. The one-way tickets were
for trip from Hong Kong to Zhuhai. The round-trip tickets were for the trip from Hong Kong
to Zhuhai and then from Zhuhai back to Hong Kong.

RTL entered into agreements with three Zhuhai hotels, whereby the hotels sold one-
way tickets for the trip from Zhuhai to Hong Kong for RTL on a commission basis. The
agreements were negotiated and concluded in Zhuhai.

RTL maintained neither office nor staff in Zhuhai. RTL had contracted a garage in
Zhuhai to provide services to any bus that broke down in Zhuhai.

For the year ended December 2018, among the total revenue of RTL, 60% of the
revenue were from sales of round-trip tickets, 30% were from sales of one-way tickets from
Hong Kong to Zhuhai. The remaining 10% were from sales of one-way tickets from Zhuhai
to Hong Kong.

Required

Discuss the extent to which the revenue RTL generated from its coach operations between
Hong Kong and Zhuhai is chargeable to tax in Hong Kong.

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Apply and Analyse 3 (continued)

Analysis

Profits tax is charged on the Hong Kong source profits of a trade, profession or business
carried on in Hong Kong. When it comes to cross-border transport, profits may arguably
arise both from the location where the passengers or goods are boarded onto the
transport and the place where they are offloaded or otherwise where supporting
contractual operations take place. In order to provide some practical clarity, the IRD is of
the view that the general rule is that the profits of cross-border transport businesses are
sourced in the place where the goods or passengers as the case may be are uplifted onto
the transport. If the revenue was derived from transportation where the passengers were
uplifted in Hong Kong, the revenue was derived from Hong Kong. Hence, the revenues
derived from coach services from Hong Kong to Zhuhai was derived from Hong Kong. The
revenue derived from coach services from Zhuhai to Hong Kong was not derived from
Hong Kong. The places where the tickets were sold and where the coaches were repaired
was not relevant in determining the source (see DIPN No. 21 (Revised), para. 45(h)).

It is further explained in DIPN No. 21 (Revised) that if it is not possible to identify

separately the revenue generated from the return trip to Hong Kong from Zhuhai, no
apportionment will be allowed. The 30% revenue for trips from Hong Kong to Zhuhai was
derived from Hong Kong and assessable. The 10% revenue for trips from Zhuhai to Hong
Kong was not derived from Hong Kong and not assessable. In respect of the 60% revenue
for round-trip tickets, if the revenue cannot be separated into portions related to the trips
that started from Hong Kong and those that started from Zhuhai, the IRD is not prepared
to allow for any apportionment. Accordingly, to ascertain the tax position of RTL with
greater certainty, further information and documents should be collated and reviewed to
ascertain the revenue for the two types of trips.

3.3.11 Current Developments in Source Issues

Recent court decisions in Hong Kong have affirmed the broad guiding principle in Hang
Seng Bank and emphasised the importance of source as a concept tied to the substantive
and commercial operations carried on by the taxpayer. Source is therefore not a matter of
‘impression’ – the facts that a taxpayer is resident in Hong Kong or has extensive activities
in Hong Kong do not necessarily mean that all or any of its profits are chargeable to profits
tax. In CIR v Li & Fung (Trading) Ltd (2012) HKCU 643, the court emphasised the importance
of looking at the actual profit-making transaction and discounting antecedent or incidental
matters. Even though the taxpayer company was administered from Hong Kong and provided
certain back-office functions in Hong Kong, it did not mean that the profits from its contracts
effected offshore were in any measure sourced in Hong Kong. There is, therefore, a divergence
between the courts, who affirm the principle of strictly assessing the second limb of the
s.14 charging provision independently of the first limb, and the IRD, which agrees with the
comments of one of the judges in HK-TVB International that it will only be in rare circumstances
that no Hong Kong source profits will arise to a person that has a principal place of business in
Hong Kong.

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One should nevertheless bear in mind that understanding the specific trade or business
carried on by the taxpayer is crucial in understanding how the source of profits is to be
established. That is because finding what the taxpayer did to earn its profits as required by the
‘broad guiding principle’ depends on understanding on how economically speaking the trade or
business of the taxpayer operates. For example, in Kim Eng Securities (Hong Kong) Ltd v CIR (2007)
2 HKLRD 117, the taxpayer’s business was to act as an intermediary between investors and
certain overseas stock exchanges to enable the investors to invest on those exchanges without
paying certain fees that would otherwise have accrued to them. The Court of Final Appeal
held that what the taxpayer did to earn its profits was interposing itself between the investors
and the overseas exchanges but that it did this in Hong Kong. Consequently, its profits were
sourced in Hong Kong and chargeable to profits tax.

The general approach preferred by the IRD is to focus on the ‘effective cause’ of the profit,
that is, the transaction or operation that in substance gave rise to the profit. The operations
themselves must therefore be identified to determine as a commercial matter what the
taxpayer does to earn its profits. That position was clearly articulated in Kwong Mile Services
Ltd v CIR (2004) HKCU 782, where the Court of Final Appeal reaffirmed the importance of
understanding source in the commercial rather than technical sense of the term. In so doing, it
also emphasised there is no universal test for ascertaining the source of profit. The situations
in which the source of a profit has to be ascertained are too many and too varied for a
judge-made test. The only constant is the need to grasp the reality of each case, focusing on the
effective causes without being distracted by antecedent or incidental matters.

Similarly, in ING Baring Securities v CIR (2008) 1 HKLRD 412 the taxpayer derived its profits
from placing trades on offshore exchanges. The Court of Final Appeal held that its profits were
sourced offshore notwithstanding that it had Hong Kong resident customers. The rationale
was that the effective cause or the operations most proximate to its profits were the trades
conducted offshore and that, accordingly, such profits should be regarded as arising offshore.
The orthodox position in Hong Kong is therefore the focus on operation as the effective
cause of profits. That approach is to be favoured as against the ‘totality of facts’ approach
taken by the Court of Appeal in Magna Industrial v CIR (1997) 1 HKLRD 173. In substance,
what this means is that whereas the factual matrix of a given case is relevant, analytical focus
should rest on the profit-making operations of the taxpayer, discounting antecedent and
incidental matters.

Key Learning Point

Source is a hard, practical matter of fact. One looks to what the taxpayer has done to earn
its profits and where it has done it, discounting antecedent or incidental matters.

3.3.12 Transfer Pricing

Hong Kong now has a comprehensive transfer pricing regime. The key to understanding
transfer pricing is the application of the so-called arm’s length principle (ALP). When a
transaction is conducted at arm’s length and thus in a manner consistent with the ALP, it is
conducted on terms relevantly including the consideration given for a given supply of goods
or services, which one may expect to find between two independent persons. Transfer pricing

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rules provide that essentially all transactions and arrangements between associated persons,
including a head office and a PE, should be conducted on a basis consistent with ALP. Where
a transaction or arrangement between associated persons does not take place on a basis
consistent with the ALP, and a tax advantage arises from that arrangement or transaction, the
IRD is empowered to substitute an ALP compliant price or consideration for tax purposes to
negate the tax advantsage. That is known as a ‘transfer pricing adjustment’.

The transfer pricing regime in Hong Kong has two principal rules. Rule 1 is found in s.50AAF,
and provides that any arrangement or transaction made between two associated persons
– that is, where one person directly or indirectly controls the other, or both are directly or
indirectly under the control of the same person – must be consistent with the ALP; if it does not
and the actual arrangement or transaction gives rise to a Hong Kong tax advantage for one of
the persons, then the Commissioner will be authorised to make a transfer pricing adjustment.
That means that, for tax purposes, the actual arrangement or transaction will be disregarded,
and an ALP compliant arrangement or transaction will be substituted to negate the tax
advantage that would otherwise have arisen. There are tax symmetry provisions to ensure that
the other party to the transaction can claim that the ALP compliant arrangement or transaction
as substituted by the IRD will apply to it, too, such that it is not disadvantaged.

Rule 2 is found in s.50AAK and provides that the ALP applies in allocating profits or
losses between a head office and a PE for tax purposes. That means that the profits or
losses allocated to a PE for tax purposes are such profits or losses as one may expect to
have arisen in the PE if the PE and head office were two separate and distinct enterprises
acting independently and engaged in the same or similar activities under the same or similar
conditions. The purpose of this provision is to prevent a head office and PE from allocating
profits or losses for aggressive tax planning purposes. The IRD is authorised to make a transfer
pricing adjustment for tax purposes where the allocation of profits or losses between a head
office and a PE is not consistent with the ALP. Note that Rule 2 is only concerned with the
allocation of profits. Merely because profits are allocated to a Hong Kong PE or head office does
not mean that those profits are necessarily Hong Kong source. Whether they are a Hong Kong
source must be determined by references to the approaches we have outlined above.

It is the policy of the government of Hong Kong to comply with OECD international taxation
policies and guidelines. That means that the development of tax law in reform is increasingly
exposed to international pressure and influences. The introduction of a transfer pricing regime
is evidence of this shift. For detailed discussion on transfer pricing matters, please refer to
Chapter 11.

Illustrative Example 13
GSHM is the 100% parent of a Vietnamese company (VietCo), which supplies GSHM with
garments for sale from its retail stores in Hong Kong. With a view to decreasing its profits
chargeable to Hong Kong profits tax, GSHM causes VietCo to increase all its supply
prices by 25% over the standard market rate for the same or similar products, thereby
increasing the amount of deductible expenditure incurred by GSHM in the production
of assessable profits under s.16. This arrangement is not an ALP compliant arrangement,
and is in breach of Rule 1 of the transfer pricing regime. The IRD may make a transfer
pricing adjustment, thereby decreasing the amount of deductions GSHM can claim with
respect to the supplies to such an amount as is ALP compliant.

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Key Learning Point

The ALP applies to transactions between associated persons, and between a head office
and a PE. Where an arrangement or transaction between two persons or an allocation of
profits or losses between a head office and a PE are not consistent with the ALP, the IRD
will be authorised to make a transfer pricing adjustment and substitute an ALP compliant
arrangement, transaction or allocation, as the case may be, for tax purposes.

Knowledge Check Questions

Question 4
Ah Toh Ltd (ATL), a company incorporated in Singapore trading in high street fashion, is
considering establishing a business presence in Hong Kong. Identify which of the following
strategies is least likely to give rise to a charge to Hong Kong profits tax for ATL.
I. Establish a retail branch in the New Territories, with all supplies being sourced
from ATL’s contractors in Vietnam.
II. Enter into a joint venture with GSHM Ltd, a company incorporated in Hong Kong,
for the sale of ATL fashion brands in Hong Kong.
III. Establish a trading subsidiary, which will be exclusively responsible for establishing
and maintaining the business presence of the ATL brand in Hong Kong.
IV. Establish a sales representative office, enabling customers to acquire ATL products,
which are then sourced directly from Singapore.
A I and II only
B III and IV only
C III only
D IV only

Question 5
Identify in which of the following two scenarios the taxpayer will be assessable to
profits tax.
I. A financial institution trades in US Dollars and Japanese Yen with a view to making
forex profits from its forex desk in Hong Kong.
II. Lord Soth is a wealthy expatriate who carries on the profession of being a
professional investment adviser. He has made business loans to some of his
friends in Hong Kong from his working capital and receives interest on the
outstanding principal at 4% per annum.
III. GSHM establishes a retail branch in Taiwan, from which it sells its merchandise
sourced directly from its warehouses in the New Territories.

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Knowledge Check Questions (continued)

IV. Lord Soth is, as per (II) above, a stockbroker, who carries on his profession
exclusively in Hong Kong. He realises a large profit in the course of his profession
by selling shares on the Seoul Stock Exchange.
V. Billion Super Profit Golden Tours is a Mainland logistics company, which transports
goods and part-time workers from Zhuhai by land into Hong Kong.

A I and II
B I and III
C II and IV
D IV and V

Question 6
Identify which of the following receipts is chargeable to profits tax.
A Mist Ltd, a US company carrying on the business of providing an online marketplace for
the downloading of computer games, books HK$15 million of profits from sales on its
platform to Hong Kong customers. Mist Ltd makes use of servers in Hong Kong, but does
not have any office or staff in the jurisdiction.
B Suzie Wong is a writer of romantic fiction based in Hong Kong and sells the rights to
one of her novels to a Japanese publisher, for translation and publication in Japan, in
consideration for a royalty computed as a proportion of total Japanese sales.
C Dobermann Properties GmbH, a company incorporated in Germany and carrying on
a property development business in Hong Kong receives HK$1 million deposit interest
from DragonBank, a Hong Kong bank authorised under the Banking Ordinance. The
deposit was not used as security for any borrowing.
D GSHM Ltd, a company incorporated in Hong Kong, disposes of its 100% shareholding
in its Vietnamese trading subsidiary to a third-party buyer, realising a profit of
HK$100 million. The sale and purchase agreement was negotiated and concluded in
Hong Kong.

Question 7
Identify the significance of transfer pricing when advising clients on Hong Kong tax.

3 . 4
MISCELLANEOUS INCOME AND EXEMPTIONS

There are a number of additional rules applying to miscellaneous income and expenses.

3.4.1 Sums Specifically Chargeable to Profits Tax

You have learnt that the general charging provision to profits tax is in s.14 of the IRO. But
that is not where profits tax ends. Certain sums are deemed to be chargeable to profits tax,

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irrespective of whether they independently meet the criteria in s.14. Deeming means that
a sum that is not otherwise taxable under s.14 is nonetheless taxable by operation of an
express section of the IRO. Conveniently, those deeming provisions are listed in s.15. The most
important deeming provisions are as follows:

3.4.1.1 Royalties
Royalties are in essence payments for the right to use certain intellectual property rights.
Royalties can be taxable under s.14, for example, if a person carries on the trade or business
of licensing intellectual property rights in Hong Kong and the licence agreements are effected
in Hong Kong. Certain royalties are, however, taxable irrespective of whether the licensor
(i.e. the person receiving the royalty) carries on a business in Hong Kong if the royalty relates
to the use of intellectual property in Hong Kong or to a performance in Hong Kong. Turner
Entertainment Networks Asia, Inc v CIR (2015) HKC 33 is the authority for the propositions that
‘to ‘use’ intellectual property rights’ should generally be given an ordinary and non-technical
meaning for the purposes of s.15(1)(a)–(bc) and that the various deeming provisions in s.15 are
not necessarily mutually exclusive; indeed, in many respects they may overlap.

1. S.15(1)(a): royalties received by or accrued to a person from the exhibition or use in

Hong Kong of cinematograph or television film or tape, any sound recording, or any
advertising material connected with such film, tape or recording.

2. S.15(1)(b): royalties received by or accrued to a person for the use, or the right to
the use, in Hong Kong of any patent, design, trademark, copyright material, layout
design (topography) of an integrated circuit, performer’s right, plant variety right,
secret process or formula, other property or right of a similar nature, or for imparting
or undertaking to impart knowledge directly or indirectly connected with the use in
Hong Kong of any such patent, design, trademark, copyright material, layout design
(topography) of an integrated circuit, performer’s right, plant variety right, secret
process or formula, or other property or right.

3. S.15(1)(ba): royalties received by or accrued to a person for the use, or the right to the
use, outside Hong Kong of any patent, design, trademark, copyright material, layout
design (topography) of an integrated circuit, performer’s right, plant variety right, secret
process or formula, other property or right of a similar nature, or for imparting or
undertaking to impart knowledge directly or indirectly connected with the use outside
Hong Kong of any such patent, design, trademark, copyright material, layout design
(topography) of an integrated circuit, performer’s right, plant variety right, secret
process or formula, or other property or right, which are deductible in ascertaining the
assessable profits of any person to profits tax. This is a tax symmetry provision: where a
deduction has been claimed for a royalty in Hong Kong, then the royalty itself is taxable
to the extent the deduction has been claimed.

4. S.15(1)(bb): sums received by or accrued to a performer or an organiser for an

assignment of, or an agreement to assign, a performer’s right in relation to a
performance given by the performer in Hong Kong. Accordingly, performer’s right as
regards performances in Hong Kong are chargeable to tax, notwithstanding that the
performer in question is neither resident nor carries on a business in Hong Kong.

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5. S.15(1)(bc): sums received by or accrued to a person for the use or the right to use
outside Hong Kong of any intellectual property rights or know-how generated from
any R&D activity in respect of which a deduction is allowable under s.16B or otherwise
for imparting or undertaking to impart knowledge directly or directly connected with
the use outside Hong Kong of any such property or know-how. This is a tax symmetry
provision, which refers further to the deductions expressly provided in s.16B.

The deemed assessable profit for the purposes of ss.15(1)(a), (b), and (ba) will be
determined under s.21A, normally the assessable profit will be 30% of the gross receipt of the
royalty. Under s.21A, if the following two conditions are satisfied: (i) income is received from
an associated person, and (ii) the intellectual property has, at any time, been owned, partly or
wholly, by any person carrying on business in Hong Kong, the assessable profit shall be 100% of
the gross royalty receipt. For those purposes, A and B are ‘associated persons’ if A controls B, or
B controls A, or A and B being controlled by the same person. Examples of ‘associated persons’
include group companies, holding company and subsidiary company, proprietor and their
proprietorship business, etc.

The provisions are described in Exhibit 3.3.

Sums chargeable to profits tax Section

Royalties Use or exhibition in Hong Kong of cinematograph or television film or s.15(1)(a)
tape, or any sound recording or any advertising material connected
with such film, tape or recording.
Use or right to use in Hong Kong any patent, design, trademark, s.15(1)(b)
copyright material, layout design (topography) of an integrated
circuit, performer’s right, plant variety right, secret process or
formula, other property or right of a similar nature, or for imparting
or undertaking to impart knowledge directly or indirectly connected
with the use in Hong Kong of any such patent, design, trademark,
copyright material, layout design (topography) of an integrated
circuit, performer’s right, plant variety right, secret process or
formula, or other property or right.
Use or the right to use sums designated in s.15(1)(b) outside of Hong s.15(1)(ba)
Kong, but deductible in ascertaining the assessable profits of any
person to Hong Kong profits tax.
Sums to a performer or an organiser for an assignment of or an s.15(1)(bb)
agreement to assign, a performer’s right in relation to a performance
given by the performer in Hong Kong.
Use or the right to the use outside Hong Kong any intellectual s.15(1)(bc)
property or know-how generated from any R&D activity in respect of
which a deduction is allowable under s.16B in ascertaining profits of
the person under this part or for imparting or undertaking to impart
knowledge directly or indirectly connected with the use outside Hong
Kong of any such property or know-how.
Grants, subsidies and other fiscal assistance in connection with the carrying on of a trade s.15(1)(c)
or business.
Rental income for the use or the right to use movable property in Hong Kong. s.15(1)(d)
Refunds received by or accrued to a person for contributions paid as an employer to a s.15(1)(h)
recognised occupational retirement scheme or voluntary payments paid as an employer
to an MPF scheme, provided that a deduction had been allowed for that contribution.

EXHIBIT 3.3 Important deeming provisions in s.15 of IRO

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Sums chargeable to profits tax Section

Interest For a corporation (other than a financial institution) carrying a trade, s.15(1)(f)
profession or business in Hong Kong where that interest is Hong
Kong source.
For a person (other than a corporation) carrying on a trade, profession s.15(1)(g)
or business in Hong Kong where the interest is Hong Kong source and
in respect of the funds of that trade, profession or business.
For financial institution. s.15(1)(i)
Interest For a corporation (other than a financial institution) from the carrying s.15(1)(ia)
on in Hong Kong of its intra-group financing business even if sourced
outside of Hong Kong.
Gains or profits For a corporation (other than a financial institution) carrying on a s.15(1)(j)
trade, profession or business in Hong Kong from the sale or other
disposal or on the redemption, on maturity or presentment or
otherwise, of a certificate of deposit, bill of exchange or regulatory
capital security where those gains are Hong Kong source.
Gains or profits For a person (other than a corporation) carrying on a trade, s.15(1)(k)
profession or business in Hong Kong from the sale or other disposal
or on the redemption, on maturity or presentment or otherwise, of
a certificate of deposit, bill of exchange or regulatory capital security
where those gains are Hong Kong source and in respect of the funds
of the trade, profession or business.
Gains or profits For a financial institution from the carrying on of its business in s.15(1)(l)
Hong Kong from the sale or other disposal or on the redemption, on
maturity or presentment or otherwise, of a certificate of deposit, bill
of exchange or regulatory capital security.
Gains or profits For a corporation carrying on an intra-group financing business in s.15(1)(la)
Hong Kong through or from that business, from the sale or other
disposal or on the redemption, on maturity or presentment or
otherwise, of a certificate of deposit, bill of exchange or regulatory
capital security.
Consideration For a person as consideration for the transfer of a right to receive s.15(1)(m)
for transfer of income under s.15A.
income stream
Gains or profits For a corporation arising through or from the carrying on in Hong s.15(1)(n)
Kong of an aircraft leasing business or managing such an aircraft
leasing business, but excluding capital gains.

EXHIBIT 3.3 Important deeming provisions in s.15 of IRO (Continued)

Illustrative Example 14
Mr. Wong transferred all of the GSHM intellectual property (essentially, trademarks and
the clothing designs), which he previously owned in his own name, to Red Lantern Ltd (Red
Lantern), which then licensed it to GSHM for an arm’s length fee of HK$5 million per annum.
Although Red Lantern does not carry on a trade or business in Hong Kong and is therefore
not taxable under s.14, it receives sums for the right to use trademarks and designs in
Hong Kong. Accordingly, such sums are chargeable to profits tax under s.15(1)(b).

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Tax under ss.15(1)(a)–15(1)(bb) is collected by withholding, and profits tax on royalties is the
only withholding tax currently levied in Hong Kong. Withholding tax means that instead of the
royalty payee having to file a tax return (which in practice is difficult to enforce and detect if it is
resident outside of Hong Kong), the royalty payor withholds an amount from the payment on
account of tax. S.20B(1) provides for the withholding mechanism, and imposes an obligation
on the Hong Kong payor to withhold an amount on account of tax owed by the payee. S.21A
provides for special withholding tax rates for royalties deemed assessable under ss.15(1)(a), (b)
or (ba). The default withholding tax rate is the standard rate of 15% or 16.5% as the case may be
for royalties paid by a company associated to the other, but the lower rate of 4.95% is charged
where the Commissioner is satisfied that no person carrying on a trade, profession, or business
in Hong Kong has at any time wholly or partly owned the property in respect of which the
sum was paid. Compliance with the withholding tax regime is important, because the IRD may
recover tax due with respect to a royalty taxable under s.15(1) from the assets of the payor. Note
that the withholding obligation is an absolute defence against any contractual claim the payee
may have against the payor for failure to pay the royalty gross. In practice, licence agreements
will include contractual stipulations as to which party must bear any tax withheld at source
with respect to the royalty. The rate of withholding tax charged on royalties may be decreased
under the terms of a DTA having effect. Certain DTAs provide that the maximum withholding
tax that can be charged on a Hong Kong payor in respect of royalty paid to a payee resident in
the other contracting jurisdiction is less than 4.95% and, under those circumstances, the rate of
withholding tax is reduced accordingly.

Illustrative Example 15
Gee Ltd carries on business in Hong Kong. Hungry Ltd is incorporated, based and carries
on business in Country H. Gee and Hungry are unrelated. For the year ended 31 March
2019, Hungry granted a licence to Gee to show a film in Hong Kong for a royalty income
of HK$10 million.

The royalty income will be deemed as taxable under s.15(1)(a) as it is received from
granting the right to show the film in Hong Kong. The assessable profits under s.20A is 30% as
Gee and Hungry are unrelated entities. Under s.20B, Gee has the obligation to retain profits
tax payment out of the sum of royalty to be paid to Hungry and pay the tax for and on behalf
of Hungry, i.e. the withholding tax obligation. Gee has to report the royalty payment in the BIR
54 form for and on behalf of Hungry. Assuming Hungry has no connected entity in Hong Kong
to claim the two-tiered profits tax rates, the tax liability for Hungry is computed as follows:

Profits tax computation

Hungry Ltd
Year of assessment 2018/19
HK$
Royalty payment 10,000,000
Deemed assessable profits @30% 3,000,000
Profits tax on first HK$2,000,000 @8.25% 165,000
Profits tax on assessable profits exceeding HK$2,000,000: 165,000
16.5% × (HK$3,000,000 − HK$2,000,000)
Total profits tax payable before tax reduction 330,000
Tax reduction of 100%, limited to HK$20,000 (20,000)
Profits tax payable after tax reduction 310,000

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Illustrative Example 16
Bee Ltd carries on business in Hong Kong. Cat Ltd is incorporated, based and carries
on business in Country C. Bee is wholly owned by Cat. Bee produced and owned the
copyright of a film, Film X. Bee then sold the ownership of the copyright of Film X to Cat
in the year 2018. For the year ended 31 March 2019, Cat granted a license to Bee to show
Film X in Hong Kong for a royalty income of HK$10 million.

The royalty income will be deemed as taxable under s.15(1)(a) as it is received from
granting the right to show the film in Hong Kong. The assessable profits under s.20A is
100% as Bee and Cat are related entities, and the film has been previously owned by Bee,
which carries on business in Hong Kong. Under s.20B, Bee has the obligation to withhold,
report (in BIR 54) and pay profits tax for and on behalf of Cat. Assuming Bee would be
nominated to claim the two-tiered profits tax rates, Cat would not be eligible for the
two-tiered tax rates. The tax liability for Cat is computed as follows:

Profits tax computation

Cat Ltd
Year of assessment 2018/19
HK$
Royalty payment 10,000,000
Deemed assessable profits @100% 10,000,000
Total profits tax payable before tax reduction 1,650,000
Tax reduction of 100%, limited to HK$20,000 (20,000)
Profits tax payable after tax reduction 1,630,000

Illustrative Example 17
Red Lantern licences intellectual property rights to GSHM. Accordingly, Red Lantern is
chargeable to profits tax under s.15(1)(b). We assume Red Lantern is non-resident in
Hong Kong; it therefore does not file a tax return. GSHM, however, is required by s.20B
to file a tax return on Red Lantern’s behalf and to withhold profits tax out of the gross
annual royalty payable to Red Lantern, and to pay this over to the IRD on account of
profits tax owed by Red Lantern.

3.4.1.2 Grants, Subsidies or Other Similar Financial Assistance

Under s.15(1)(c), grants, subsidies or other similar financial assistance received by or accrued
to a person in connection with a trade, profession or business carried on in Hong Kong, other
than sums in connection with capital expenditure are deemed as chargeable.

Illustrative Example 18
A loan of HK$2,000,000 has been borrowed by ABC Ltd from its holding company in the
year 2015. The loan fund was applied by ABC as working capital for its daily business
operations, and has been stated in the financial statements of ABC in relevant years as
a long-term liability. In a recent meeting, directors of the holding company resolved to
waive ABC from the requirement to repay the loan.

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Illustrative Example 18 (continued)

The waiver of a loan is technically a capital receipt and therefore not taxable. In
principle, the IRD could argue that the waiver of a loan conferred a gratuitous benefit to
a company carrying on a trade or business in Hong Kong and is therefore deemed to be
taxable under s.15(1)(c) though ABC could rebut that assertion by arguing that the words
‘grant’ or ‘subsidy’ by their technical meaning connote a payment from a public law body,
such as a government or governmental institution, and cannot apply in the context of a
commercial relationship between private law parties.

3.4.1.3 Rental Income from Movable Property

Under s.15(1)(d), hire or rental received for the use of or right to use movable property in Hong
Kong is deemed as chargeable.

In applying s.15(1)(d), the assessable profit must be ascertained based on the actual
revenue less deductible expenses. Unlike royalty under s.15(1)(a), (b) and (ba), s.21A does not
apply in relation to s.15(1)(d). Failing an ascertainment of the true profit arising in Hong Kong,
s.21 provides that it may be computed on a fair percentage of the receipt.

3.4.1.4 Interest and Debts
Interest is consideration for the time value of money. It is in effect compensation to a lender
for losing the utility of the principal that they have loaned out to the borrower, and for
assuming the risk of borrower default. Interest used to be taxable as an independent taxing
schedule in Hong Kong, which was abolished. Interest can be taxed under s.14 in cases in
which the taxpayer carries on the trade or business of lending money, and such operations are
substantially carried on in Hong Kong (see Orion Caribbean). Where interest is not taxable under
s.14, it can nonetheless be taxable under the following deeming provisions in s.15:

1. S.15(1)(f): sums received by or accrued to a corporation carrying on a trade, profession

or business in Hong Kong by way of interest derived from Hong Kong.

2. 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 derived from Hong
Kong which interest is in respect of the funds of the trade, profession or business.

3. S.15(1)(i): sums received by or accrued to a financial institution (e.g. a bank or other

entity authorised under the Banking Ordinance [Cap.155]) by way of interest which
arises through or from the carrying on by the financial institution of its business
in Hong Kong, notwithstanding that the moneys in respect of which the interest is
received or accrues are made available outside Hong Kong.

Under ss.15(1)(f) and 15(1)(g), interest is taxable only to the extent that it is sourced in Hong
Kong. The source of interest has therefore been the subject of extensive debate in the case law.
The consensus view in Hong Kong is that interest for the purposes of s.15(1)(f) and s.15(1)(g) is
sourced in the place where the principal with respect to which the interest is payable was made
available to the borrower (CIR v N V Philips Gloeilampenfabrieken, 10 ATD 435 and CIR v Lever
Brothers & Unilever Ltd (1946), 14 SATC 1), i.e. ‘the provision of credit test’ (see Section 3.3.5). Per
DIPN No. 13, the ‘provision of credit test’ is not applicable where the loans are not simple loans
of money. The Privy Council held in the case of Orion Caribbean Limited v CIR (1997) 4 HKTC 432

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that where the taxpayer earned its profits by borrowing and lending of money, the proper test
to determine the source of the profits was the operations test, i.e. ‘one looks to see what the
taxpayer has done to earn the profit in question and where [they have] done it’. In the case of a
moneylending business, the taxpayer’s business would normally encompass a broader range of
activity, including the borrowing and/or lending of money. For this type of business, the IRD will
apply the operations test instead of the provision of credit test in determining the source of the
interest income.

Separately, s.15(2) provides that where a profits tax deduction has been allowed for any
debt (principal, in this case, and not interest) incurred for the purposes of the trade, profession,
or business, then, if the whole or any part of that debt is thereafter released, the amount
released shall be deemed to be taxable. This is another tax symmetry provision. Where a
deduction has been secured with respect to a debt, then where the debt is released, the
amount released becomes taxable.

Illustrative Example 19
GSHM Ltd decides to extend a commercial loan to an associated enterprise, Gyaru Inc, a
Japanese fashion brand. GSHM agreed to a loan of HK$15 million with interest at 3% per
annum. If the principal of the loan were made available to Gyaru Inc in Hong Kong (for
example, on a Hong Kong bank account), it would be Hong Kong source. Because GSHM
is a corporation that carries on a trade in Hong Kong, the interest would thereby be
chargeable to profits tax under s.15(1)(f).

3.4.2 Concessionary Trading Receipts Chargeable to Tax at Half of the

Profits Tax Rate
As a consequence of the efforts of the government to encourage the establishment of certain
industries in Hong Kong, concessionary tax regimes are available for profits derived in the
course of certain trade or business that are considered strategic. Assessable profits derived
from qualifying debt instruments (short or medium term) (s.14A) (Exhibit 3.4); assessable
profits of insurance companies derived from qualifying insurance business and insurance
brokerage business (s.14B); qualifying profits from carrying on the trade or business of being
qualifying corporate treasury centres – i.e. companies operating as financing companies or
performing lending and borrowing functions within a group of companies (s.14D); qualifying
profits earned by qualifying aircraft lessors (s.14H), qualifying aircraft leasing managers (s.14J),
qualifying ship lessors (s.14P) and qualifying ship leasing managers (s.14T) are chargeable

Maturity period (qualifying debt instruments)* Tax rate Section

Less than 3 years Half tax rate s.14A
Not less than 3 years but less than 7 years Half tax rate s.14A
Not less than 7 years Exempt s.26A(1)

*Applicable to qualifying debt instruments issued on or after 25 March 2011 but before 1 April 2018.
Interest income and trading profits derived from a qualifying debt instrument issued on or after 1 April
2018, regardless of the maturity period, are all exempt from profits tax.
EXHIBIT 3.4 Summary of certain receipts deemed to be taxable

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to profits tax, subject to the specific conditions contained in each of those concessionary
regimes at half the standard rate: namely, 8.25% for corporations and 7.5% for unincorporated
businesses, with the exception that qualifying ship lessors may avail themselves of a de facto
complete exemption from profits tax with respect to profits arising from qualifying ship leasing
activities.

Separately, the first HK$2 million of assessable profits are, subject to certain conditions,
taxed at half the standard rate of profits tax. You may recall that as regards the two-tiered
profits tax rates regime, only one taxpayer in a given set of associated taxpayers can avail itself
of the regime. Where a taxpayer is associated with another, they must make an election as to
which of them will be chargeable to tax on a two-tiered basis and which will be chargeable on
the conventional basis (Exhibit 3.5) (see Section 3.1.2 for details).

Assessable profits Corporations Non-corporations

First HK$2 million 8.25% 7.5%
Exceeding HK$2 million 16.5% 15%

EXHIBIT 3.5 The two-tiered profits tax rates

3.4.3 Sums Specifically Exempt from Profits Tax

Certain sums are statutorily exempt from profits tax. The most relevant of these include:

• Gains from sale of capital assets (s.14(1)). Note that while it is often argued that Hong
Kong does not have a capital gains tax, this exemption is limited to the sale of capital
assets; other transfers of capital assets may technically be taxable. Refer further to the
discussion of the distinction between trading and capital transactions in Section 3.6: In
practice, the IRD often asserts that transactions are trading and not capital in nature in
order to charge the profits thereof to tax.
• Dividends received from corporations chargeable to profits tax (s.26). It is often stated
that Hong Kong does not tax dividends. In practice, this is true, but note that the
exemption for dividends technically relates only to dividends declared by a company
that is chargeable to profits tax. Dividends declared by companies not incorporated
in Hong Kong are not Hong Kong sourced and are accordingly not taxable by virtue of
s.14, and not s.26.

• Interest income derived from a bank deposit placed in Hong Kong, excluding interest
received by or accrued to a financial institution (Exemption from Profits Tax (Interest
Income) Order 1998). This is, in practice, perhaps the most important exemption from
profits tax since it excludes all interest derived from banks or other financial institutions
in Hong Kong for all taxpayers excluding financial institutions themselves. However, no
exemption is available for the following situation:

°° If the relevant deposit has been used to secure any borrowing where the interest
expense on such borrowing satisfies the condition for deduction under S.16(2)(c),
(d) or (e), and the deduction of which is not restricted under S.16(2A)

°° If the relevant interest is received by a financial institution

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Exhibit 3.6 shows a summary of sums that are exempted from profits tax.

Sums exempted from profits tax Section

Gains from sale of capital assets s.14(1)
Gains and profits from certain stock borrowing and lending transactions s.15E
Interest derived from a bank deposit in Hong Kong, excluding interest Exemption from Profits
received by or accrued to a financial institution Tax (Interest Income)
Order 1998
Certain profits of non-resident investment funds and their SPVs ss.20AC and 20ACA
Certain profits of investment funds and their SPVs ss.20AN and 20AO
Dividends received from corporations chargeable to profits tax and any s.26(a)
profits taxed in the hands of any other person
Interest paid or payable on a Tax Reserve Certificate s.26A(1)(a)
Interest paid or payable on (1) a bond issued under the Loans Ordinance s.26A(1)(b)–(i)
(Cap.61) or the Loans (Government Bonds) Ordinance (Cap.64); (2) an
alternative bond issued by the government within the meaning of the Loans
Ordinance; (3) Exchange Fund debt instrument; (4) multilateral agency
debt instrument; and (5) long-term debt instrument (except if issued by an
associate), and any profit on the sale or other disposal or redemption on
maturity of such instruments as aforesaid
Sums received or accrued in respect of a mutual fund, unit trust or similar s.26A(1A)
investment scheme that is either authorised as a collective investment
scheme under s.104 of the Securities and Futures Ordinance (Cap.571) or is
otherwise a bona fide widely held and regulated investment scheme

EXHIBIT 3.6 Exemptions from profits tax

Illustrative Example 20
E Ltd carries on business in Hong Kong and receives interest income from a bank deposit
in Hong Kong. The deposit is not used as security for any borrowing. The interest income
from the deposit is exempt from profits tax.

F Ltd carries on business in Hong Kong and receives interest income from a bank
deposit in Hong Kong. The deposit is used as a security for a loan borrowed to finance the
general trading operation of F Ltd. All trading profits of F Ltd are taxable in Hong Kong.
Hence, the interest expense is tax deductible. The deposit interest income received is
taxable because the deposit has been used to secure for a loan and the interest expense
so incurred on the loan is deductible. From the perspective of the bank, the exemption
order does not apply because it is a financial institution: interest income is taxable in
its hands.

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Knowledge Check Question

Question 8
Identify which of the following is not deemed as taxable.
A A royalty income received by an overseas company (which does not carry on business in
Hong Kong) from a Hong Kong person for granting right to the Hong Kong person to use
its trademark in Hong Kong.
B A royalty income received by an overseas company (which does not carry on business in
Hong Kong) from a Hong Kong person for granting right to the Hong Kong person to use
its trademark in Japan. The Hong Kong person can claim deduction on the royalty.
C A royalty income received by an overseas company (which does not carry on business in
Hong Kong) from a Hong Kong person for granting right to the Hong Kong person to use
its trademark in Japan. The Hong Kong person cannot claim deduction on the royalty.
D A royalty income received by an overseas company (which does not carry on business
in Hong Kong) from a Hong Kong person for granting right to the Hong Kong person
to show a film in mainland China. The Hong Kong person can claim deduction on
the royalty.

3 . 5
GENERAL DEDUCTIONS AND SPECIFIC
DEDUCTIONS

S.16 provides that expenditure and outgoings incurred in (albeit not necessarily wholly and
exclusively) by the taxpayer in the production of chargeable profits, which are not capital in
nature or otherwise expressly excluded under s.17 are generally tax deductible. That means
that they must be deducted from the trading revenue of a taxpayer to determine the liability
to profits tax. Although capital expenditure is in general not deductible, capital allowances
are available as regards specified capital assets. Capital allowances spread out the cost of
the acquisition of a capital asset over a given period of time, enabling the taxpayer to make
periodic deductions on account of such expenditure.

3.5.1 General Deduction Rule

S.16(1) of the IRO provides a deduction for all outgoings and expenses, to the extent to which
they have been incurred by the taxpayer in the production of profits chargeable to profits tax.
In that context, the qualifying words ‘to the extent’ means that only outgoings and expenditure
actually incurred, in a causal sense, to generate taxable profits are deductible. Ultimately, the
question will focus on for what was the expenditure incurred? If, as a commercial and legal
matter, the answer to that question is in the production of profits chargeable to profits tax,
then the sum will in general be deductible, unless expressly excluded. By way of indication,
deductible expenditure is expenditure incurred to fund the operations of the taxpayer that in
substance give rise to its profits. This should be contrasted with the words ‘wholly, exclusively
and necessarily incurred’, which apply to deductions for salaries tax purposes and, in various

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forms, to the tax codes of other common law jurisdictions. It would follow that expenditure
incurred in the production of profits chargeable to tax and for some other purpose may
nonetheless be wholly deductible. For an expenditure to be incurred, it must actually be
payable or otherwise have crystallised: One cannot incur a wholly contingent or hypothetical
expenditure that is deductible within the meaning of s.16(1). Finally, the mechanics of
deduction are tied to a given year of assessment (or basis period): expenditure or outgoings
incurred in that temporal window are deductible accordingly. One cannot therefore in general
claim a deduction for expenditure that incurred in a prior year of assessment or which it is
envisaged will be incurred in a subsequent year of assessment.

Expenditure or outgoings occasioned for other reasons is not deductible in this way. The
general deduction provision is not only confined to cash payments, but also includes amounts
of definite commitment or legal liability to pay, excluding contingent liabilities (CIR v Lo & Lo
(1984); Banque Nationale de Paris Hong Kong Branch v CIR (1985)). Care should be taken when
applying case law on the deductibility of expenditure or outgoings decided in jurisdictions other
that Hong Kong. Many of those jurisdictions, including the United Kingdom, require that the
expenditure be ‘wholly and exclusively’ incurred in the production of taxable profits. No such
requirement exists in Hong Kong, which only requires that there be a causal nexus between
the expenditure in question and the production of taxable profits (CIR v Lo & Lo). The test for
deductibility in Hong Kong as regards expenditure incurred in the production of chargeable
profits is therefore more generous than it is in the United Kingdom. For completeness, UK
case law is, however, of direct relevance when applying the separate deductibility provision for
salaries tax in s.12(1)(a), which is likewise drafted in terms of expenditure ‘wholly, exclusively
and necessarily’ incurred in the production of assessable income (see Chapter 4).

3.5.2 Deductible Items

Under s.16(1)(a)–(h) of the IRO, certain items of expenditure are expressly deductible. This
list is not exhaustive but provides an example – without excluding anything else – of what will
be deductible for the purposes of s.16 (provided always that the expenditure in question is
incurred in the production of assessable profits as required by s.16(1)). The deductibility of
interest is an especially complex area and will be considered in detail in Section 3.5.3.

• Rents paid on land or buildings (s.16(1)(b)), but (by way of an anti-avoidance provision)
not exceeding, in the case of rent paid to the tenant’s spouse, or by a partnership to
one or more of the partners thereof or to the spouse of any such partner, an amount
equal to the assessable value of the land or buildings in question. Refer to s.5B and
Chapter 5 for the concept of assessable value of immovable property.

• Foreign taxes paid on interest income that is subject to foreign tax (s.16(1)(c)). S.16(1)
(c) allows deduction of tax of substantially the same nature as tax imposed under the
IRO, proved to the satisfaction of the Commissioner to have been paid elsewhere other
than in a territory outside Hong Kong with which DTAs have been made (DTA territory),
whether by deduction or otherwise, by a person who carries on a trade, profession or
business in Hong Kong, during the basis period for the year of assessment in respect
of profits chargeable to tax by virtue of ss.15(1)(f), (g), (i), (ia), (j), (k), (l) or (la). As regards
foreign taxes other than those borne on interest income, the IRD is of the view in
DIPN No. 28 (Revised) that only certain taxes that are not in the nature of profits tax or

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income tax and are incurred in the production of chargeable profits (e.g. value-added/
goods and services tax) are deductible. Historically, the IRD accepted that taxes on
gross income (such as withholding taxes) would likewise be deductible, while taxes
borne on profits would not be deductible. In the most recent iteration of DIPN No. 28,
however, the IRD now appears to be of the view that taxes on gross income are not
deductible, either. This is curious since there is extensive English case law to suggest
that foreign taxes on gross income (but not on profits) are deductible (see, for example,
Harrods (Buenos Aires) Ltd v Taylor-Gooby (1964) 41 TC 450).

Note that s.16(1)(c) would not be applicable if the foreign tax is paid in a DTA territory,
and under the DTA with that territory, relief from double taxation is provided by way of
credit under s.50.

• Bad or doubtful debts, subject to certain conditions under s.16(1)(d)), the most relevant
of which is that the debt is really bad, which in effect means that it must be shown
to be commercially irrecoverable. Thus, in order to be regarded as a bad debt, the
circumstances must indicate to a reasonable and prudent business person, that, on
a balance of probabilities, the debt is unlikely to be recovered (Graham v CIR (1995)
17 NZTC 12). Debts incurred in any trade proved to the satisfaction of assessor to
have become bad during the year would be deductible, if proof that recovery actions
have been taken to chase the debts but in vain can be provided, and provided that the
debts are:

°° Previously included as taxable trading receipts, or

°° In respect of money lent in the ordinary course of a money lending business carried
on in Hong Kong (to prove it is a money lending business, the relevant evidence
includes: money lender licence, organised set-up, frequency of similar transactions,
scope of activities mentioned in the memorandum and article of association, etc.)

Subsequent recovery of bad debts previously allowed for deduction is taxable in the
year of recovery.

Specific provision for doubtful debts, which is ascertained based on detailed rules and
supporting documents, is regarded as ‘incurred’ because the provision amounts to an
accrued liability, whether legal or practical, and is an accurate measured liability (see:
CIR v Lo & Lo (1984) case).

General provision, which is ascertained based on rough estimation without sufficient

documentary evidence, is not regarded as ‘incurred’.

Illustrative Example 21
H Ltd sold goods on credit. The trade debt has been included as a taxable trading income
but subsequently become uncollectible. The trade debt is written off. Such a written off
amount is deductible.

J Ltd lent money to an employee on commercial terms and outside the ordinary course
of its business. The employee subsequently terminated his contract of employment with J
Ltd and the loan became uncollectable and was written off. Such a write-off is not deductible
because the loan took course outside of the scope of the business of J Ltd – that is, J Ltd was
not a money lender or a financial institution by way of trade or business – and it would follow
that the loan has never been included as a taxable trading receipt in the hands of J Ltd.

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• Repair costs for premises, machinery, plant, implement, utensil or article used in
producing assessable profits (other than the cost of improvements) (s.16(1)(e)).

• The replacement costs of implement, utensil and article used in producing

assessable profits (no depreciation allowance would be allowed for the same
items) (s.16(1)(f)).

• Despite s.17 (i.e. irrespective of whether the sum in question is a capital sum), a sum
expended for the registration of a trademark or design, or the registration or grant of a
patent or plant variety right, used in the trade, profession, or business which produces
such profits (s.16(1)(g)).

Exhibit 3.7 shows a summary of the items that are deductible.

Expenditure that is expressly deductible Section

Interest, provided that s.16(2) applies s.16(1)(a)
Rents paid on business premises/quarters for employees s.16(1)(b)
Foreign taxes paid on income that is subject to foreign tax s.16(1)(c)
Bad or doubtful debts, subject to certain conditions s.16(1)(d)
Repair of any premises, plant, machinery, implement, utensil or article s.16(1)(e)
Replacement of any implement, utensil or article s.(16)(1)(f)
Registration of a trademark or design, or registration or grant of a patent or plant s.16(1)(g)
variety right
Ss.16AA, 16C, 16E, 16EA, 16F, 16G and 16I payments, as provided in those sections s.16(1)(ga)
S.16B deduction s.16(1)(gb)
Other deductions expressly prescribed in IRO s.16(1)(h)

EXHIBIT 3.7 Summary of items that are deductible

Certain expenditure is expressly deductible under ss.16A–16L. Such expenditure is

deductible notwithstanding anything in s.17, which sets out outgoings and expenditure that are
not in general deductible. The most relevant types of expressly deductible expenditure under
those sections include:

• Any mandatory contribution to a mandatory provident fund scheme made by a

person as a sole proprietor or a partner in a partnership; this in effect equalises
the fiscal treatment of pension contributions for employed and self-employed
persons (s.16AA).

• Special payments under an approved retirement scheme (s.16A). In order to incentivise

participation in and contributions to retirement schemes, deductions are allowable for
exceptional payments by an employer for one or more employees into a mandatory
provident fund scheme or recognised occupational retirement scheme, subject to
s.17(1)(k) (see Section 3.5.4) and the proviso that the contribution not be excessive in
all circumstances. Such payments are to be amortised on a straight-line basis over five
years (that is, one-fifth deduction each year for five years).

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• R&D expenditure (s.16B). This is one of Hong Kong’s most important tax incentives and
allows for super-deductions of 300% (i.e. a HK$3 deduction for each HK$1 spent) for
the first HK$2 million of qualifying expenditure and a super-deduction of 200% for all
remaining qualifying expenditure. Non-qualifying R&D expenditure is still deductible on
the normal 100% basis. Qualifying R&D expenditure is defined in Schedule 45: Broadly
speaking, it includes genuine expenditure in the pursuit of some technical or scientific
discovery, improvement, or breakthrough, which is carried on in Hong Kong.

Type A expenditure (entitled to normal 100% deduction) refers to R&D expenditure

other than Type B expenditure. Type B expenditure is eligible for a super-deduction
of 300% for the first HK$2 million of qualifying expenditure and thereafter to a super-
deduction of 200%. S.10 of Schedule 45 defines Type B expenditure as including a
payment made or other expenditure incurred for R&D expenditure falling within any of
the following descriptions:

°° A payment to a designated local research institution for a qualifying R&D activity

related to the trade, profession or business;

°° A payment to a designated local research institution which has, as an object, the

undertaking of a qualifying R&D activity related to the class of trade, profession or
business to which the trade, profession or business belongs, where the payment is
used for pursuing that object; or

°° A qualifying R&D expenditure related to the trade, profession or business.

‘R&D institution’ is defined to mean: a designated local research institute; and any
university or college that is not a designated local research institute.

• Payments for technical education (s.16C), which is related to the trade, profession,
or business and is sought at any university, university college, technical college or
other similar institution approved for the purposes by the Commissioner; the course
of education in question must therefore be relevant to the trade or business of
the taxpayer. This provision can extend to payments made by an employer for the
education of employees in a relevant area.

• Donations to a charity recognised as such under s.88 from a minimum of HK$100 to a

maximum of 35% of assessable profits after making any adjustment for allowances and
deductions (s.16D). It is important to distinguish between donations, which are gifts,
and payments for some consideration and are transactions by way of bargain and the
relevant expenditure is therefore not deductible.

• Purchase of patent rights and know-how (s.16E). Such sums, including legal expenditure
and valuation fees incurred in connection with the expenditure are deductible in the
year of assessment in which they were incurred notwithstanding that the purchase
would ordinarily be regarded as capital expenditure barred under s.17(1)(c). The patent
rights and know-how in question relate to the trade, profession or business carried on
by the person claiming the deduction. Where the asset is partial, an apportionment
exercise would need to be undertaken to ascertain the extent of usage in the taxable
trade, profession or business of the taxpayer on a pro-rata basis. The tax symmetry
provision in s.16E(3) that deems the proceeds from the sale of a patent right with
respect to which a deduction was claimed under this section to be chargeable to profits

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tax up to an amount not exceeding the original deduction claimed. That provision has
the effect of clawing back the deduction claimed where the person who claimed the
deduction in turn sells the patent for consideration.

• S.16EA has deduction provisions similar to s.16E for the acquisition of specified
intellectual property rights. While s.16E is limited in scope to patents and know-how,
s.16EA provides for deductions for expenditure incurred in the acquisition of a much
broader range of intellectual property rights. Such rights relate to broad classes of
intellectual property rights that are exhaustively defined in s.16EA(11) as meaning a
copyright, a performer’s economic right, a protected layout design (topography) right,
a protected plant variety right, or a registered design or registered trademark. To the
extent that they are acquired for the purposes of the production of assessable profits, a
deduction is allowed for the expenditure incurred in purchasing them (including legal and
valuation fees, per s.16E above), subject to s.16EC(2). That deduction is, however, subject
to two important limitations. First, under s.16EA(5), a deduction is allowable only if, at the
end of the basis period for a year of assessment for which an amount is to be deducted,
the specified intellectual property right concerned has not been sold by the person
claiming the deduction. Second, under s.16EA(6), the deduction is only allowed where:

°° The specified intellectual property right concerned has been used in the trade,
profession or business in the production of profits in respect of which the person
claiming the deduction is chargeable to profits tax where it is partly used for those
purposes, a pro-rata apportionment should be effected to ascertain the extent of
the deduction;

°° In the case of the specified intellectual property right being a copyright, the
copyright subsists;

°° In the case of the specified intellectual property right being a performer’s economic
right, the performer’s economic right has not expired;

°° In the case of the specified intellectual property right being a protected layout
design (topography) right the protection of the layout design has not ceased;

°° In the case of the specified intellectual property right being a protected plant variety
right the grant of the protected plant variety right is in force;

°° In the case of the specified intellectual property right being a registered design the
registration of the design is in force;

°° In the case of the specified intellectual property right being a registered trademark
the registration of the trademark is in force;

during a part or the whole of the basis period for a year of assessment for which an
amount is deducted.

Deductions are allowed on a straight-line basis of five equal amounts over five years
of assessment, starting from the year in which the expenditure is incurred, provided that
such intellectual property right (IPR) is owned at the end of the basis period for that year.
If the rights in question, excluding a registered trademark per s.16EA(4)(a), have an expiry
period of less than five years, the purchase cost will be deductible in equal amounts over
the number of remaining years of the right’s lifetime. As with s.16E, note the tax symmetry

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provisions in s.16EB, which deem the proceeds from the sale of such specified intellectual
property rights with respect to which a deduction has been claimed to be a taxable receipt
to the extent that the proceeds of sale exceed the aggregate allowed deduction, up to
a maximum of the total allowable deduction. Further, no deduction will be allowed if
the specified intellectual property right was acquired wholly or partly from an associate
(s.16EC(2)).

• S.16EC is an anti-avoidance provision limiting the scope of a deduction under ss.16E

and 16EA which stipulates that no deduction will be allowed under s.16E or s.16EA

°° if the relevant right was acquired wholly or partly from an associate; and

°° if at a time when the relevant right is owned by the taxpayer, a person holds rights
as a licensee under a licence of the relevant right;

–– The relevant right was, before it was purchased by the taxpayer, owned and
used by that licensee or any associate of that licensee;

–– The relevant right is, while the licence is in force, used wholly or principally
outside Hong Kong by a person other than the taxpayer; or

–– The whole or a predominant part of the consideration for the purchase of the
relevant right was financed directly or indirectly by a non-recourse debt.

That is an anti-avoidance provision, which prevents the use of transfers of patents

between associates from being exploited to generate excessive deductions.

Illustrative Example 22
In the year of assessment 2019/20, K Ltd acquired Patent Right A at a price of
HK$1 million. K Ltd sold Patent Right A at a price of HK$1.2 million in the year of
assessment 2020/21. K Ltd could claim deduction of HK$1 million on the acquisition cost
of Patent Right A for the year of assessment 2019/20 assuming the patent was used for
the purpose of its trade. For the year of assessment 2020/21, the sale proceeds (limited
to deduction previously allowed) of HK$1 million is taxable.

Illustrative Example 23
In the year of assessment 2019/20, L Ltd acquired Patent Right B at a price of
HK$1 million from its holding company. It sold Patent Right B at a price of HK$1.2 million
in the year of assessment 2020/21.

L Ltd could not claim deduction of HK$1 million on the acquisition cost of Patent Right
B for the year of assessment 2019/20 because it was acquired from an associate. For the
year of assessment 2020/21, the taxable amount for the sale proceeds will be zero as no
deduction was claimed on the acquisition cost.

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Illustrative Example 24
LD Silver Limited (LDSL) is a company carrying on the business of publishing romance
novels in Hong Kong. In the year of assessment 2018/19, it acquired the copyright to a
novel written by Suzie Wong for HK$2.5 million, with a view to publishing it in Hong Kong.
This is prima facie a capital payment and thus barred from deduction under s.17(1)(c);
however, the deductibility of the payment is rescued by s.16EA, which applies despite
anything in s.17. Applying the s.16EA test, the copyright will evidently be used in the
course of LDSL’s trade or business as a publisher. Assuming that it does not sell the
copyright in the year of assessment 2018/19 and that the copyright remains in force,
the applicable conditions for deduction under s.16EA will be met. LDSL must, however,
further comply with the anti-avoidance restrictions in s.16EC: Thus, it must be the case
that Suzie Wong is not an associate of LDSL, and further that the copyright not be
licensed to any person other than the taxpayer, which is in this case LDSL.

Illustrative Example 25
P Ltd paid HK$500,000 to acquire Trademark A (registered in Hong Kong) and
HK$600,000 to acquire Trademark B (non-registered) in the year of assessment 2019/20.

P Ltd can claim deduction in respect of the acquisition cost of Trademark A over five
years from the year of assessment 2019/20 onward in the amount of HK$100,000 for each
year. No deduction for Trademark B is allowed under s.16EA because it is not registered.

Illustrative Example 26
Q Ltd paid HK$500,000 to acquire a Design D (registered in Hong Kong) in the year of
assessment 2019/20, with four years protection period from 2019/20 onward.

Q Ltd can claim deduction in respect of the acquisition cost of Design D over four
years from the year of assessment 2019/20 onward in the amount of HK$125,000 for
each year.

Illustrative Example 27
In the year of assessment 2019/20, R Ltd acquired Trademark E (registered in Hong Kong)
at a price of HK$1 million. It sold Trademark E at a price of HK$1.2 million in the year of
assessment 2020/21.

R Ltd can claim deduction of HK$200,000 being one-fifth of the acquisition cost of
Trademark E for the year of assessment 2019/20.

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Illustrative Example 27 (continued)

For the year 2020/21, the taxable amount is:

HK$
Acquisition price 1,000,000
Less: deduction in 2019/20 (200,000)
Unallowed amount 800,000
Less: sale proceeds (1,200,000)
Sales proceeds in excess of the unallowed amount 400,000
Taxable amount limited to deduction allowed 200,000

Assuming the same facts except that Trademark E was sold for HK$700,000 in the year
of assessment 2020/21. R Ltd can claim deduction calculated as below:

HK$
Acquisition price 1,000,000
Less: deduction in 2019/20 (200,000)
Unallowed amount 800,000
Less: sale proceeds (700,000)
Unallowed amount in excess of sale proceeds 100,000
Deductible amount 100,000

Illustrative Example 28
In the year of assessment 2019/20, S Ltd acquired Trademark F at a price of HK$1 million
from its holding company. It sold Trademark F at a price of HK$1.2 million in the year of
assessment 2020/21.

Under s.16EC(2), S Ltd cannot claim deduction on the acquisition cost of Trademark
F for the year of assessment 2016/17 because it was acquired from an associate. For the
year 2021/21, the taxable amount for the sale proceeds will be zero as no deduction was
claimed on the acquisition cost.

• Refurbishment of a building or structure other than a domestic building or structure

(s.16F). This is an exception to the general rule that expenditure on improvements
to a structure that constitutes a capital asset is not deductible. Capital expenditure
incurred on renovation or refurbishment of any non-domestic buildings or structures
(i.e. not used for habitation, unless a hotel or a guest house, which are self-evidently
commercial structures) used in the production of chargeable profits are deductible.

S.16F provides that the deduction will be granted in equal instalment over five years of
assessment. S.16F does not apply to expenditure incurred:

°° On initial construction and decoration – that is, expenditure for the edification of
the structure (though note that building allowances may be available with respect to
such expenditure) and for preparing to be first used by occupants; and

°° To enable a building to be used for a purpose different from that it was used
immediately before the refurbishment.

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Under s.16F(3), depreciation allowances may not be claimed with respect to any capital
expenditure if a deduction for the expenditure under s.16F has been claimed. This is an anti-
avoidance provision to prevent double deduction. The IRD’s published policy on s.16F is in DIPN
No. 5, paras 8–15. S.16F does not have any provisions for balancing adjustments upon disposal
of the refurbishment regardless of whether sales proceeds exist. The deduction would be taken
over five years and could continue even after the disposal.

Illustrative Example 29
In the year of assessment 2017/18, M Ltd paid HK$1 million to refurbish its office and
HK$500,000 to refurbish its staff quarters. M Ltd also paid HK$2 million to decorate a
newly acquired retail shop.

M Ltd can claim deduction of HK$200,000 for the refurbishment cost of its office
(non-domestic structure) under s.16F from the year of assessment 2017/18 onward for five
years (i.e. 2017/18 to 2021/22). No deduction is allowed under s.16F for the refurbishment
cost of its staff quarters, which is a domestic structure (however, it might qualify for
commercial building allowance). The initial decoration cost of the new retail shop will be
entitled to commercial building allowance (see Section 3.7.3).

Illustrative Example 30
In the year of assessment 2019/20, N Ltd paid HK$1 million to refurbish its office into a
research laboratory.

N Ltd cannot claim any deduction for the refurbishment cost of its office under s.16F
because the structure is used as a research laboratory after refurbishment, which is
different from its original use as an office. However, industrial building allowance will be
available (see Section 3.7.2). There is no deduction under s.16B as it is an expenditure on
‘building and structure’.

• Prescribed fixed assets (s.16G). This is an important exception both to the general
prohibition against the deductibility of capital expenditure on the one hand and to
the straight-line depreciation approach to capital allowances on the other. Under this
section, capital expenditure on prescribed fixed assets (PFAs) is eligible for a 100%
deduction in the year of assessment of acquisition of the PFA in question. PFAs include,
for these purposes, certain plant and machinery used directly in the manufacturing
process, computer software, and computer hardware. The following capital expenditure
is, however, expressly excluded from being deductible under s.16G:

°° Capital expenditure that can be deducted in any other section (to avoid double
deduction); or

°° Capital expenditure incurred under a hire purchase agreement.

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PFA excludes any fixed asset held by a person as a lessee under a lease, i.e. an asset used
by anyone, not the owner. For those purposes, a ‘lease’ includes any arrangement under which
a right to use the machinery or plant is granted by the owner of the machinery or plant to
another person (s.2). Expenditure for PFAs that does not qualify for deduction under s.16G (i.e.
assets leased out or assets under hire purchase) may nevertheless be eligible for depreciation
allowance (see Section 3.7.1). If the PFA is sold or is destroyed subsequent to a deduction
being successfully claimed with respect to its acquisition, the sale proceeds or compensation
receipts are deemed to be a trading receipt, with the deemed taxable receipt being limited to
the original deduction previously allowed. The IRD’s published policy on 16G is in DIPN No. 5,
paras 17–34.

Illustrative Example 31
In the year of assessment 2019/20, T Ltd paid HK$1 million to buy a production machine
and HK$200,000 to buy an office equipment.

For the year of assessment 2019/20, T Ltd can claim deduction of HK$1 million for
purchase price of the production machine under s.16G. T Ltd is entitled to depreciation
allowance on the purchase price of the office equipment

Illustrative Example 32
In the year of assessment 2019/20, U Ltd paid HK$1 million to buy a production machine.
U Ltd allowed V Ltd to use the machine to produce goods, which will be sold to U Ltd.

For the year of assessment 2019/20, U Ltd cannot claim deduction on the purchase
price of the production machine under s.16G because it is a ‘leased asset’.

U Ltd will be entitled to depreciation allowance on the purchase price of the

machine instead.

Illustrative Example 33
In the year of assessment 2019/20, W Ltd bought a production machine under hire
purchase terms. The cash price is HK$1 million. W Ltd paid a down payment of
HK$200,000. The remaining price of HK$800,000 will be paid by 20 equal monthly
instalments, starting 1 February 2018.

For the year of assessment 2019/20, W Ltd cannot claim deduction on the purchase
price, down payment or instalment payment for the production machine under s.16G
because it is a ‘hire-purchased asset’. W Ltd will be entitled to depreciation allowance for
the machine instead.

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• Ss.16H to 16K – Capital expenditure on environmental protection facilities

A deduction is allowed on capital expenditure incurred on:

°° The provision of any environmental protection machinery;

°° The construction of any environmental protection installation; or

°° The provision of any environment-friendly vehicle.

Expenditure so allowed is deductible in its entirety in the year of assessment that it is

incurred. Contrast with the writing-down treatment of plant and machinery, which is usually
written down on a straight-line basis over a given period of time. The IRD’s published policy in
this regard is in DIPN No. 5, paras 35–62.

Environmental protection machinery:

• Environmental protection machinery (EPM) means:

°° Low noise construction machinery or plant registered under the system

administered by the Environmental Protection Department;

°° Air pollution control machinery in compliance with the Air Pollution Control
Ordinance (Cap.311);

°° Waste treatment machinery or plant in compliance with the Waste Disposal

Ordinance (Cap.354); and

°° Wastewater treatment machinery or plant in compliance with the Water Pollution

Control Ordinance (Cap.358).

• ‘Specified capital expenditure’ does not include:

°° Capital expenditure that can be deducted in any other section (to avoid double
deduction); or

°° Capital expenditure incurred under a hire purchase agreement.

• EPM excludes any fixed asset held by a person as a lessee under a lease, i.e. an asset
used by anyone, not the owner. ‘Lease’ includes any arrangement under which a right
to use the machinery or plant is granted by the owner of the machinery or plant to
another person (s.2(1)).

• For EPM not qualified for deduction under s.16I (i.e. assets leased out or assets under
hire purchase), depreciation allowance may be available (see Section 3.7.1).

• Where an EPM is used partly in the production of profits chargeable to profits tax, the
deduction allowable shall be such relevant part of the specified capital expenditure.

• If the EPM is sold or is destroyed subsequently, sale proceeds or compensation receipts

are treated as a trading receipt to the extent that they do not exceed the amount of the
deduction granted before.

Environment-friendly vehicles:

• ‘Specified capital expenditure’ incurred in a year of assessment on provision of

environment-friendly vehicles is wholly deductible in that year of assessment.

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• Environment-friendly vehicle (EFV) means:

°° Vehicles qualified for remission of first registration tax under the relevant schemes
administered by the Environmental Protection Department;

°° Hybrid electric vehicles;

°° Electric vehicles.

• ‘Specified capital expenditure’ does not include:

°° Capital expenditure that can be deducted in any other section (to avoid double
deduction)

°° Capital expenditure incurred under a hire purchase agreement

• EFV excludes any fixed asset held by a person as a lessee under a lease, i.e. an asset
used by anyone, not the owner. ‘Lease’ includes any arrangement under which a right
to use the machinery or plant is granted by the owner of the machinery or plant to
another person (s.2(1)).

• For EFV not qualified for deduction under s.16I (i.e. assets leased out or assets under
hire purchase), depreciation allowance may be available (see Section 3.7.1).

• Tax treatments for vehicles partly used for producing profits and on disposal are the
same as those for EPM.

Environmental protection installation:

• Effective from 2008/09, specified capital expenditure incurred on construction of

environmental protection installation is deductible in equal instalment over five years of
assessment, as long as the installation has not been sold at the end of the basis period.

• Effective 1 April 2018, 100% deduction on the specified capital expenditure is allowed in
the year of assessment the expenditure is incurred.

• Environmental protection installation (EPI) means any installation specified in

Schedule 17 and forms a building or structure, including:

°° Solar water heating installations;

°° Offshore wind farm installations;

°° Wave power installations;

°° Hydroelectric installations; and

°° Energy efficient building installations registered under the relevant scheme

administered by the Electrical and Mechanical Services Department.

• ‘Specified capital expenditure’ does not include:

°° Capital expenditure that can be deducted in any other section (to avoid double
deduction) or

°° Capital expenditure incurred under a hire purchase agreement.

• Excludes expenditure incurred for the acquisition of land or any rights over land.

• There is no exclusion of ‘leased’ asset for EPI similar to PFA, EPM and EFV. It means
an EPI used by a person other than the owner may qualify for EPI deduction if other
conditions are satisfied.

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• Where an EPI is used partly in the production of profits chargeable to profits tax, the
deduction allowable shall be such relevant part of the specified capital expenditure.

• If the EPI is sold or destroyed subsequently:

°° Unallowed amount > sale proceeds: the excess is deducted in the year of sale; and

°° Sale proceeds > unallowed amount: the excess is treated as taxable trading receipt
(limited to the amount of deduction).

A summary on tax deductions:

A straightforward strategy to assess whether an item of expenditure or an outgoing is

deductible is:

1. Start with s.16 and verify whether it is incurred in the production of taxable profits
and, if it is interest, whether it meets the various deductibility conditions considered in
Section 3.5.3.

2. If it falls within s.16, next verify whether it is excluded under s.17 by, for example, being
capital expenditure (See Section 3.5.4).

3. If it is excluded under s.17, verify whether it can nonetheless be deductible under the
express deductibility provisions in s.16A–16L.

Other expressly deductible items include:

• Employee and/or director’s salaries, wages, allowances, bonuses, severance or long

service payments paid at termination of employments or payments to end strikes (CIR v
Cosmotron Manufacturing Co Ltd (1997) 2 HKC 417);

• Approved charitable donations from a minimum of HK$100 to a maximum of 35% of

taxable income (s.16D) – donations must be made to an entity that is a charity as a
matter of Hong Kong law – that is, exempt from tax charged under the IRO by virtue of
s.88. The IRD maintains a register of entities that it recognises as charitable. Note that a
donation must be a true donation – that is, a gift. A ‘donation’ in exchange for anything
in money’s worth, even including recognition of the donor (for example, a donation to a
university on condition that it names a building after the donor), is not a true gift and is
therefore not deductible. The IRD’s published policy on approved charitable donations
can be found in DIPN No; and 37.

• Capital expenditure on prescribed fixed assets (subject to limitations) (s.16G) – this is

an exception to the general rule in s.17(1)(c) that capital expenditure is not deductible;
however, it is limited specifically to the capital assets prescribed in s.16G.

3.5.3 Deductible Interest

Loan interest and related expenditure (such as legal fees, stamp duty and other resultant
expenses) is deductible under limited circumstances. To the extent interest expenditure
meets the statutory requirements considered below, it will be deductible when it is payable or
otherwise incurred: A deduction of interest expense is therefore allowable where the interest is
payable at a future date, notwithstanding that it has not actually been paid in the basis period
of the relevant year of assessment for which the deduction was claimed (CIR v National Mutual
Centre (HK) Ltd (1998) 3 HKC 397). It would follow that in order for interest to be deductible, it
is sufficient that there exists an obligation to pay it and not that it actually be paid. That said,
once a deduction is claimed in respect of a given interest payment, a second deduction in the

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same amount cannot be claimed when the interest is actually paid by the debtor. The IRD has
published guidance on its views on the deductibility of interest in DIPN No. 13A, which helpfully
subdivides the deductibility of interest into several ‘conditions’ each of which is subject to
slightly different rules.

3.5.3.1 Borrowing by Financial Institutions and Public Utility Companies – Conditions

(a) and (b)
The rules governing the deduction of interest are complex in order to avoid aggressive tax
planning centred on interest expense. That being said, in practice the most important general
rule in ascertaining the deductibility of interest expenditure is that interest paid by a financial
institution in the ordinary course of business is deductible (s.16(2)(a)) as is interest on money
borrowed from such a financial institution or overseas financial institution (s.16(2)(d)). A
financial institution for those purposes is an authorised institution within the meaning of
s.2 of the Banking Ordinance (Cap.155), or an associated corporation of such an authorised
institution, which would have been liable to be authorised as a deposit-taking company or
restricted licence bank had it not been exempted under s.3(2) of the Banking Ordinance.
The reason for this general rule is likely that tax symmetry is assumed where the payment
of interest is made to a bank; in other words, the bank will likely be chargeable to profits tax
on the interest receipt following the general principle of ascertaining the locality of profits in
the ‘operations test’ articulated in, among other cases, Orion Caribbean. Note that transfer
pricing rules will apply to the rate of interest charged: merely because money is borrowed by a
financial institution or a public utility company does not mean that any interest payable thereon
will necessarily be deductible.
Interest payable on money borrowed by a public utility company as specified in Schedule 3
of the IRO is likewise deductible in the hands of that company (s.16(2)(b)). Currently, such
utility companies include: The Hong Kong Electric Company, Limited; China Light and Power
Company, Limited; and the Hong Kong and China Gas Company, Limited.

3.5.3.2 Borrowing from a Person Other than a Financial Institution – Condition (c)

Interest on money borrowed from a person other than a financial institution is, subject to
the other conditions in s.16(2), only deductible if the lender is chargeable to profits tax on the
receipt of that interest.

3.5.3.3 Borrowing from Financial Institutions – Condition (d)

In addition to the deduction of interest payable to local financial institutions, interest payable
on money borrowed from an overseas financial institution – that is a financial institution
carrying on a money lending business outside of Hong Kong and therefore not authorised
under the Banking Ordinance (Cap.155) – is also in general deductible (s.16(2)(d)). That
said, the Commissioner has the authority to determine that a lender does not qualify as an
overseas financial institution for the purposes of the deductibility of interest expenditure if it
is not satisfied that the lender is subject to sufficient regulatory oversight in its jurisdiction of
residence or operation (s.16(4)).

3.5.3.4 Borrowing for Specified Purposes – Condition (e)

S.16(2)(e) provides for the general deductibility of interest payable on money borrowed wholly
and exclusively to finance:

1. Capital expenditure on the provision of machinery or plant which qualifies for

depreciation allowances (i.e. capital allowances) under Part 6;

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2. Capital expenditure on machinery or plant for research and development activities as

defined in s.2 of Schedule 45;

3. Capital expenditure for the provision of a prescribed fixed asset as defined in s.16G(6);

4. Capital expenditure on any environmental protection machinery or environment-

friendly vehicle as defined in s.16(H)(1); or

5. The purchase of trading stock which is used by the borrower in the production of
assessable profits, provided always that the lender is not an associate of the borrower.

The essential requirement ‘wholly and exclusively’, which means that the borrowing must
have no other purpose but the funding of the specific classes of expenditure enumerated
in s.16(2)(e), to the exclusion of any non-business purpose (Mallalieu v Drummond (1990)
2 AC 239).

3.5.3.5 Interest in Debentures and Debt Instruments – Condition (f)

Interest payable on corporate borrowings by way of debentures or other marketable debt
instruments is in general deductible, subject to the following conditions:

• For the interest payable on debentures, interest is deductible where the debentures are
listed on a stock exchange in Hong Kong or any other stock exchanges recognised by
the Commissioner; and

• Insofar as debt instruments are concerned, interest payable thereon will be deductible
if the instruments are issued:

°° Bona fide and in the course of carrying on business and is marketed in Hong Kong
or any other major financial centre recognised by the Commissioner; or

°° Pursuant to any agreement or arrangements, where the issue of an advertisement,

invitation or document in respect of the agreement or arrangements to the public
has been authorised by the Securities and Futures Commission under s.105 of the
Securities and Futures Ordinance (Cap.571).

Condition (f) will also be satisfied where the borrowing is from an associated corporation
and the moneys borrowed in the hands of the associated corporation arose entirely from the
proceeds of an issue of debentures or instruments qualifying for the purposes of s.16(2)(f). As
for borrowings from associated corporations, the deduction of interest paid by the borrowing
corporation is restricted to the amount of interest paid by the associated corporation to the
holders of its debentures or instruments.

3.5.3.6 Interest Payable by a Corporate Treasury Centre – Condition (g)

Interest payable by a corporate treasury centre (CTC) carrying on an intra-group financing
business in Hong Kong is deductible to the extent that each of the following conditions is met:

• The deduction claimed is in respect of interest payable by the CTC on money borrowed
from a non-Hong Kong associated corporation (lender) in the ordinary course of
that business;

• The lender is, in respect of the interest, subject to a similar tax in a territory
outside Hong Kong at a rate that is not lower than the reference rate set by the
Commissioner; and

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• The lender’s right to use and enjoy that interest is not constrained by a contractual or
legal obligation to pass that interest to any other person unless the obligation arises
as a result of a transaction between the lender and a person other than the borrower
dealing with each other at arm’s length.

3.5.3.7 Limitations to the Deductibility of Interest

The following limitations, which apply specifically to certain conditions listed above, must be
borne in mind in ascertaining whether interest is deductible under s.16(2):

• The production of profits test;

• The tax symmetry test (if the lender is not a financial institution or an overseas financial
institution);

• The secured loan test; and

• The interest flow-back test.

The Production of Profits Test

The general rule in s.16(1) applies to all loan interest, irrespective of the condition under which
it is claimed to be deductible. The loan must therefore be contracted in the production of
profits assessable to profits tax in Hong Kong. The exclusion in s.17(1)(c) for capital expenditure
likewise applies (Wharf Properties v CIR (1997) STC 351). It would follow that interest incurred in
the acquisition of an asset of a capital nature will not be deductible unless that expenditure is
otherwise deductible by virtue of any other provision in the IRO. In BFC v CIT (Singapore) (2014)
SGCA 39, discounts and redemption payments relating to a corporate bond issue were not
allowed as deductions because the bonds in question were issued to fund capital expenditure,
specifically the refurbishment of a hotel. It follows that if a taxpayer wishes to show that a loan,
which it has taken is revenue in nature such that the borrowing costs incurred on that loan are
revenue expenditure, it must establish sufficient linkage or relationship between that loan and
a main transaction that is revenue in nature.

In Zeta Estates Limited v CIR (2007) 2 HKLRD 102, the taxpayer company had borrowed
money from shareholders to fund working capital; it had recently made a large distribution and
claimed that it needed shareholder finance to fund the continuous exercise of its business. The
Commissioner rejected that argument, and sought to disallow the deduction of interest. The
matter was litigated to the Court of Final Appeal, which found for the taxpayer. While the lower
courts had focused on the apparent discrepancy between a large distribution having been
declared and a subsequent requirement for working capital, the Court of Final Appeal held that,
in point of fact, while the company was asset-rich, it needed liquidity which was duly supplied
by way of shareholder financing. It followed that the deduction was incurred in the production
of the taxpayer’s assessable profits. Had it not been for the shareholder loans, the company
would have had to sell capital assets to meet its liabilities, relevantly including the distributions
themselves.

The Tax Symmetry Test

Where the lender is not a financial institution, interest is deductible in the hands of the
borrower only if the lender is taxable in Hong Kong with respect to that interest (s.16(2)(c)). This
test was introduced when Hong Kong ceased levying withholding tax on interest payments and
applies only to condition (c).

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The Secured Loan Test

This test is stipulated by s.16(2A) and applies to conditions (c), (d), and (e). If the payment of any
sum payable by way of principal or interest in respect of the money borrowed is secured or
guaranteed, whether wholly or in part and whether directly or indirectly, by a deposit or loan
made by the borrower or an associate of the borrower with or to:

1. The lender or an associate of the lender;

2. A financial institution or an associate of a financial institution; or

3. An overseas financial institution or an associate of an overseas financial institution;

and any sum payable by way of interest on the deposit or loan is not chargeable to tax, the
amount of the interest deduction will, if excessive, be reduced to a reasonable and appropriate
amount. This is in effect a transfer pricing provision.

The Interest Flow-Back Test

This test is stipulated by s.16(2B) and applies to conditions (c), (d), and (e). It is an anti-avoidance
provision, which provides that there must be no arrangement between the borrower and the
lender providing that the interest expenditure will ultimately be repaid to the borrower. It
would follow that a deduction is only available where the borrower actually bears the economic
cost of the interest. An excepted person as defined in ss.16(2E)(c) and 16(2F)(c) is, however,
subject to less stringent rules. The restriction on the deductibility of interest under this test
does not apply where, under the arrangement concerned, the interest flows to a connected
person who is an ‘excepted person’. An excepted person is defined as including any one of:

1. A person who is charged to tax in respect of the interest in question (compare the tax
symmetry test);

2. A person acting as a bare trustee;

3. A member of a recognised retirement scheme, such as an MPF scheme, or a similar

scheme established outside Hong Kong accepted by the Commissioner;

4. A public body;

5. A body corporate of which the government of Hong Kong owns more than half in
nominal value of the issued share capital; or

6. A financial institution or an overseas financial institution.

An interest flow-back test specifically applicable to condition (f) is found in s.16(2C), again
subject to a person through which the interest payable on the debenture flows not being an
excepted person.

3.5.3.8 Summary of Interest Deduction Rules

Summary of details of the interest deduction rules is as follows:

S.16(1)(a) stipulates that:

• Interest (and related expenses) on money borrowed is deductible if:

°° The borrowing is made for the purpose of producing chargeable profit;

°° It satisfies any one condition under s.16(2); and

°° It is subject to the limitations in ss.16(2A), (2B), (2C), etc. (see discussion below for
more details);

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• CIR v County Shipping Co Ltd (1990) states that interest expense on money borrowed
must satisfy one of the s.16(2) conditions summarised above in order to qualify for
deduction. It is not sufficient if only the general rule under s.16(1) is satisfied;

• Strictly, interest charged on outstanding trade debt is not covered by s.16(1)(a) because
there is no money borrowed. Hence, for interest on a trade debt, if the general rule in
s.16(1) is satisfied, the relevant interest expense will be deductible; and

• For the purpose of s.16(1)(a), it is not necessary for the interest expenses to directly
produce chargeable profits. It would be sufficient if the interest is incurred for the
purpose of producing chargeable profits (re: Zeta Estates Ltd v CIR (2007) 2 HKLRD
102). In the Zeta case, it was held deductible for the interest expense incurred on a
shareholders’ loan in relation to dividend payments, where the shareholders’ loan
was borrowed for the purpose to maintain profits earning assets by way of avoiding
disposal of trading stock. The relevant facts of Zeta are summarised as follows. Zeta
carried on business of development of properties for sale. It developed and sold
certain residential units of a project, earned profit and declared dividend. But at the
times certain units were sold, there were other units of the same project still under
development and/or completed but yet to be sold. These units were held as work-in-
process/trading stock. Zeta did not have enough cash to pay all the dividend because
a portion of the sale proceeds was used to finance the continuing development of
the project. Hence, it turned the dividend payable into a shareholders’ loan, which
was interest bearing. The Court of Final Appeal held that, had the dividend payable
not been turned into a shareholders’ loan, Zeta would have to dispose the work-in-
process/residential units at unfavourable prices. Therefore, the shareholders’ loan
was borrowed to maintain the profit earning assets of the company and hence it was
borrowed ‘for the purpose of’ Zeta’s trade and s.16(1)(a) was satisfied.

S.16(1)(a) requires that any one of the conditions stipulated in s.16(2) must be satisfied:

• S.16(2)(a) is satisfied if the money is borrowed by a financial institution. A ‘financial

institution’ is an authorised institution within the meaning of s.2 of the Banking
Ordinance (Cap.155), e.g. licensed bank and deposit-taking company, including any
associated corporation of such an authorised institution;

• S.16(2)(b) is satisfied if the money is borrowed by a public utility company, i.e. HK

Electric, China Light & Power, and HK & China Gas and the interest is not exceeding the
rate specified by the Financial Secretary; and

• S.16(2)(c) is satisfied if the money is borrowed from a person other than financial
institution, and the interest received by the lender is chargeable to tax in Hong Kong.

Illustrative Example 34
If the lender is a person other than a financial institution (i.e. broadly speaking, a bank) a
tax symmetry requirement arises: A deduction claimed by the borrower must correspond
to a taxable receipt in the hands of the lender. That means that a deduction will only be
allowed to the extent the interest paid by the borrower and accruing to or received by
the lender is chargeable to tax under ss.14, 15(1)(f), or 15(1)(g).

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• S.16(2)(d) is satisfied if the money is borrowed from a financial institution.

• S.16(2)(e) is satisfied if the money is borrowed wholly and exclusively to finance:

1. The provision of

• Plant and machinery qualifying for depreciation allowance,

• Plant and machinery for research and development,

• Prescribed fixed asset,

• Environmental protection machinery or environment-friendly vehicle; or

2. The purchase of trading stock;

and the lender is not an associate of the borrower.

• S.16(2)(f) is satisfied if the money is borrowed by a corporation by way of:

1. Debentures listed on a stock exchange in Hong Kong or other stock exchange

recognised by the CIR; or

2. Other instruments issued

• Bona fide in the course of carrying on business and is marketed in Hong

Kong or other major financial centre approved by the CIR (e.g. New York;,
Luxembourg, etc.); or

• Pursuant to the authorization of the Securities and Futures Commission under

s.105 of the Securities and Futures Ordinance (Cap.571).

Where money is borrowed from an associated corporation which raises the proceeds
from such an issue, deduction is limited to the amount payable by the associated
corporation to debentures/ instruments holders

• S.16(2)(g) is satisfied if the money is borrowed by a corporation carrying on in

Hong Kong an intra-group financing business, from a lender which is a non-Hong Kong
associated corporation where:

• The interest expenses were incurred for intra-group financing business. That is, a
Hong Kong company borrowed money from group companies for on-lending to other
group companies;

• Interest received is subject to tax in overseas at a rate not lower than the profits
tax rate of the Hong Kong company which has paid the interest (i.e. the reference
rate); and

• The associated corporation (lender) is the beneficial owner (BO) of the interest, has real
control over the interest and is not constrained by any contractual or legal obligation
to pass that interest to any other person unless the obligation arises as a result of a
transaction between the lender and a person other than the borrower dealing with
each other at arm’s length.

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Ss.16(2A), (2B) and (2C) – limitations on deduction:

• Secured Loan Test – s.16(2A) is applicable to a loan borrowed where ss.16(2)(c), (d) or (e)
is satisfied. Restriction on interest expense deduction applies if:

• The loan is secured by a deposit or a loan made by the borrower or its associate with/
to the lender, a financial institution, an overseas financial institution, or its respective
associate; and

• The interest on such deposit/loan is not taxable in Hong Kong.

• Deduction is to be reduced by an amount calculated on the most reasonable and

appropriate basis, having regard to the amount of interest income arising from the
deposit/loan.

Illustrative Example 35
Elephant Company Ltd borrowed HK$1 million from a bank at 5% per annum as
working capital for its Hong Kong business. All profits derived from the business were
derived from Hong Kong and subject to profits tax. The loan was secured by a personal
guarantee provided by its shareholder, Mr. Wong and some shares which are worth
HK$400,000.

The loan is borrowed from a financial institution to produce chargeable profits and
ss.16(1)(a) and (2)(d) are satisfied. As the loan is not secured by a deposit or another loan,
s.16(2A) does not apply and all loan interest is therefore deductible.

Illustrative Example 36

(Adapted from DIPN No. 13A, Example 5)

Flower Company Ltd (FCL) borrowed HK$2 million from a bank at 5% per annum as
working capital for its Hong Kong business. All profits derived from the business were
derived from Hong Kong and subject to profits tax. The loan was secured by a fixed
deposit (placed with an overseas bank) of HK$2 million earning interest income of 4% per
annum. In the year of assessment 2018/19, FCL earned tax-free interest of HK$80,000
from the deposit and paid HK$100,000 interest on the loan.

The whole of the deposit is used to secure the loan. Deductible interest is reduced by
the tax-free interest of HK$80,000 on the deposit.

Deductible interest = HK$100,000 − HK$80,000 = HK$20,000

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Illustrative Example 37

(Adapted from DIPN No. 13A, Example 6)

A HK$2 million loan was secured by an overseas bank deposit of HK$1 million that
generated tax-free interest of HK$40,000 and some shares which were worth HK$1 million.

As the loan (HK$2 million) is larger than the overseas bank deposit (HK$1 million),
the whole of the deposit is used to secure the loan. Deductible interest is reduced by the
tax-free interest of HK$40,000 on the deposit.

Deductible interest = HK$100,000 − HK$40,000 = HK$60,000

Illustrative Example 38

(Adapted from DIPN No. 13A, Example 7)

On 1 January 2019, Giraffe Company Ltd (GCL) borrowed HK$1 million from an overseas
bank as working capital for its Hong Kong business. All profits derived from the business
were derived from Hong Kong and subject to profits tax. The loan was secured by a
deposit of HK$2 million placed by GCL’s holding company (HCO) with a bank in Hong
Kong. HCO did not carry on any business in Hong Kong. For the year ended 31 December
2019, GCL incurred interest expense of HK$50,000 on the loan and HCO derived interest
income of HK$80,000 from the deposit.

For the year ended 31 December 2019, a portion of the deposit was used to secure the
loan. The interest income derived from the deposit is not chargeable as HCO did not carry
on business in Hong Kong.

Deductible interest expense is reduced by the tax-free interest from the deposit.

Deductible interest = HK$50,000 − HK$80,000 × HK$1 million÷HK$2 million

= HK$10,000

Illustrative Example 39

(Adapted from DIPN No. 13A, Example 8)

On 1 January 2019, Hawk Company Ltd (HCL) borrowed HK$1 million from an overseas
bank as working capital for its Hong Kong business. All profits derived from the business
were derived from Hong Kong and subject to profits tax. The loan was secured by a
deposit of HK$1 million placed by HCL’s director, Mr. Wong with a bank in Hong Kong
and shares of Mr. Wong worth HK$500,000. Mr. Wong did not carry on any business in
Hong Kong. For the year ended 31 December 2019, HCL incurred interest expense of
HK$50,000 on the loan while Mr. Wong derived interest income of HK$40,000 from the
deposit and dividend of HK$20,000 from the shares.

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Illustrative Example 39 (continued)

For the year ended 31 December 2019, a portion of the deposit was used to secure the
loan. The interest income derived from the deposit is not chargeable as Mr. Wong did not
carry on any business in Hong Kong.

Deductible interest expense is reduced by the tax-free interest from the deposit.

Deductible interest HK$50, 000 HK$40, 000 HK$1 million * HK$ (1* 0.5# ) million
HK$23, 333

* being HK$1 million deposit

 being HK$0.5 million shares
#

Illustrative Example 40

(Adapted from DIPN No. 13A, Example 9)

On 1 January 2019, Ibis Company Ltd (ICL) borrowed HK$1 million (Loan-1) from an
overseas bank as working capital for its Hong Kong business and contracted another
loan of HK$1.5 million (Loan-2) for financing construction of an office building. All profits
derived from the business were derived from Hong Kong and subject to profits tax. The
two loans were secured by a deposit of HK$2 million placed by ICL with another overseas
bank. For the year ended 31 December 2019, ICL incurred interest expense of HK$50,000
on Loan-1 and interest expense of HK$75,000 on loan-2. ICL derived interest income of
HK$80,000 from the overseas bank deposit.

For the year ended 31 December 2019, a portion of the deposit was used to secure the
loan. The interest income derived from the deposit was not chargeable to profits tax.

Deductible interest expense is reduced by the tax-free interest from the deposit.

Deductible interest HK$50, 000 HK$80, 000 HK$1 million * HK$ (1* 1.5# ) million

HK$50, 000 HK$32, 000

HK$18, 000

* being Loan-1 of HK$1 million, which is trading in nature

being Loan-2 of HK$1.5 million, which is capital in nature. Interest on Loan-2 of
#

HK$75,000 could be ranked for commercial building allowance (see Section 3.7.3). There
is no restriction under s.16(2A) for qualifying expenditure ranking for commercial building
allowance.

• Interest Flow-back Test – s.16(2B) is applicable to a loan borrowed where ss.16(2)(c),

(d) or (e) is satisfied, and s.16(2C) is applicable for debentures/marketed instruments
issued where s.16(2)(f) is satisfied. Restriction on interest expense deduction applies if
there is an arrangement in place whereby interest payment is ultimately paid back to

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the borrower (issuer) or any connected person, and such interest income is not taxable.
However, the restriction does not apply to the case of debenture/debt instrument,
where the connected person receiving the interest is a market maker holding
securities in the ordinary course of business (s.16(2G)). Partial deduction is allowed
if only part of the interest payment flows back to the borrower or to a connected
person. Apportionment will be made by reference to the portion of loan assigned to
or sub-participated by the borrower or connected person that generates the interest
flow-back, and the length of time in which such arrangement is in place, on the basis of
the following formulae which calculate the non-deductible amounts:

For s.16(2B):

A
C
B

where:

A Means the total number of days during the basis period of the borrower for the year of
assessment concerned at the end of each of which the principal in respect of the money
borrowed or in respect of the relevant part of the money borrowed, as the case may be,
is outstanding and the arrangements are in place;

B Means the total number of days during the basis period of the borrower for the year of
assessment concerned at the end of each of which the principal in respect of the money
borrowed or in respect of the relevant part of the money borrowed, as the case may be,
is outstanding; and

C Means the total amount of sums payable by the borrower by way of interest on the
money borrowed or on the relevant part of the money borrowed, as the case may be,
which, excepting s.16(2B) and ss.16(2A), (2C) and (2CA), would have been deductible
under s.16(1)(a) for the year of assessment concerned.

For s.16(2C):

X
Z
Y

where:

X Means the total number of days during the basis period of the borrower for the year
of assessment concerned at the end of each of which the principal in respect of the
debentures or instruments concerned or in respect of the relevant interest in the
debentures or instruments concerned, as the case may be, is outstanding and the
arrangements are in place;
Y Means the total number of days during the basis period of the borrower for the year
of assessment concerned at the end of each of which the principal in respect of the
debentures or instruments concerned or in respect of the relevant interest in the
debentures or instruments concerned, as the case may be, is outstanding; and
Z Means the total amount of sums referred to in paragraph (c) or (d), as the case
may be, which, excepting s.16(2C) and ss.16(2A), (2B) and (2CA), would have been
deductible under s.16(1)(a) for the year of assessment concerned.

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Illustrative Example 41

(Adapted from DIPN No. 13A, Example 12)

A Ltd borrowed money from Bank B to finance its trading business in Hong Kong. A Ltd’s
subsidiary, C Ltd, which is an overseas company with no business in Hong Kong, entered into
a loan sub-participation arrangement with Bank B. Under the arrangement, C Ltd advanced
a loan of HK$100M to Bank B on the condition that the repayment of principal and interest
of this loan by Bank B to C Ltd would only be made on the condition of the repayment of
principal and interest of the loan by A Ltd to Bank B. In practical terms, Bank B is risk free.

In this situation, the interest paid by Bank B to C Ltd is treated as if it were the interest
on the loan borrowed by A Ltd from Bank B when the restriction of s.16(2B) is considered.
As the interest was paid to an associated company (C Ltd) of the borrower (A Ltd) of the
loan, the interest deduction claim would be denied.

Illustrative Example 42
A Ltd carried on business in Hong Kong and issued debentures of HK$10 million to finance its
Hong Kong trading business. A Ltd paid interest expense of HK$1 million for the year 2018/19
on the debentures. Out of the HK$10 million debenture, HK$8 million was held by A Ltd’s
overseas subsidiary for the whole year 2018/19. The overseas subsidiary did not carry on
business in Hong Kong.

The interest would be flowed back to A Ltd’s associate, i.e. the overseas subsidiary and
would be disallowed: HK$1 million × 8 ÷ 10 = HK$800,000, allowable interest: HK$200,000

If the associate has only held the debenture for 183 days out of the whole year,
i.e. 365 days, interest to be disallowed will be time-apportioned: HK$800,000 × 183 ÷ 365 =
HK$401,095.89

If the associate is a market maker who bought the debentures in its ordinary business,
no restriction will apply under s.16(2C).

Restriction under ss.16(2CA) and 16(2CC):

Deduction under s.16(2)(g) is subject to the restriction stipulated in ss.16(2CA) and 16(2CC).
Interest deduction is disallowed, or partially allowed, if:

1. There is an arrangement in place where all or part of the interest concerned are payable
on money borrowed from a non-Hong Kong associated corporation, directly or through
an interposed person, to the borrower or a person connected with the borrower or the
lender (i.e. a related person), and the related person is neither subject to profits tax nor
a similar tax outside Hong Kong or subject to such tax at a rate lower than the reference
rate (i.e. the applicable profits tax rates of the Hong Kong borrowing company), which
is – the ‘interest diversion test’ in s.16(2CA). The amount of the interest deduction shall be
reduced by an amount calculated in accordance with the formula provided in s.16(2CB)
(see below); and

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2. The Commissioner is satisfied that the main purpose, or one of the main purposes, of
the borrowing of the money is to utilise a loss sustained by a person connected with
the borrower or the lender in a trade or business in Hong Kong or elsewhere to avoid,
postpone or reduce any profits tax liability of the borrower or another person – the ’loss
shifting test’ in s.16(2CC). No interest deduction is allowed if s.16(2CC) applies.

Apportion formula under s.16(2CB):

Interest expense not deductible A B C

where:

A Means the total number of days during the basis period the loan is outstanding and the
arrangement is in place;

B Means the total number of days during the basis period the loan is outstanding; and

C Means the total amount of interest expense that but for ss.16(2A), (2B), (2C) and (2CA)
would have been deductible under s.16(1)(a) for the year of assessment concerned.

Illustrative Example 43

Interest Diversion – s.16(2)(g), s.16(2CA) and s.16(2CB)

Macaw Company Ltd (MCL) carried on an intra-group money lending business in Hong
Kong within a multinational group of companies, namely Birdy Group. Nightingale
Company Ltd (NCL) is one of the group’s company and is a resident in Country N, which
charges income tax at 16.5% on assessable income. Parrot Company Ltd (PCL) is another
company within the Birdy Group and is a resident in Country P. Income tax rate in
Country P is 1%.

On 1 January 2019 for the purpose of its intra-group financing business, MCL borrowed
a loan of HK$20 million from NCL at an annual interest rate of 5%. On 1 July 2019, PCL
acquired the 70% equitable right of the loan from NCL.

For the year 2019, MCL incurred interest of HK$1 million for the loan, out of which
HK$350,000 received by NCL was paid to PCL.

MCL, NCL and PCL are within the same group and hence they are related persons. The
assignment of 70% equitable right of the loan to PCL constituted an arrangement. Since
Country P only charged 1% income tax on the interest of HK$350,000 accrued to PCL,
interest disallowed for deduction under s.16(2CB) was HK$350,000 (HK$1 million × 70% ×
6 months ÷ 12 months)

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Illustrative Example 44

Interest Diversion – s.16(2)(g), s.16(2CA) and s.16(2CB)

On 1 January 2019, Ace (HK) Ltd borrowed a loan of HK$10 million from Bee (OVB) Ltd,
its associated corporation resident in Country B, at an interest rate of 5% p.a. in the
ordinary course of its intra-group financing business. Bee (OVB) Ltd is subject to income
tax in Country B at a rate of 16.5%. Bee (OVB) Ltd and Cat (OVC) Ltd entered into a
management service agreement whereby Cat (OVC) Ltd had arranged the loan for Bee
(OVB) Ltd for a service fee of 50% of the interest income received. Cat (OVC) Ltd is an
associated corporation resident in Country C which did not levy any income tax. For the
year ended 31 December 2019, Ace (HK) Ltd incurred interest of HK$500,000 under the
loan, out of which HK$250,000 received by Bee (OVB) Ltd was paid to Cat (OVC) Ltd as the
management service fee for arranging the loan.

The IRD states in DIPN No. 52, para. 34, that the provisions in s.16(2CA) and (2CB) are
designed to combat profit shifting schemes involving disguised expenses and to protect
Hong Kong’s tax base. Hence, they would apply to disallow an interest deduction even if
the interest is paid out to a related person in other forms, such as management fee or
service fee under an arrangement.
Cat (OVC) Ltd was a related person since Ace (HK) Ltd and Bee (OVB) Ltd were
connected persons. The management service agreement between Bee (OVB) Ltd and Cat
(OVC) Ltd constituted an arrangement. Since Country C did not levy any income tax on the
management service fee of HK$250,000 accrued to Cat (OVC) Ltd, interest disallowed for
deduction under s.16(2CB) would be HK$250,000.

Illustrative Example 45

Loss Shifting (1) – s.16(2)(g), s.16(2CC)

Jacanas Company Ltd (JCL) carried on an intra-group money lending business in Hong
Kong within a multinational group of companies. Holding Company (HCO) is the ultimate
holding company of the group. During the year 2018, for the purpose of its intra-group
financing business, JCL borrowed a loan of HK$25 million from HCO. HCO earned profits
of HK$100 million for the year 2018. During the year 2019, JCL paid interest expense of
HK$3 million to HCO. HCO sustained a loss of HK$200 million for the year 2019.

It was unlikely that the main purpose or one of the main purposes of the loan
transaction was to utilise the current year loss of HCO to reduce the profits tax liabilities
of JCL. At the time of borrowing the loan from HCO (i.e. 2018), it might not be reasonably
foreseeable that HCO would incur a loss in 2019. In the circumstances, s.16(2CC) might not
be invoked and the interest deduction claimed by JCL could be allowed under s.16(2)(g),
provided that the tax rate of HCO was not lower than the reference rate.

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Illustrative Example 46

Loss Shifting (2) – s.16(2)(g), s.16(2CC)

Ho (HK) Ltd is a regional corporate treasury centre resident in Hong Kong of a

multinational group of companies and is subject to profits tax at 8.25%. Dee (OVD) Ltd
which was an associated corporation resident in Country D, which charges income tax at
10%. During the year ended 31 December 2019, Dee (OVD) Ltd borrowed a loan from a
bank in Country D at an interest rate of 5% per annum and on-lent the loan fund to Ho
(HK) Ltd at an interest rate of 7% per annum. In respect of the loan, Ho (HK) Ltd had paid
interest of HK$2.5 million to Dee (OVD) Ltd for the year ended 31 December 2019. Dee
(OVD) Ltd has accumulated tax losses of HK$30 million as at 1 January 2019.

It was likely that the main purpose or one of the main purposes of the loan transaction
was to utilise the tax losses of Dee (OVD) Ltd to avoid profits tax liabilities of Ho (HK) Ltd.
The provisions in s.16(2CC) might be applicable. However, it may be argued that it is not
practicable for Ho (HK) Ltd to borrow the loan directly from the bank in Country D. Due to
geographical proximity, it is more administratively convenient and cost effective for Dee
(OVD) Ltd to borrow the loan and on-lend the loan fund to Ho (HK) Ltd. The 2% interest
spread is charged by Dee (OVD) Ltd on an arm’s length basis. If such argument can be
substantiated by valid documentary evidence, it might be accepted by the IRD that the
main purpose of the arrangement is not for utilisation of tax losses of Dee (OVD) Ltd and
hence, s.16(2)(CC) might not apply.

Illustrative Example 47

Loss Shifting (3) – s.16(2)(g), s.16(2CC)

Kangaroo Company Ltd (KCL) carried on an intra-group money lending business in Hong
Kong within a multinational group of companies. Parent Company (PCO) is the ultimate
holding company of the group. On 31 December 2018, for the purpose of its intra-group
financing business, KCL borrowed a loan of HK$25 million from PCO. For the year 2018,
PCO earned profits of HK$10 million from its own business and, being a partner of a
partnership, shared 30% losses of the partnership, amounting to HK$200 million. KCL
paid interest expense of HK$3 million to PCO for the year 2019.

At the time of borrowing the loan from PCO, it was reasonably foreseeable that PCO
would absorb losses incurred by the partnership. It was likely that the main purpose or one
of the main purposes of the loan transaction was to utilise PCO’s share of losses from the
partnership to reduce the profits tax liabilities of KCL. Hence, the provisions in s.16(2CC)
might be applicable to disallow the entire amount of interest expense of HK$3 million.

Note that not all interest is deductible merely because it is incurred in the production of
assessable profits. If the interest is incurred to fund capital expenditure, the interest will be
treated as capital expenditure barred from deduction under s.17(1)(c). In CIR v Tai On Machinery
Works Ltd (1969) 1 HKTC 411, the court held that interest payments on a loan to finance the

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construction of a building which was a capital asset were non-deductible payments of a capital
nature to the extent that the payments were made before the building could be used to
produce profits. Similarly, in Wharf Properties Ltd v CIR (1997) 4 HKTC 310, the Privy Council held
that whether an interest payment was of a capital or revenue nature depended on the purpose
for which the money was required during the relevant period. The interest expense which is
capital nature may be eligible for depreciation allowances (discussed in Section 3.7).

Illustrative Example 48
GSHM has to meet certain urgent cashflow requirements. Accordingly, it contracts two
loans. The first is with Ah Long Bank, a bank regulated under the Banking Ordinance,
for a principal of HK$100 million at 5% interest per annum. Realising that this first loan
is insufficient to meet its funding needs, GSHM borrowed an intra-group loan from Red
Lantern of HK$15 million at 7% interest per annum. Interest expenditure incurred with
respect to the Ah Long Bank loan is deductible: Ah Long Bank is a financial institution,
and, to be clear (although there is no tax symmetry requirement for financial institutions,
tax symmetry is in practice maintained because Ah Long Bank will be chargeable to
profits tax with respect to the interest income under s.15(1)(i) or otherwise under s.14).
Conversely, Red Lantern does not pay tax in Hong Kong on the interest received because
it is not a financial institution and does not carry on a trade, profession, or business in
Hong Kong. As such, the tax symmetry test is not met. Accordingly, the interest payable
with respect to the Red Lantern loan is not deductible.

3.5.4 Deductions Not Allowed

S.17 provides that certain items of expenditure are barred from being deductible. These
relevantly include:

• Domestic or private expenses (s.17(1)(a)).

• Any sums not expended for the purpose of producing assessable profits (s.17(1)(b)).

• Any expenditure of a capital nature or any loss or withdrawal of capital (s.17(1)(c)). This is
the most important exclusion and we shall consider it in further detail in Section 3.6.2.

• The cost of any improvements (s.17(1)(d)).

• Any sum recoverable under insurance or contract of indemnity (s.17(1)(e)). In other

words, no deduction is allowed unless the taxpayer claiming the deduction bore the
actual economic cost of the expenditure or outgoing in question.

• Rent of or expenses relating to premises not occupied or used for the purpose of
producing assessable profits (s.17(1)(f)).

• Taxes paid or payable under the IRO, except salaries tax paid for employees’
remuneration (s.17(1)(g)).

• Sums an employer paid in respect of an employee (to the extent they exceed 15% of
that employee’s total income from employment) as an ordinary annual contribution
to a recognised occupational retirement scheme or an ordinary annual premium for a
contract of insurance under such a recognised occupational retirement scheme, or as
regular contributions paid to an MPF scheme (s.17(1)(h)).

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• Any provision made for the payment in respect of an employee of any sum referred
to in paragraph (h), to the extent that the aggregate of such provision and any such
payment as is referred to in that paragraph exceeds 15% of the total emoluments of
that employee for the period in respect of which the provision is made (s.17(1)(i)).

• Any provision made in respect of an occupational retirement scheme other than for the
payment of any sum referred to in paragraph (h) (s.17(1)(j)).

• Any sum mentioned in s.17(1)(h) whereby a deduction has already been allowed in a
prior year of assessment (s.17(1)(k)).

• Any contribution or payment made to a retirement scheme other than recognised

occupational retirement scheme (i.e. to a non-recognised pension scheme) (s.17(1)(l)).

• Spousal salary or other payment (s.17(2)(a)), or salary or other payment of a partner or

partner’s spouse (s.17(2)(d)(i)).

• Interest on capital or loans provided by that spouse (s.17(2)(b)), or interest on capital or

loans provided by a partner or partner’s spouse (s.17(2)(d)(ii)).

• Contributions made to a mandatory provident fund scheme related to that spouse

(s.17(2)(c)), or contributions made to a mandatory provident fund scheme in respect of
a partner or a partner’s spouse, subject to s.16AA (s.17(2)(d)(iii)).

Refer to Exhibit 3.8 for a useful summary for reference.

Non-deductible expenses Example

Domestic or personal expenses • Meals, medical expenses, insurance premiums
• Birthday celebration expenses for the sole proprietor/partners
and/or their family members, etc.
• Private share of utilities, e.g. rates, electricity, water if the
premises is used for both business and residential purposes
• Private share of motor vehicles expenses for vehicles used for
both private and business purpose
• Costs of travelling between residence and place of business
and overseas travelling taken not for business purpose
• Payments to spouse including salaries/remuneration
• Interest on personal capital/loans
• Withdrawal of capital
Capital expenditures or losses • Cost of acquiring fixed assets such as plant and machinery
• Costs of acquiring business premises including the related
stamp duty and legal fees
• Costs of any improvements to business premises
• Loss of capital
• Loss on disposal of fixed assets
Sum expended not for producing • Penalties/fines for breaking the laws
assessable profits
• Entertainment expenses not expended for business purpose
• Rent or expenses relating to premises not occupied for the
purpose of producing assessable profits

EXHIBIT 3.8 Summary of non-deductible expenses

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Illustrative Example 49
Assume GSHM incurs the following expenditure in the year of assessment 2018/19:

(1) acquisition of apparel from a supplier in Vietnam for resale in Hong Kong at
HK$25 million; (2) HK$45 million in employee salary and mandatory provident fund
contributions for its Hong Kong retail outlets; (3) HK$2 million in electricity costs, being the
aggregate electricity bill for all its Hong Kong retail outlets; (4) HK$10 million in modernising
the appearance of its flagship store in Wanchai; and (5) acquisition of exclusive rights to a
garment design from Gyaru Inc, a Japanese company. Consider whether each such item of
expenditure is deductible in the computation of the assessable profits of GSHM. Is there
any other information that you may require to opine more robustly?

The acquisition of trading stock is a revenue expenditure incurred in the production

of taxable profits. It is accordingly deductible. Employee salaries are likewise a recurring,
revenue expenditure incurred in the production of taxable profits, and are therefore
deductible. The same argument would apply to electricity costs. Costs of improvements are
expressly barred from being deductible in s.17(1)(d), though query whether this could be
regarded as a refurbishment rather than an improvement. The purchase of an intellectual
property right may be deductible, notwithstanding that it is a capital expenditure,
under s.16EA.
It must, however, be queried whether any of the counterparties to such operations or
transactions are associated with GSHM. If they are, the relevant transfer pricing rules will
apply and, accordingly, you must query whether the consideration given is arm’s length.

Knowledge Check Question

Question 9
Identify which of the following statements is true.
A Interest received from a bank in Hong Kong regulated under the Banking Ordinance is
never chargeable to profits tax.
B GSHM Ltd, a company carrying on the trade of being an apparel retailer in Hong Kong,
borrows HK$25 million to build a new head office in Shatin, with interest on the principal
charged at 3.5% per annum. Such interest will be deductible to the extent that it
complies with the conditions in ss.16(1)(a) and 16(2).
C GSHM Ltd borrows money from its parent company, Red Lantern Limited, a company
carrying on a trade in Hong Kong in consideration for interest payable at 2.5% per
annum. Red Lantern makes the principal available on the DragonBank account of GSHM
in Hong Kong. Such interest will be deductible under s.16.
D Payments made under a hybrid instrument that is in substance equity will be treated
under the IRO as a dividend and not interest, under the substance over form approach.

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3 . 6
DISTINCTION BETWEEN CAPITAL
AND REVENUE ITEMS

The distinction between revenue and capital is one of the oldest and most important questions
in revenue law.

3.6.1 Capital Receipts and Revenue Receipts

The general rule under s.14(1) is that revenue profits are taxable and capital gains (or,
specifically, gains derived from the sale of a capital asset) are expressly exempt from tax.
What constitutes a capital asset as opposed to a revenue asset will depend on the specific
trade or business carried on by the taxpayer. The distinction between revenue and capital
is one of the oldest issues of revenue law. An introductory analogy that is often used is that
capital is the plant and revenue is the fruit. Capital comprises those assets that are used in the
production of profits, or are held otherwise than as the stock-in-trade of the taxpayer. Revenue
assets are, generally speaking, trading stock, that is, an asset turned over to generate trading
profits. Typically, revenue receipts (also called trading receipts) include receipts from services
in the course of business, the disposal of trading stock and activity that is only incidental to
the business.

For example, from the perspective of a company providing consultancy services, immovable
property is likely a capital asset; it is necessary to house the offices where the employees of
the taxpayer work and meet their clients. But immovable property is not turned over in the
ordinary course of a consultancy undertaking. Conversely, immovable property will likely be a
revenue asset in the context of a property developer’s trade. A property developer turns over
immovable property in the ordinary course of its trade: Immovable property is the subject
matter of its profit-making operations.

One approach to distinguishing revenue and capital assets is to consider the distinction
between fixed capital and circulating capital. Receipts may be separated into those that are
related to fixed capital and those related to circulating capital. Capital receipts are typically
connected to a business’s fixed assets (i.e. fixed capital), whereas revenue receipts are those
that are connected to a business’s current assets (i.e. circulating capital).

The English decision in IRC v John Lewis Properties plc (2003) STC 117 provides some helpful
general guidance. The court held in that case that one should consider: (1) an asset that is
long-lasting is more likely to be a capital asset (although this factor must be considered in the
context of the overall business); (2) the higher the value of the asset relative to the aggregate
assets of the taxpayer as a whole, the likelier it is to be capital in nature; (3) if a payment
permanently diminishes the value of an asset held by the taxpayer, it is more likely to be a
capital payment; (4) a lump sum tends to indicate a capital payment, while recurring payments
tend to be receipts of a revenue nature; and (5) where risk is transferred to the transferee, the
transaction is more likely to be capital in nature. Those are general rules, but case law provides
for additional guiding principles that can assist in distinguishing between a revenue asset and a
capital asset in specific contexts:

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1. Where a trader is deprived of an asset and receives compensation or damages, the sum
received may be either a taxable trading receipt or a non-taxable capital receipt. Where
the sum is received to compensate for lost trading profits, the compensatory sum
assumes the same character of the trading profits themselves and is therefore taxable
(Lincolnshire Sugar v Smart (1937) AC 697). Where the sum is received in compensation
for the total cessation of the business or for the ‘sterilisation’ (that is, the total cessation
of function) of a capital asset, the sum will, by the same logic, be a capital receipt
(Glenboig Union Fireclay Co Ltd v IRC (1921) 12 TC 427).

2. Compensation for the cancellation of a business contract affecting the structure of the
taxpayer’s business will likewise be treated as a capital receipt, the view being taken
that such contracts are in effect capital assets (Van den Berghs Ltd v Clark (1935) AC
431). Conversely, compensation for the cancellation of ordinary trading contracts is, by
analogy, comparable to compensation in lieu of trading profits and is therefore revenue
receipt (Kelsall Parsons & Co v IRC (1938) 21 TC 608). Whether a given contract goes to
the structure of the taxpayer’s business or is a mere trading or business contract will be
a mixed question of fact and law. You should always bear in mind the specific context of
the taxpayer’s business.

3. A payment in consideration for a restriction on trade (such as an undertaking not to

trade or otherwise to limit business activity) will in general not be treated as a revenue
receipt because it will by definition be received outside the ordinary course of a
trade or business (Higgs v Olivier (1952) CH 311). Note that since the introduction of
comprehensive competition legislation in Hong Kong, such payments may in certain
cases be unlawful.

4. Even though a transaction is an isolated transaction, the profits thereof may

nonetheless be of a revenue nature (Edwards v Bairstow (1956) AC 14). The underlying
question will in any event be whether as a matter of fact and law the transaction was a
trading transaction, for which you may refer back to the badges of trade as discussed
in Section 3.2.1. Thus, the one-off disposal of a single piece of immovable property may
nonetheless give rise to a revenue receipt. By the same token merely because there are
recurring transactions does not mean that the transaction was in the ordinary course of
trade (Lee Yee Shing v CIR (2008) 3 HKLRD 51).

5. Merely deriving income or a gain from an asset does not necessarily mean that the
income or gain in question are revenue in nature. Where a capital asset is turned
to account apart from the ordinary course of the taxpayer’s trade or otherwise
immediately prior to its commencement, receipts arising from the exploitation of that
capital asset will not be revenue receipts (Mamor Sdn Bhd v DGIR (1985) STC 801).

6. Debt forgiveness (i.e. waiver of a loan) has been held not to be taxable (British Mexican
Petroleum Co Ltd v Jackson (1932) 16 TC 570) though note the effect of s.15(2) is to tax
any debt remitted with respect to which tax deductions had previously been claimed.

Shares and other securities and immovable properties are in common parlance often
regarded as paradigmatic capital assets. You will recall, however, from the application of the
badges of trade and the case law on s.14 that what constitutes a revenue or capital asset will
depend on what exactly it is that the taxpayer does with the asset in question. It is a matter of
fact and degree. For example, as regards shares and other securities an investor who manages
and realises an investment and reaps a capital gain is not trading (CIR v Dr Chang Liang-jen

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(1977) 1 HKTC 975); however, if the operation in question were sufficiently systematic, capital
intensive, and organised such that one or more badges of trade applied, it could cross the line
into trading. Thus, in Lee Yee Shing v CIR (2008) 3 HKLRD 51, the Court of Final Appeal while
affirming that it would only be in rare cases that a taxpayer would be found to be trading in
shares, especially unlisted shares:

The intention to trade to which Lord Wilberforce referred is not subjective but objective: Iswera v
IRC (1965) 1 WLR 663 at 668. It is inferred from all the circumstances of the case, as Mortimer J
pointed out in All Best Wishes Ltd v CIR (1992) 3 HKTC 750 at 771. A distinction has to be drawn
between the case where the taxpayer concedes that he or she had the intention to resell for profit
when the asset or commodity was acquired and the case where the taxpayer asserts that no such
intention existed. If the taxpayer concedes the intention in a case where the taxing authority claims
that a profit is assessable to tax, the concession is generally but not always decisive of intention.
(IRC v Reinhold (1953) 34 TC 389)

In general, the IRD and the courts are slow to accept that trading in shares by any entity
other than large and professional trading organisations such as financial institutions are
revenue in nature. That is because if trading in shares that was in reality speculation were
sufficient to constitute a trade or business, the losses from that trade or business would
be available for set off against current or future profits. It is, however, well-established that
gains arising from the disposal of investments by insurance companies and banks, which by
definition trade in such investments, are chargeable to profits tax (CIR v Sincere Insurance and
Investment Co Ltd (1973) 1 HKTC 602).

Similar principles apply to transactions in land. In the hands of, say, a manufacturer, land
is a capital asset: It constitutes the space necessary for its manufacturing activities to take
place. Conversely, in the hands of a developer, land is stock-in-trade; the developer acquires
properties, improves them, and sells these at a profit. It is therefore well-established at revenue
law that a person may trade in immovable property such that the gains from the disposal
thereof are chargeable to profits tax (Rhodesia Metals Ltd v CoT (1940) AC 774). If the taxpayer,
however, were merely an agent arranging leasing or purchasing transactions of foreign
property on behalf of the real owner, then the taxpayer’s profits will consist of commissions
from the provision of services and will be taxable if the relevant agency services are rendered in
Hong Kong (Kwong Mile Services Ltd v CIR (2004) 3 HKLRD 168).

Illustrative Example 50
GSHM retails garments. Garments, supplied from its manufacturers, are therefore
its stock-in-trade. Profits realised from the sale of garments are therefore income or
trading profits: they arise from the sale of trading stock. Conversely, the leases to the
various retails premises it owns in Hong Kong are, in the context of its business, capital
in nature. They are essential to the carrying on of the business of GSHM, but they are not
its stock-in-trade: GSHM does not deal in leases, or sell these in the ordinary course of its
business. If it did find a willing purchaser for one of its commercial leases, and decided
to sell on the grounds that it no longer required the premises, any gains arising from
that disposal would not be chargeable under s.14(1). That is because they would be gains
from the sale of a capital asset.

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3.6.1.1 Change of Intention
An asset may begin its life as a capital asset and subsequently by virtue of a change in intention
of the taxpayer become a revenue asset. If a taxpayer acquires a parcel of land with a view to
setting up production or retail facilities there, but at a later stage decides that it also wishes to
enter into an adventure in the nature of trade with respect to property development, the land
in question would, applying the badges of trade in the specific ambit of the trade or business
carried on by the taxpayer, thereby be appropriated to trading stock. Consider, for example, the
case of Church Body of the Hong Kong Sheng Kung Hui v CIR (2017) 1 HKC, where an ecclesiastical
foundation owning a plot of land entered into a redevelopment project ultimately to realise that
land for a profit. It was common ground that the disposal of the land was a trading disposal for
the taxpayer, and not a capital disposal, because it had entered into an adventure in the nature
of trade when it agreed to participate in the redevelopment project. The key issue, however,
was when the change of intention occurred because that would have established the ‘base
price’ against which the profits of the taxpayer were to be computed upon realisation of the
redevelopment project. Since property prices have increased considerably in Hong Kong over the
past several decades, it was in the commercial interest of the taxpayer to argue that its intention
to hold its immovable property as trading stock emerged at the latest possible opportunity. In
so doing, it would increase the ‘base cost’ of acquisition (which would in essence have been the
market price of the property at the time the taxpayer changed its intention from holding the
property as capital to trading) and therefore commensurately decrease any taxable profits it
would derive from the future sale of the property. That case serves as an important reminder
that where an asset has been used as capital, it can become trading stock if the taxpayer changes
its intention with regards to that asset. Similarly, an asset that was once trading stock can become
capital in nature if it is no longer as a matter of fact and law used as trading stock.

Similarly, in CIR v Perfekta Enterprises Ltd (2019) HKCFA 25, the taxpayer had historically been a
manufacturer owning industrial property initially held as a capital asset. It subsequently decided
to redevelop that property for sale via a special purpose vehicle. In finding for the taxpayer, the
court held that there was no question that the holding intention of the property had changed.
Once it was decided that the land should be redeveloped, the land became a revenue asset in the
hands of the persons who conducted the redevelopment operations. On the facts of the case,
however, there had been no change of intention on the part of the taxpayer itself in disposing of
the property to the special purpose vehicle; instead, it was the special purpose vehicle itself that
was the trader, and the property remained a capital asset in the hands of the taxpayer.

See further discussion on the matter of change of intention in Section 3.10.1.

Illustrative Example 51
Gordik Ltd (Gordik) was historically a textiles manufacturer in Hong Kong but by the
late 1980s had outsourced all of its production facilities to the Mainland. By the mid-
1990s, all of its production was offshore though it maintained its management and
principal sales office in Hong Kong. It also retained certain derelict factory sites in Wong
Chuk Hang, which it used as storage facilities for textiles it imported from the Mainland
prior to shipment to customers both in Hong Kong and abroad. In 2005, the property
developer Jumbo Billion Profit Limited (Jumbo) approached Gordik suggesting that the

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Illustrative Example 51 (continued)

industrial sites in Wong Chuk Hang be redeveloped for sale as residential property. After
some negotiation, the board of directors of Gordik Ltd agreed in 2007 to enter into a
joint venture with Jumbo to redevelop the industrial sites. On these facts, it seems likely
that the industrial sites were up to at least 2005 capital assets in the hands of Gordik. As
soon as the decision was taken at a corporate level to redevelop the land in question,
however, it would appear that the intention of Gordik changed from holding the land as
capital to holding it as trading stock in the course of its new trade as a developer. Since
intention is critical to understanding whether and to what extent a person is trading
and the intention of a company is most readily ascertained by reference to its corporate
decision-making process, the better view would appear to be that Gordik became a
trader in property in 2007. Accordingly, the base cost of the property for the purposes of
ascertaining any taxable profits arising from any future sale of residential units should be
fixed at its market value as it was in 2007.

3.6.2 Capital Expenditure and Revenue Expenditure

Although there is no single judge-made test to determine whether a given item of expenditure
is revenue or capital, there are some broad guiding principles articulated in the case law that
are of assistance.

3.6.2.1 Once and for All Expenditure

One of the distinguishing factors of revenue (or income) expenditure is that it tends to
recur. Conversely, capital expenditure tends to be made once and for all. Contrast the yearly
recursion of expenditure for the acquisition of trading stock or the payment of utility bills on
the one hand and, on the other, the once and for all character of the acquisition of a machine
or office premises (Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529).

3.6.2.2 Enduring Benefit
That is a useful starting point, but it is not necessarily applicable to all cases. In British Insulated
and Helsby Cables Ltd v Atherton (1926) AC 205, the court held that when an expenditure is
made, not only once and for all but with a view to bringing into existence an asset or an
advantage for the enduring (albeit not necessarily permanent) benefit of a trade, in the absence
of special circumstances leading to an opposite conclusion, it should be treated as capital. An
enduring benefit may inure if the expenditure is for the acquisition or the generation of an
asset. In CIR v Swire Pacific Ltd (1979) 1 HKTC 1145, the Court of Appeal allowed a deduction for
a lump sum payment made to end a strike, holding that the expenditure was not ‘once and for
all’ because merely settling one industrial action did not mean that the necessity to do so would
not arise again in future, and further that the payment did not bring into existence an asset, but
simply enabled the taxpayer’s business to continue without any further disruption.

3.6.2.3 Fixed Capital and Circulating Capital

Sometimes a distinction is drawn between expenditure for ‘fixed capital’ and ‘circulating capital’.
In summary, the distinction is as follows: Fixed capital comprises assets for the purpose of
producing income (such as machinery or land), and circulating capital comprises assets, which

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are temporarily parted with to be circulated in the business and return with an increment (such
as trading stock).

In Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) HCA 73, the court held
that expenditure is of a capital nature if it was made to establish, replace, or enlarge the capital
structure of the taxpayer’s business. Such expenditure is, however, to be distinguished from
expenditure to preserve the capital or profit-yielding structure of a business, which would
generally be deductible.

In determining whether an expenditure is capital or revenue in nature, substance is more

important than form. One needs to ask what the payment was for. The payment for a capital
operation – for example, clearing a piece of land to make it suitable for cultivation or another
form of exploitation – is capital in nature even if it is spread out over a number of years (KWP
Quarry Co Ltd v IRBR HCAL 102/2016). Similarly, a lump sum payment as a prepayment of
interest to a bank should be treated as revenue in nature, and so deductible if incurred in the
production of taxable profits.

Note that the general rule in s.17(1)(c) is subject to the availability of deductions under
ss.16A–16L and depreciation allowances.

Illustrative Example 52
GSHM wishes to expand its retail presence in the New Territories with a view to taking
advantage of Chinese day trippers. Accordingly, it acquires the lease to commercial
premises in Yuen Long, and acquires a sophisticated IT system to keep track of inventory
and sales. The acquisition of the lease is capital in nature: it is a once and for all
expenditure, because no further payments are required for GSHM to enjoy exclusive use
of the premises. If, however, GSHM had merely rented the premises with rent payable on
a monthly basis, that would have been a periodic expenditure. Rent is consideration for
the right to continue to occupy the property, but if GSHM fails to pay rent, the landlord
may re-enter the premises. Accordingly, rent is distinguishable from a lease because
renting on a monthly or even annual basis confers no lasting benefit. Conversely, a lease
does. Similarly, the IT system is a once and for all expenditure that confers a lasting
advantage to the business of GSHM. It is accordingly capital in nature. However, to the
extent that it is IT software, it would likely qualify as a prescribed fixed asset under s.16G,
and therefore the expenditure incurred in procuring the system would be deductible in
full, notwithstanding anything in s.17(1)(c).

Illustrative Example 53

Capital Expenditure – Lease Premium

Doolittle Ltd was operating a chain of retail shops for high-end watches and jewellery. Its
flagship store was located in Tsim Sha Tsui. Recently, Doolittle Ltd has renewed the lease
of the Tsim Sha Tsui Store. The new lease was for a period of 10 years. Doolittle Ltd had
paid a sum of HK$10 million (the Sum) upfront in order to obtain the lease. The Sum was
paid in addition to monthly rental of HK$1 million, which was comparable to monthly
rental of similar stores located in Tsim Sha Tsui.

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Illustrative Example 53 (continued)

Under s.16(1), expenses incurred in the production of assessable profits are tax
deductible. However, under s.17(1)(c), no deduction shall be allowed in respect of any
expenditure of a capital nature. Notwithstanding that all the conditions stipulated under
s.16 are fulfilled, an expenditure would be disallowed for deduction under s.17(1)(c) if it
is capital in nature (re: Wharf Properties Limited v CIR (1997) 1 HKLR 347). Following the
decision in British Insulated and Helsby Cables Limited v Atherton (1926) 10 TC 155), when an
expenditure is made, not only once and for all but with a view to bringing into existence
an asset or an advantage for the enduring benefit of a trade, the expenditure is capital
in nature. An enduring benefit which should be distinguished from a permanent benefit,
refers to an enough durability to justify an item being treated as a capital asset (re:
Henriksen v Grafton Hotel Ltd (1942) 24 TC 453). In the present case, the payment of the Sum
enabled Doolittle Ltd to obtain the right to lease the retail store for a term of 10 years. It
was paid in addition to the arm’s length monthly rental, which was paid for the right to use
the store for the relevant month. Though the Sum did not bring Doolittle the ownership
title of the retail store, the right to lease for 10 years so acquired brought into existence an
advantage for the enduring benefit of Doolittle. Therefore, the Sum should be regarded as
capital in nature and non-deductible under s.17(1)(c).

Illustrative Example 54

Capital Expenditure – Keyman Insurance Premium

Drinkwater Ltd has bought two insurance policies respectively for its marketing manager,
Mr. Chan, and marketing director, Miss Nancy. The policies insuring against loss of profits
arising from the death, sickness or injury of Mr. Chan and Miss Nancy. The beneficiary for
both policies is Drinkwater Ltd. The policies are life insurance policies covering the life
of Mr. Chan and Miss Nancy within the terms of the policies, which only cover the period
of employment respectively of Mr. Chan and Miss Nancy with Drinkwater Ltd. Miss
Nancy owned 20% share capital in Drinkwater Ltd. Drinkwater Ltd paid premiums for the
policies on an annual basis.

The deductibility of the premiums paid by Drinkwater Ltd for the policies and taxability
of the proceeds received from the policies are analysed as below:

The premium paid for Mr. Chan was incurred for the purpose of Drinkwater Ltd’s trade
hence s.16(1) is satisfied. The premium payment would be recurring. Also, it seems the
payment of the policy would not bring into existence any asset or advantage with enduring
benefit to Drinkwater Ltd. Hence, it would not be capital in nature and be disallowed
under s.17(1)(c). The proceeds for the policy of Mr. Chan are taxable as trading receipts of
Drinkwater Ltd, being compensation for loss of profits.

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Illustrative Example 53 (continued)

The situation for the policy of Miss Nancy would be different from the case of Mr.
Chan. Miss Nancy owned 20% share capital of Drinkwater Ltd. It is likely that the purpose
of the policy is to protect the value of the shares because the life or well-being of Miss
Nancy, being the keyperson, would significantly affect the value of the shares. There is an
advantage with enduring benefit brought by the payment of premium for the policy of
Miss Nancy. Notwithstanding that the payment would be recurring, the premiums are of a
capital nature. Correspondingly, the proceeds from the policy are for compensation of loss
of value of the company’s shares and are capital in nature and not taxable.

Knowledge Check Question

Question 10
Identify which of the following is trading nature and taxable.
A Compensation received for permanent loss of a capital asset.
B Compensation received for cancellation of the sole sale contract.
C Compensation received for temporary loss of a capital asset.
D Compensation received for early termination of a 10-year lease.

3 . 7
DEPRECIATION ALLOWANCES

Whereas expenditure of a capital nature is generally not deductible, s.18F provides for the
assessable profits of a person for any year of assessment to be decreased by the amount of
any depreciation allowances (also known as capital allowances) made to the person under
Part 6 of the Ordinance and to be increased by the amount of any balancing charge directed
to be made on the person under the same part. The relevant allowances and charges apply in
respect of certain:

1. Industrial buildings and structures;

2. Commercial buildings and structures; and

3. Machinery and plant.

The prohibition against deducting capital expenditure is disadvantageous to capital-

intensive industries, such as those that require extensive plant and machinery. Accordingly, the
availability of depreciation allowances mitigates the harshness of s.17(1)(c) for capital-intensive
sectors by allowing taxpayers acquiring a qualifying capital asset, such as machinery and
industrial buildings, to deduct a portion of the acquisition cost each year, until the acquisition
cost is fully used up. In practice, that approach enables the taxpayer to spread the cost of
acquiring plant, machinery, and industrial or commercial buildings over a period of time.

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There are significant differences between the rates of depreciation allowances applicable to
different assets.

Balancing charges or allowances may arise to reflect the cessation of use or disposal of
the asset subject to depreciation allowances. The general rule is that because the depreciation
regime is to provide for allowances on the acquisition cost of the capital asset, where the asset
is then disposed of at a profit relative to the acquisition cost as adjusted to reflect depreciation,
a balancing charge to tax will arise; conversely, where the asset is sold at less than the adjusted
acquisition cost, a corresponding balancing allowance will arise.

Note that the general test of use in the production of assessable profits must always be
satisfied with respect to the capital asset for which depreciation allowances are claimed. If
the asset is used outside of the course of the trade or business carried on by the taxpayer, no
deductions are available and the depreciation allowance regime would not apply.

3.7.1 Depreciation Allowance for Machinery or Plant

Plant and machinery attract much more generous depreciation allowances than buildings. This
is likely linked with the fact that the useful life for buildings is generally significantly longer than
for machinery. It is therefore important to distinguish between machinery or plant and building,
and to identify what assets qualify as machinery or plant and what assets are excluded.
‘Machinery’ and ‘plant’ are not defined in the IRO. The case law on this point – see, for example,
CLP Power Hong Kong Ltd v Commissioner of Rating and Valuation (2017) 3 HKC 249 – suggests
that machinery involves a complex system composed of constituent parts, such as a machine
so-called or electronic hardware, whereas plant is a physically fixed capital asset, for example,
a drainage system or electric wires. Conversely, a building is some man-made structure or
erection (usually, but not always above ground) and is not therefore a composite system.
S.40(1) provides, inter alia, that ‘capital expenditure on the provision of machinery or plant’
includes capital expenditure on alterations to an existing building incidental to the installation
of that machinery or plant.

In Yarmouth v France (1887) 19 QBD 647, it was held that plant includes ‘whatever apparatus
used by a businessman for carrying on his business, not his stock-in-trade which he buys or
makes for sale, but all goods and chattels, fixed or movable, live or dead, which he keeps for
permanent employment in his business’.

In IRC v Scottish & Newcastle Breweries (1982) 2 All ER 230, it was held that for a hotel
business, the light fittings, tapestries, sculptures and murals were ‘plant’ as they could create
the atmosphere and therefore were apparatuses providing important function to the hotel.

In CIR v Aberdeen Restaurant Enterprises Ltd (1989) 1 HKRC 90-009, the bridges enabling
customers to board the restaurant were held to be plant.
The functional test and setting test are two general rules to distinguish plant from
a building:

1. The functional test: plant means the tools or apparatus with which the business is
carried on; and

2. The setting test: building means the environment or a general setting in which the
business is carried on.

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You may refer to DIPN No. 7 (Revised), appendices B and C, for the IRD practice on items,
which qualify/do not qualify as plant and machinery.

Deduction/Depreciation allowances for capital equipment are in general as follows:

• 100% first year deduction for manufacturing plant and machinery, computer equipment
specially related to manufacturing, environmental protection machinery, environment-
friendly vehicles (ss.16G and16I);

• Depreciation allowances at 60% of the cost of all other plant and machinery can
be written off in the first year with a rate of 10–30% on reducing value written off
thereafter; and

• Special provisions apply to plant and machinery under a sale and leaseback
arrangement where deduction/depreciation allowances would be denied.

You should consult part 1 of the table in s.2 of the Inland Revenue Rules (IRR) for the
exact rates of depreciation applied to various capital assets. In particular, s.85 empowers the
Commissioner to make rules on certain definitional matters, including to prescribe what is or
is deemed to be included in the expression implement, utensil or article, which are likewise
defined in the second part of the table in s.2 of the IRR. You will recall that expenditure incurred
in the acquisition of implements, utensils and articles used for the purposes of generating
taxable profits as defined is fully deductible in the year of assessment in which it was incurred
(ss.16(1)(e)–(f) of the IRO).

Under s.38A, where assets which qualify for capital allowances are sold together or with
other assets in pursuance of one bargain (i.e. one transaction or a series of interrelated
transactions) the Commissioner is authorised, having regard to all the circumstances of the
transaction, to allocate a purchase price to each individual asset specifically for the purposes of
determining any balancing charges or allowances, as appropriate.

Illustrative Example 55

Specific Deductions versus Depreciation Allowances

Ho King Ltd carried on manufacturing business in Hong Kong and all profits derived from
the business are chargeable to profits tax. It would acquire all assets, including tangible
assets and intangible assets from Tin Tin Ltd for use in its Hong Kong business. The
acquisition prices were based on respective market prices as assessed by a professional
valuer. The tangible assets consisted of equipment, motor vehicles, machines, etc. The
intangible assets were comprised of patents, technical know-how, product designs, etc.

The deductibility of the acquisition costs of various types of assets to Ho King Ltd are
analysed below:

The acquisition costs of all the assets are capital in nature and cannot be deductible
under s.16(1) and s.17(1)(c). However, there are specific deductions allowable for certain
types of assets.

Tangible assets:

Under s.16G(1), Ho King Ltd is entitled to a full deduction for specified capital expenditure
on the tangible assets if the assets can be classified as prescribed fixed assets (i.e.

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Illustrative Example 55 (continued)

fixed assets used specifically and directly for any manufacturing purpose or computer
software and hardware under s.16G(6)). Also, under ss.16H–K, Ho King Ltd is entitled to
full deduction on specified capital expenditure incurred on acquisition of environmental
protection machines, environment-friendly vehicles and environmental protection
installations. For the acquisition costs of tangible assets, which cannot be qualified for full
deduction under ss.16G, 16H–K, Ho King Ltd can claim depreciation allowances (i.e. initial
and annual allowances) if the relevant tangible assets could be qualified as ‘plant and
machinery’ under ss.39(B)(1) and (2).

Intangible assets:

As to the intangible assets, Ho King Ltd can claim full deduction on the acquisition costs
on patent, technical know-how under s.16E. For the copyrights, registered designs and
registered trademarks, the acquisition costs could be spread and deductible over five
succeeding years or the remaining protection period, whichever is shorter under ss.16EA(2)
and 16EA(3).

However, the deductions under ss.16E(1) and 16EA(3) are not allowed if the respective
intangible assets are purchased wholly or partly from an associate under s.16EC(2) and an
associate includes an associated corporate. If Ho King Ltd and Tin Tin Ltd are associated,
the deduction would be denied.

3.7.1.1 Pooling System
In general, depreciation allowances for machinery or plant are computed under the pooling
system. The system is devised to avoid the frequent computation of balancing allowances or
charges by creating a ’pool’ of capital expenditure on machinery or plant, which qualifies for
an annual allowance at the same rate. This is primarily a matter of computation. The prior
question always remains whether the asset in question qualifies for depreciation allowances
and, if so, at what rate.

Initial Allowance Under s.39B(1)

A person who has incurred capital expenditure on the provision of machinery or plant is
entitled to an initial allowance (IA) at 60% of the capital expenditure. Capital expenditure
includes purchase price, freight, insurance, delivery/installation expenses, alteration cost,
interest and commitment fees incurred on a loan, etc. But capital expenditure excludes those
allowed under ss.16B, 16F and 16G, environmental protection machinery, environment-friendly
vehicle (ss.16H to K), and those on implements, utensils and articles. The initial allowance will
be granted as long as the person has incurred the capital expenditure and intended to use the
plant and machinery in the production of assessable profits. There is no requirement for the
machinery or plant to be in use in the basis period for the granting of the initial allowance.

Annual Allowance Under s.39B(2)

Annual allowance (AA) is given at the appropriate rate (10%, 20% or 30%) on the ‘reducing value’
of the pool where the person owned and used the machinery and plant in the production of
assessable profits either during the basis period or during an earlier period.

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The template in Exhibit 3.9 shows how to compute the IA and AA.

Opening reducing value (written-down value [WDV]) b/f

Add: Additions A
Less: Initial allowance at 60% (B = A x 60%) (B)
Hire-purchased assets (reducing value)
(ownership passed in the preceding year) C
Assets brought into business use
(original cost less notional allowance under s.39B(6)) D
Succeeded assets (reducing value under s.39B(7)) E
Subtotal (F = A – B + C + D + E) F
Less: Sale, insurance, salvage or compensation moneys
(limited to cost/deemed cost) (G)
Assets taken from the pool for private use (market value) (H)
Reducing value before annual allowance (I = F – G – H) I
Less: Annual allowance (10%, 20% or 30%) on I (J)
Closing reducing value (WDV) c/f (K = I – J) K

EXHIBIT 3.9 How to calculate initial allowance and annual allowance

Balancing Charge or Balancing Allowance Under s.39D

Balancing charge/allowance (B/C or B/A) arises when the asset is sold or destroyed or
permanently put out of use.

B/C = excess of disposal proceeds over reducing value

(B/C is restricted to total IA and AA granted previously)

B/A = excess of reducing value over disposal proceeds

Assets Brought into Business After Non-business Use: ss.37(2A) and 39B(6)
When an asset previously acquired for non-Hong Kong business use is brought into Hong Kong
business use for production of assessable profits, the value of the asset to be transferred into
the relevant pools is the amount of the cost of acquisition of the asset less notional allowance.
Annual allowance will be granted based on the reducing value of the asset. There will be no
initial allowance as the taxpayer has not incurred any capital expenditure on provision of the
asset during the basis period.

Apply and Analyse 4

Assets Transferred from Non-business Use into Business Use

Mr. Minamino was the sole proprietor of a CPA firm, namely Minamino & Co, which carried on
business in Hong Kong. He was fond of collecting Japanese artefacts. He had purchased two
Japanese artefact masterpieces in February 2017 at a price of HK$200,000 each and kept both
at home until March 2019 when he decided to place one of the items (Art-A) at his CPA firm
office and the other (Art-B) at his newly set-up fine dining Japanese style restaurant, namely
Minamino Omakase, located in Tsim Sha Tsui. Both Minamino & Co and Minamino Omakase

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Apply and Analyse 4 (continued)

close accounts on 31 March every year. In its first year of operation, Minamino Omakase had
acquired equipment at a cost of HK$1 million for the year of assessment 2018/19.

Analysis

If the artefacts could be qualified as ‘plant’ and had been used for the purpose of producing
charging profits for the businesses of the CPA firm and the Japanese restaurant, these two
businesses would be entitled to deduction of depreciation allowances thereof under s.39B.

Art-A, being displayed at the CPA firm office, would not constitute ‘plant’ based on the
decision of D52/04. Though Art-A could create atmosphere and ambience, such function is
not important to the CPA firm’s business.

On the other hand, Art-B, being displayed at the Japanese restaurant, could be
regarded as ‘plant’ for the trade of fine dining Japanese restaurant because, arguably,
ambience and atmosphere are part of its services provided to customers (CIR v Scottish &
Newcastle Breweries Ltd (1981) 1 WLR 322 followed).

Minamino Omakase had not incurred capital expenditure on acquisition of Art-B during
the basis period for 2018/19, it could not be entitled to deduction of initial allowance
thereof (s.39B(1)). Since it used the artefact for the purpose of its trade, it could be entitled
to annual allowance based on the value at its acquisition reduced by notional allowances
as calculated below (s.39B(6)):

HK$
Actual cost of Art-B 200,000
Less: 2016/17 Notional annual allowance (40,000)
(HK$200,000 × 20%)
160,000
Less: 2017/18 Notional annual allowance (32,000)
(HK$160,000 × 20%)
Deemed value transferred to 20% pool 128,000

Calculation of depreciation allowances for Minamino Omakase for 2018/19:

20% pool Total allowances

HK$ HK$
Addition – equipment 1,000,000
Less: Initial allowance (HK$1,000,000 × 60%) (600,000) 600,000
400,000
Deemed value of Art-B transferred to pool 128,000
528,000
Less: Annual allowance (HK$528,000 × 20%) (105,600) 105,600
Tax written-down value carried forward 422,400
705,600

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Assets Succeeded from a Trade Without Purchase

There is no balancing adjustment for the transferor (s.39D(3)). The reducing value brought
forward from the business to be succeeded is transferred to the successor (ss.37(4) and 39B(7)).

There is no initial allowance for the successor as it has not incurred any capital expenditure
on provision of the inherited assets (ss.37(5) and 39B(8)). Annual allowance is to be computed
based on the reducing value transferred.

3.7.1.2 Non-pooling System
The pooling system shall not apply in the following circumstances:

(a) An asset is acquired under a hire purchase agreement (s.39C(1)(a)).

(b) An asset is not wholly and exclusively for business use (s.39C(1)(b) and (3)).

(c) Application of the pooling system is impracticable or inequitable (s.36A(2)).

When the pooling system is not applicable, depreciation allowance is calculated for each
asset separately. The types of allowances are the same as those under the pooling system, and
are calculated in the same way, with the following exceptions:

(a) Annual allowance is given at the appropriate rate (10%, 20% or 30%) on the ‘reducing
value’ of the asset each year where it is owned and in use at the end of the basis period
(s.37(2)).

(b) A balancing charge or balancing allowance arises when an asset is sold, destroyed or
permanently put out of use; either when the business is still carried on or at the time
the business ceases (s.38(1)).

Apportionment on the Basis of Use

For assets not wholly and exclusively used for business purpose, depreciation allowances
will be calculated on each asset (i.e. no pooling), and both the initial allowance and annual
allowance are limited to the portion for business use on a pro-rata basis.

Illustrative Example 56

Asset Partly Used for Business Purpose

Chan & Co was a sole proprietorship business owned by Mr. Chan. Mr. Chan bought a
motor vehicle at a price of HK$200,000 during the year 2017/18 and had used it partly
for the business of Chan & Co and partly for his private purpose. The IRD agreed that
the extent of business use was 60% and 50% respectively for the years 2017/18 and
2018/19. Mr. Chan sold the motor vehicle in year 2019/20 at a price of HK$100,000. The
tax written-down value brought forward from 2016/17 for 30% pool of Chan & Co was
HK$90,000.

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Illustrative Example 56 (continued)

Calculation of depreciation allowances for Chan & Co

30% Allowances Motor vehicle Business Allowances

pool (pooling) 30% (partly use (non-pooling)
HK$ HK$ private use) % HK$
HK$
TWDV b/f 90,000 Nil
Addition Nil 200,000
Initial allowance at Nil (120,000) 60% 72,000
60% (2017/18)
90,000 80,000
Annual (27,000) 27,000 (24,000) 60% 14,400
allowance (2017/18)
63,000 56,000
Annual (18,900) 18,900 (16,800) 50% 8,400
allowance (2018/19)
44,100 39,200 94,800
Sale proceeds Nil (100,000)
*Balancing 60,800
charge before
restriction (2019/20)
Annual 13,230 13,230
allowance (2019/20)
TWDC c/f 30,870

*Balancing charge is restricted to the portion attributable to allowances previously granted, calculated as:)

HK$60, 800 HK$94 , 800 (HK$200, 000 HK$39, 200) HK$ 35, 844

Assets Acquired Under Hire Purchase: s.37A

The tax treatment for hire-purchasing and leasing are different. There will be depreciation
allowances for a hire-purchased asset if the asset is used in the production of assessable
profits. For a leased asset, the lease payment would be treated as a rental payment deductible
under s.16(1), if the asset is used in the production of assessable profits.

S.2 provides that a ‘hire purchase agreement’ means an agreement for the bailment of
goods under which the bailee may buy the goods or under which the property in the goods will
or may pass to the bailee.

‘Lease’, in relation to any machinery or plant, includes:

(a) Any arrangement under which a right to use the machinery or plant is granted by the
owner of the machinery or plant to another person; and

(b) Any arrangement under which a right to use the machinery or plant, being a right
derived directly or indirectly from a right referred to above, is granted by a person to
another person,

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but does not include a hire purchase agreement or a conditional sale agreement unless, in
the opinion of the Commissioner, the right under the agreement to purchase or obtain the
property in the goods would reasonably be expected not to be exercised.

In general, a lease that provides an option to the lessee to acquire the asset upon the
expiry of the lease would be regarded as a hire purchase agreement.

Initial Allowance for Hire Purchase

Initial allowance is granted at 60% on the capital portion of instalments made during the basis
period: s.37A(1A).

Annual Allowance for Hire Purchase

Annual allowance is granted at the appropriate rate (10%, 20% or 30%) on the reducing value
(cash price minus initial allowance and annual allowance) of the asset in use at the end of the
basis period: ss.37A(2) and (3).

After the asset passes into the ownership of the taxpayer or the taxpayer as the lessee
exercises the option to acquire the leased asset, the reducing value will be transferred to the
relevant pool in the following year of assessment: s.39C(2).

Illustrative Example 57 – Depreciation Allowances for Hire

Purchase Assets
Kong Kong Ltd carries on business in Hong Kong and closes account on 31 March every year.
On 1 September 2019, Kong Kong Ltd acquired a set of office equipment (non-computerised)
on hire purchase terms. The cash price of the equipment was HK$480,000, and Kong
Kong Ltd would pay 24 monthly instalments of HK$26,000 each for the cash price and hire
purchase interest together, at the beginning of each month starting from 1 September 2019.

For the monthly instalment of HK$26,000, the capital portion was HK$20,000 and the interest
portion was HK$6,000. The interest element should be deductible under ss.16(1)(a) and (2)(e).

The depreciation allowances for Kong Kong Ltd are calculated as below:

20% Allowances
HK$ HK$
Cash price 1 September 2019 480,000
2019/20 (84,000)
Initial allowance (HK$20,000 × 7 × 60%) 84,000
396,000
Annual allowance (79,200) 79,200
TWDV c/f 316,800 163,200
2020/21 (144,000)
Initial allowance (HK$20,000 × 12 × 60%) 144,000
172,800
Annual allowance (34,560) 34,560
TWDV c/f 138,240 178,560
2021/22 (60,000)
Initial allowance (HK$20,000 × 5 × 60%) 60,000
78,240
Annual allowance (15,648) 15,648
TWDV (transferred to the 20% pool in 2022/23) 62,592 75,648

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Leasing Arrangements
S.39E is an anti-avoidance provision limiting capital allowances for plant and machinery subject
to offshore equipment leasing and leveraged leasing arrangements. S.39E operates to deny
to an owner of plant and machinery depreciation allowances in respect of any machinery or
plant owned by him where a person holds rights as lessee under a lease of the machinery or
plant and:

• The machinery or plant was previously owned and used by the lessee or their associate
(i.e. a sale and leaseback arrangement);

• The machinery or plant, other than a ship or aircraft or any part thereof, is while the
lease is in force:

°° Used wholly or principally outside Hong Kong by a person other than the lessor; or

°° The whole or a predominant part of its cost of acquisition or construction was

financed directly or indirectly by a non-recourse debt (i.e. a leveraged lease
arrangement);

• The machinery or plant is a ship or aircraft or any part thereof and:

°° The lessee is not an operator of a Hong Kong ship or aircraft; or

°° The whole or a predominant part of its cost of acquisition or construction or the

part thereof was financed directly or indirectly by a non-recourse debt, that is, a
method of financing where the borrower has no absolute liability in respect of the
borrowing and in the event of default in repayment the rights of the lender are
restricted to the asset itself or the income generated by it.

Thus, the availability of depreciation allowances is highly limited in cases where the plant
and machinery in question are utilised outside of Hong Kong by a person other than the
taxpayer. Whether plant and machinery are utilised wholly or principally inside or outside
of Hong Kong is a strict matter of fact to be decided having regard for the circumstances,
including, but not limited to, the place where the asset was physically located, the nature of the
asset, the nature of the asset user’s business and the locality in which the asset is designated
for use under the terms of any lease agreement. In practice, this territoriality provision can be
highly limited because little actual manufacturing still takes place in Hong Kong. Hong Kong
enterprises engaged in manufacturing generally do so in the Mainland. Such manufacturers
therefore cannot acquire plant and machinery and lease it to Mainland Chinese associates and
obtain depreciation allowances.

DIPN No. 15, Part B, sets out the IRD’s views on the application of s.39E. As regards contract
processing, under which a Hong Kong company is often required to provide machinery or
plant for the use of the mainland Chinese enterprise, the IRD considers such arrangement
to be a lease to which s.39E applies. Mirroring the 50 : 50 profits tax concession for contract
processing profits, the IRD will allow 50% of the depreciation allowances on the leased
machinery or plant in the contract processing arrangement on the condition that the profits
from manufacturing activities of the Hong Kong company are symmetrically assessed on the
aforementioned concessionary 50 : 50 basis. That concession, however, will not apply where
the Hong Kong company has ceased to be owner of the machinery or plant. For example, the
Hong Kong company will be denied depreciation allowances on the machinery or plant which
are injected as its share of equity of a ‘foreign investment enterprise’ (FIE) in the Mainland as
such machinery or plant is owned by the FIE.

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Balancing Charge or Balancing Allowance

When the asset under hire purchase is being sold, destroyed, or put out of use, a balancing
charge or a balancing allowance will be recognised: s.38(1). When the disposal proceeds
(limited to cost) exceed the reducing value of the pool, a balancing charge arises and is
taxable. When the reducing value of the pool exceeds the disposal proceeds (limited to cost), a
balancing allowance arises.

Apply and Analyse 5 – A Comprehensive Case

Wong Ltd carries on business principally in Hong Kong and operates a retail branch in
Macau. The IRD agreed profits derived from the Macau branch is offshore in nature. Wong
Ltd closes accounts on 31 December of each year. The company’s fixed assets records
show the following information:

a. Tax written-down values of plant and machinery brought forward from the year of
assessment 2017/18 are as follows:

HK$
20% pool 100,000
30% pool 60,000

b. Movements of fixed assets for the year ended 31 December 2018 are as follows:

(i) An electric car was sold at a price of HK$100,000. The electric car was
purchased in 2015 at a price of HK$300,000. A second-hand motor car was
purchased at a price of HK$200,000.

(ii) A set of equipment was transferred from the Macau branch to Hong Kong head
office. The equipment was purchased in 2017 at a price of HK$200,000. The market
value at date of transfer was HK$180,000. Transportation costs and insurance
expenses of HK$18,000 and HK$2,000 respectively was paid for the transfer.

(iii) A set of computerised sale system was purchased at a hire purchase price of
HK$240,000 (cash price at HK$200,000), on a 24-monthly-instalment basis, with
the first instalment paid on 1 March 2018.

Based on the relevant provisions in the IRO and IRR, compute the depreciation
allowances for Wong Ltd for the year of assessment 2018/19 and state the taxable amount
or deductible amount, if any, in addition to the depreciation allowances.

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Apply and Analyse 5 (continued)

Analysis

(i) Pooled Assets

Wong Ltd
Depreciation Allowance Schedule
For the year of assessment 2018/19
Basis period: 1 January 2018 to 31 December 2018
20% Pool 30% Pool Total
depreciation
allowances
WDV b/f HK$100,000 HK$60,000
Addition of a second-hand motor car 200,000
Initial allowance (60%) (120,000) 120,000
Transfer of equipment from Macau 180,000
branch (See (ii) below)
280,000 140,000
Annual allowance (56,000) (42,000) 98,000
WDV c/f 224,000 98,000
Total depreciation allowance 218,000

Other taxable amount:

The cost on acquisition of the electric car in 2015 of HK$300,000 should be fully
deductible under s.16I for the year of assessment 2015/16. The sale proceeds of
HK$100,000 would be deemed taxable under s.16J.

(ii) Furniture transferred from Macau branch

HK$
Cost 200,000
Notional allowance 2017/18 (20%) (40,000)
TWDV transferred to 20% pool during 2018/19 160,000
Add:
Transportation costs 18,000
Insurance expenses 2,000
Total value added to 20% pool 180,000

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Apply and Analyse 5 (continued)

(iii) Hire purchase computerised sale system

Tax Depreciation
written value allowance
HK$ HK$
Cash price 200,000
Less: Initial allowance (200,000 ÷ 24 × 10) × 60% (50,000) 50,000
150,000
Less: Annual allowance (30%) (45,000) 45,000
TWDV c/f 105,000
Total allowance 95,000

The system cannot be qualified as a prescribed fixed asset (s.16G) because it was
purchased on hire purchase terms.

Hire purchase interest HK$16,667 [(240,000 – 200,000) ÷ 24 × 10] was incurred for the
year 2018/19 and would be deductible under ss.16(1)(a) and (2)(e).

3.7.2 Industrial Building Allowance

Depreciation allowances are available for industrial buildings and structures, as defined in
s.40(1). These include factories, plants generating electricity, structures for manufacturing and
processing facilities and buildings for the business of agriculture and scientific research in
relation to any trade, profession, or business.

The initial allowance is 20% of the cost of construction of the premises, with an annual
allowance of 4% thereafter (balancing allowance or charge will be due upon disposal of the
premises).

Industrial building allowance (IBA) is granted to a qualifying person who carries on a

qualifying trade, in respect of the qualifying expenditure on a qualifying building or structure.
The relevant definitions are as follows:

• Qualifying Trade – s.40(1)

An industrial building or structure is defined in s.40(1) as any building or structure or

part of any building or structure used:

°° For the purpose of a trade carried on in a mill, factory, etc.

°° For the purpose of a trade of transport, tunnel, dock, water, gas, electricity
undertaking, public telephonic/telegraphic service.

°° For the purpose of a trade which consists of manufacture of goods or materials, or

subjection of goods or materials to any process.

°° For the purpose of a trade of storage of goods or materials:

–– Used in manufacturing of other goods or materials,

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–– To be subjected to a process, or

–– On their arrival into Hong Kong

°° For the purpose of business of farming

°° For research and development in relation to any trade or business.

Illustrative Example 58 – Qualifying Trade

A Ltd carried on a manufacturing business. It owned a factory building and used it for
manufacturing of goods. The factory building is an industrial building/structure.

B Ltd carried on a trading business. It owned an office unit. Some goods were sorted,
repaired and packed in the office unit. B Ltd did not carry on a manufacturing business.
Even if the repairing, sorting, and packing carried out in the office unit constituted a
‘process’, as only part of B Ltd’s business qualified, the office unit could not be regarded as
an industrial building (Tai On Machinery Works Ltd v CIR. (1969) HKTC 411).

C Ltd constructed a tunnel and operated a tunnel business, where toll fee would be
collected. The tunnel could be regarded as an industrial building.

D Ltd carried on a property development business and had completed a residential

estate, namely X-estate in area X in Hong Kong. To facilitate easy access to area X, D Ltd
had constructed a tunnel and allowed residents of X-estate to use the tunnel free of
charge. D Ltd did not carry on a tunnel/transportation business, the tunnel could not be
regarded as an industrial building.

E Ltd carried on a restaurant business in a floating restaurant, which was owned by

E Ltd. Foods were cooked at the restaurant for serving clients. The floating restaurant
could not be regarded as an industrial building. In CIR v Aberdeen Restaurant Enterprises
Ltd (1989) 2 HKTC 330, it was held that a floating restaurant was not an ‘industrial building
or structure’ where ‘goods or materials are subjected to a process’. ‘Process’ connotes a
substantial measure of uniformity of treatment or system of treatment. Although cooking
of food is a process, the process is only incidental to the service business of running a
restaurant.

F Ltd owned a warehouse and carried on a storage business at the warehouse. The
warehouse had been let out to G Ltd for storage of raw materials. The raw materials
would be further processed into finished goods. The warehouse could be qualified as an
industrial building.

H Ltd owned a warehouse and carried on a trading business. The warehouse had been
used to store imported goods for distribution in Hong Kong. H Ltd did not carry on a trade
of storage, and hence the warehouse could not be qualified as an industrial building.

J Ltd carried on a trading business and had constructed a research laboratory for
development of new products, which would be manufactured by independent sub-
contractors. The research laboratory could be qualified as an industrial building.

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• Qualifying Building or Structure – s.40(1)

Any building or structure used for a qualifying trade is a qualifying building/structure. But a
qualifying building excludes:

• Dwelling house (except for manual workers)

• Retail shop

• Showroom

• Hotel

• Office

However, where the capital expenditure on non-qualifying part is not more than 10% of
the expenditure on the whole building, the whole building/structure is treated as qualifying
building or structure.

Illustrative Example 59 – 10% Rule

A Ltd carried on a manufacturing business and owned a 10-floor building. The first floor
is used as a retail shop. The rest of the floors are used as factory for manufacturing of
goods. The whole building is qualified as an industrial building.

B Ltd carried on a manufacturing business and owned a 10-floor building. The first
floor is used as a retail shop. The second floor is used as office. The other eight floors
are used as factory for manufacturing of goods. Only 80% of the building is qualified
as an industrial building. The 20% relating to the retail shop and office is qualified as a
commercial building (See Section 3.7.3).

• Qualifying person – s.18F, s.19E and s.34

A qualifying person means a person carrying on a trade, profession or business, and

the industrial building/structure is used in the production of assessable profits. Initial
allowance is given to the person who incurred capital expenditure on construction of
the building/structure. Annual allowance (and balancing allowance/charge) are granted
to (or charged on) the person who is entitled to the ‘relevant interest’ in relation to the
qualifying expenditure. A ‘relevant interest’ means the interest in a building or structure
to which the person who incurred the expenditure was entitled when he incurred it, i.e.
in general it means the owner of the building/structure.

• Qualifying expenditure – s.40(1)

A qualifying expenditure is capital expenditure incurred on the construction of a

building or structure, which includes:

°° Foundation cost

°° Cost of site investigation

°° Costs to lay drains, water mains, etc.

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°° Construction costs

°° Commitment fees, loan interest to finance construction

°° Interest expenditure with respect to a loan incurred solely and exclusively in the
acquisition of the asset in question.

Qualifying expenditure excludes:

°° Cost of land

°° Costs of preparation and levelling of land

°° Cost of demolition of old building

°° Expenditures reimbursed by grant, subsidy, etc.

Illustrative Example 60 – Land Cost and Building/Structure Cost

A Ltd paid HK$500 million to buy a piece of land. It paid HK$200 million to develop
foundation and laying drains for constructing a factory building thereon. It also paid
HK$400 million to construct a factory building.

The qualifying expenditure for the factory building is:

HK$ million
Foundation and drains cost 200
Construction cost 400
600

• Depreciation allowances for an industrial building/structure – s.34, s.35 and s.35A

Initial allowance (IA) at 20% of the qualifying expenditure is granted to a person who
incurred the qualifying expenditure on construction of an industrial building/structure.
IA will be granted for the year of assessment in which the qualifying capital expenditure
was incurred. That is the building may not necessarily be ‘in use’ at the end of the basis
period. If IA is granted during the building construction period, but the building is not
used as an industrial building upon completion, the taxpayer should inform the IRD and
additional assessment will be issued accordingly in respect of the IA wrongly granted.

Annual Allowance (AA) is granted to a person who is entitled to the relevant interest
for every year of assessment in which the building/structure was in use as an industrial
building and the relevant interest was not sold at the end of basis period. It is computed on a
straight-line basis, i.e. AA is equal to 4% of the qualifying expenditure.

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• Balancing charge (B/C) or Balancing allowance (B/A)

Balancing adjustment arises when:

(i) The relevant interest is sold;

(ii) If it is a leasehold interest, the lease comes to an end, except where either the lessee
remains in possession or a new lease is granted; or

(iii) The building is destroyed or demolished or ceased to be used as an industrial building,

except that if the building is demolished for purpose unconnected with the trade, no
balancing allowance is given.

B/A arises when there is an excess of residue of qualifying expenditure over sale proceeds
or compensation received on destroying/demolishing the building.

B/C arises when there is an excess of sale proceeds or compensation received on

destroying/demolishing the building over the residue of qualifying expenditure. B/C should be
restricted to total IA and AA granted previously.

Illustrative Example 61 – Balancing Adjustment

A Ltd owned an industrial building and used it as a factory. It demolished the building
and constructed an office building on the same site for letting out. There is no balancing
adjustment because the demolishing is ‘unconnected’ to the original trade where IBA
is granted.

• Sale of a Used Building/Structure – S.34(2)

There is no AA in the year of sale to the vendor, but balancing adjustment is required.
There is no IA to the purchaser.

AA is available to the purchaser and is computed as follows (with effect from

Y/A 2004/05):

1
Residue of expenditure after sale
No. of years from the Y/A A in the basis period for
which the sale takes place to th he25th year after the Y/A
of first use of the building or structure

Residue of expenditure after sale is calculated in the following manner:

Qualifying expenditure A
Less: Initial allowance B
Annual allowance C
Notional allowance (see below) D (E)

Residue of expenditure before sale F

Add: Balancing charge / (Balancing allowance) G

Residue of expenditure after sale H

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Notional allowance:

°° A notional allowance is to be written off for any year in which the building/
structure did not qualify as an industrial building or commercial building
and no IA nor AA has been granted (e.g. a building/structure was left vacant
and unused).

°° Notional allowance is computed at 4% of the qualifying expenditure.

Apply and Analyse 6 – Industrial Building Allowance

Ace Ltd carried on a manufacturing business in Hong Kong. In January 2013, it started
to construct a workshop to be used for manufacturing purpose. The workshop was
completed in March 2013 and Ace Ltd immediately used it for manufacturing of goods.
Ace Ltd incurred HK$50 million on the construction of the workshop and it had borrowed
a bank loan of HK$10 million to finance part of the construction costs. Ace Ltd incurred
interest expense of HK$500,000 on the loan for the year ended 31 December 2013.
The bank loan was secured by a deposit of equivalent amount placed by Ace Ltd with a
bank in overseas. Ace Ltd derived interest income of HK$200,000 from the deposit. The
manufacturing workshop was sold to Bee Ltd on 8 March 2019 at a price of HK$50 million
(including land value of HK$20 million). Ace Ltd and Bee Ltd close their accounts on
31 December and 31 March each year respectively.

Analysis

Computation of Industrial Building Allowances for Ace Ltd

HK$ HK$
Qualifying expenditure (QE)
Cost of Construction 50,000,000
Interest expense financing the construction costsa 500,000
50,500,000
IA (2013/14) @20% on QE (10,100,000)
AA (2013/14 to 2018/19) each year 4% on QE (12,120,000)
(4% × 50,500,000) for 6 years
Residue of expenditure before sale 28,280,000
Sale price 30,000,000
Balancing charge for 2019/20 (1,720,000)

a
The bank loan interest expense should be regarded as part of the qualifying expenditure. Though the bank
loan was secured by an offshore deposit of equivalent amount, which generated non-taxable interest income,
s.16(2A) restriction does not apply to exclude part of the interest expense from the qualifying expenditure for
IBA purposes. It is because we are not ascertaining deduction of interest expenses under s.16(1)(a).

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Apply and Analyse 6 (continued)

Computation of Industrial Building Allowances for Bee Ltd

HK$
Residue of expenditure before sale 28,280,000
Add:
Balancing charge 1,720,000
Residue of expenditure after sale 30,000,000
AA (2018/19) see below for computation (1,500,000)
Residue of expenditure c/f 28,500,000

Year of first use (fiscal year a in which the first use took place) 2012/13
Year of AA first available to Ace Ltd (year ended 31.12.2013) 2013/14
Year of AA first available to Bee Ltd (year ended 31.3.2019) 2018/19
Y/A in which the sale took place (refer to basis period of Bee Ltd) 2018/19
So, 25th year after the year of first use 2037/38
No. of years from the Y/A in which the sale took place to the 25th year 20
after the year of first use

1
AA HK$30, 000, 000
20

HK$1, 500, 000

Bee Ltd can claim AA of HK$1,500,000 per year from 2018/19 to 2037/38 if Bee Ltd uses the work-
shop for qualifying purpose.
a
Fiscal year is the financial year of the Hong Kong government, that is from 1 April of a year to 31 March of the
following year. The year of assessment does not need to be considered.

• Sale of an unused industrial building – s.35B

When an industrial building, which has never been used, is sold, the constructor selling
the building is not entitled to depreciation allowance. S.35B provides that where the
person constructing a building sells it before it is used for commercial or industrial
purposes, it is not entitled to any allowances on the cost of construction; however,
the purchaser who is the eventual user of the building or structure for commercial
or industrial purposes is entitled to depreciation allowances. The amount of the
depreciation allowance will be computed as a function of the net price paid by the user
of the building to its constructor. For the year of sale, the vendor is not entitled to any
IA and AA and any initial allowance granted to the vendor prior to that point will be
withdrawn. The purchaser is deemed to incur qualifying expenditure on construction
and therefore is entitled to IA as well as AA.

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Deemed qualifying expenditure is determined on the following basis:

(i) If the building is sold by a person whose business is developing properties for sale
purposes, the net building price paid (i.e. excluding the price of the land) will be
deemed as qualifying expenditure;

(ii) If the building is sold by a person whose business is not developing properties for
sale purposes, the qualifying expenditure is the lower of

°° The cost of construction, and

°° The net building price paid.

When there is a series of sales before the building is put into use, only the last
purchaser is entitled to the allowance. The qualifying expenditure is determined on the
following basis:

(i) If the first sale is made by a property developer, the qualifying expenditure is
the lower of

°° The net building price on first sale, and

°° The net building price on last sale; and

(ii) If the first sale is made by a person other than a property developer, qualifying
expenditure is the lower of

°° The cost of construction, and

°° The net building price on last sale.

Illustrative Example 62
Ace Ltd purchased a factory building from a property developer at a price of
HK$100 million (50% for land value, and 50% for construction costs of the building).
The property developer purchased the land at a price of HK$40 million and incurred
HK$35 million on construction of the factory building.

Ace Ltd purchased the building from a property developer and hence the deemed
qualifying expenditure would the sale price attributable to the building: HK$100 million ×
50%. If the seller was not a property developer the deemed qualifying expenditure would
be the cost of construction i.e. HK$35 million.

Ace Ltd purchased factory building from See Ltd at a net building price of
HK$150 million (net of land value). See Ltd purchased the building from Egg Ltd, which
was a property developer at a net building price of HK$120 million. Egg Ltd incurred
HK$80 million in constructing the building.

As the first sale was made by a property developer, the deemed qualifying expenditure
to Ace Ltd would be HK$120 million.

If Egg Ltd is not a property developer, the deemed qualifying expenditure to Ace Ltd
would be the cost of construction i.e. HK$80 million.

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3.7.3 Commercial Building Allowance

A commercial building is defined in s.40 as any building or structure or part of any building or
structure used by their entitled to the relevant interest for the purposes of its trade, profession
or business other than an industrial building or structure. The rates of depreciation are
as follows:

• Unlike industrial building, there is no initial allowance.

• An annual allowance (AA) of 4% of qualifying capital expenditure shall be granted to

the person who is entitled to a ‘relevant interest’ in a ‘commercial building or structure’
at the end of the basis period for a year of assessment.

• Balancing allowance/charge will arise in the same occasions as an industrial building

and computed in a similar way – see Section 3.7.2.

Qualifying capital expenditure is computed in the same way as an industrial building (refer
to Section 3.7.2). However, deemed qualifying expenditure for a building bought unused
(discussed in Section 3.7.2) does not apply to commercial building.

When the relevant interest of a commercial building or structure is sold, the purchaser who
is now entitled to the relevant interest may claim annual allowance using the following formula
(with effect from Y/A 2004/05):

1
Residue of expenditure after sale
No. of years from the Y/A A in the basis period
for which the sale takes place to thee 25th year after
the Y/A of first use of the building or structure*

*
Where before the commencement of s.33A, a person was entitled to the relevant interest of a commercial
building or structure, 1998/99 shall be deemed to be the year of first use for that building or structure.

Residue of expenditure after sale is computed in the same way as an industrial building
except that no initial allowance is deducted in the case of a commercial building – see
Section 3.7.2.

Illustrative Example 63
GSHM acquires a warehouse in the New Territories for HK$50 million solely for the
purposes of maintaining its stock of apparel. When required, the stock is moved by
lorry from the warehouse to individual retail shops in Hong Kong. The warehouse is a
commercial building because it is a building or structure used for the purposes of the
trade carried on by GSHM, but it is not an industrial building. Accordingly, GSHM will be
entitled with respect to the warehouse to an annual allowance of HK$2 million, being
4% of the acquisition cost. If, hypothetically, the building housed a garment production
facility, it would likely be an industrial building instead.

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Illustrative Example 64 – Computation of Commercial Building

Allowances
In November 1986, Mei Ho Ltd bought an office unit from Fat Tat Property Development
Ltd at a price of HK$120 million, where the construction costs were HK$40 million, the
land value was HK$50 million and profit to Fat Tat Ltd was HK$30 million. Mei Ho Ltd
immediately put the office into use upon acquisition. Mei Ho Ltd closed accounts on
31 March each year.

In May 2019, Mei Ho Ltd sold the office unit to Best Day Ltd:

Scenario (A): at a price of HK$120 million, being HK$80 million for property value

and HK$40 million for land value. Or Scenario (B): at a price of HK$45 million, being
HK$5 million for property value and HK$40 million for land value.

Best Day Ltd then put the office into use immediately upon acquisition. Best Day closed
account on 31 March every year.

The commercial building allowances for Mei Ho Ltd and Best Day Ltd, for scenarios (A)
and (B) respectively is calculated as follows:

HK$ HK$
Mei Ho Ltd
Cost of construction 40,000,000
1986/87 to 1989/90
Rebuilding allowance (HK$40,000,000 × 0.75% × 4) 1,200,000
1990/91 to 1997/98
Rebuilding allowance (HK$40,000,000 × 2% × 8) 6,400,000 (7,600,000)
Residue under s.33A(4)(a) (deemed qualifying expenditure) 32,400,000
1998/99 to 2018/19
Annual allowance (HK$32,400,000 × 4% × 21) (27,216,000)
Residue of expenditure 5,184,000
(a) Office Unit sold for HK$80 million under Scenario (A)
Mei Ho Ltd
Residue of expenditure before sale 5,184,000
Sale price (80,000,000)
Excess of sale price over residue of expenditure (74,816,000)
Balancing charge restricted to allowances made to Mei 27,216,000
Ho Ltd from 1998/99 to 2018/19

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Illustrative Example 64 (continued)

HK$ HK$
Best Day Ltd
2019/20
Residue of expenditure before sale 5,184,000
Add: Balancing charge 27,216,000
Residue of expenditure after sale 32,400,000
Year of first use (deemed) 1998/99
Year of assessment in the basis period of which the sale took 2019/20
place
25th year after the year of first use 2023/24
No. of years from 2019/20 to 2023/24 5 (inclusive)
Annual allowance to Best Day Ltd = HK$32,400,000 ÷ 5 = HK$6,480,000
(b) Office unit sold for HK$5,000,000 under Scenario (B)
Mei Ho Ltd
2019/20
Residue of expenditure before sale 5,184,000
Sale price (5,000,000)
Balancing allowance (184,000)

Best Day Ltd

2019/20
Residue of expenditure before sale 5,184,000

Less: Balancing allowance (184,000)

Residue of expenditure after sale 5,000,000
Year of first use (deemed) 1998/99
Year of assessment in the basis period of which the sale took place 2019/20
25th year after the year of first use 2023/24
No. of years from 2019/20 to 2023/24 5
Annual allowance to Best Day Ltd = HK$5,000,000 ÷ 5 = HK$1,000,000

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Knowledge Check Question

Question 11
Identify which of the following best summarises depreciation allowances under the IRO.
A Depreciation allowances enable deductions to be secured for expenditure incurred in
the acquisition of capital assets.
B Depreciation allowances enable the cost of acquisition of capital assets to be written
down on a 20% straight-line basis.
C Depreciation allowances may be claimed with respect to the costs of acquisition of all
classes of capital assets utilised in the production of assessable profits.
D Depreciation allowances enable a person chargeable in profits tax in Hong Kong to claim
deductions for the cost of acquiring plant and machinery utilised in the production of
assessable profits.

3 . 8
PREPARATION OF THE PROFITS TAX
COMPUTATION

Every person carrying on a trade, profession, or business in Hong Kong is required to complete
and furnish a profits tax return. In practice, there are two ways that the obligation arises:
first, the IRD will as a matter of course issue a tax return to any business registered under the
Business Registration Ordinance (Cap.310) within 18 months of registration and, once issued
with a tax return, the taxpayer must complete it and file it as provided in s.51(1). Registration
under that ordinance is compulsory for all persons carrying on or commencing to carry on a
business (and, therefore, by definition, also a trade or profession) in Hong Kong. Separately,
s.51(2) provides that it is the obligation of every person chargeable to profits tax to notify the
IRD of that liability not later than four months after the end of the basis period for that year
of assessment unless they have already been required to furnish a return under s.51(1). Once
notified, the IRD will issue the taxpayer with a tax return.

The following forms are used: Form BIR 51 (Corporation), Form BIR 52 (business entity
other than a corporation) and BIR 60 (individual sole proprietors). A tax return must be
supported by the following information and documents:

• A certified copy of the statement of financial position, auditor’s report (for a

corporation) and statement of comprehensive income/profit and loss account;

• A tax computation with supporting schedules showing how the assessable profits/
adjusted loss is arrived at; and

• Other documents and information as specified in the notes and instructions enclosed
with the return.

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Taxpayers are also required to keep sufficient business records, either in English or
Traditional Chinese, for income and expenditure so as to ensure that assessable profits can be
ascertained by IRD. Business records should be kept for at least seven years under s.51C.

3.8.1 Preparing a Profits Tax Computation

Profits tax in Hong Kong is calculated on a person’s assessable profits. The starting point in the
computation of a person’s assessable profits is its profits before taxation (i.e. accounting profits
or losses) from which non-taxable incomes are deducted whereas non-deductible expenses
are added back. Finally, items not included in the accounting P&L, such as specific deductions
on certain capital expenditures, depreciation allowance and unrelieved losses carried forward
must be set off against assessable profits to arrive at the net assessable amount, which is the
amount on which profits tax is actually charged.

Below is a general guide on various factors that should be taken into account when
determining the taxable income of Hong Kong companies. A company’s profits tax liability is
calculated by making certain adjustments to its accounting profits or losses

3.8.1.1 Step 1: Deduct Non-assessable Profits

Profits of non-assessable nature are deducted from the company’s net income (CIR v Secan Ltd
& Anor (2000) HKCFAR 411). Only those included in the accounting P&L should be adjusted.

Common examples of non-assessable profits include:

• Profits not arising in or derived from Hong Kong;

• Gains from the sale of capital assets;

• Certain dividends or profits for which profits tax has already been assessed;

• Interest income derived from a deposit placed in Hong Kong, excluding interest
received by or accrued to a financial institution; and
• Other specific exempt receipts under the provisions of the IRO.

3.8.1.2 Step 2: Add Back Non-deductible Expenditure and Outgoings

Expenditure and outgoings that are incurred in the production of assessable profits are
deductible and are detailed in Section 3.5.1. Specifically, charitable donations are first added
back in the computation. A deduction is made after Step 4 for the charitable donations of a
minimum of HK$100 and up to a maximum of 35% of the assessable profits after depreciation
allowance and balancing charge.

No tax adjustment is needed for deductible expenditures, provided that they have been
included as expenses in the accounting P&L. By contrast, if a non-deductible expenditure has
been included in the P&L, the tax adjustment should be made by adding the absolute amount
to the computation. You may recall that non-deductible expenditure includes:

• Domestic or private expenses (s.17(1)(a));

• Expenses not incurred in the production of assessable profits (s.17(1)(b));

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• Expenditure of a capital nature (s.17(1)(c));

• Cost of making improvements to property or assets (s.17(1)(d));

• Sums recoverable under insurance contracts (s.17(1)(e));

• Expenses connected with premises not occupied for profit-generating purposes

(s.17(1)(f));

• Any tax paid under the IRO other than employees’ salaries tax (s.17(1)(g)); and

• Certain payments to or for the benefit of spouses or partners (s.17(2));

• Depreciation expenses (However, see Step 4 below for depreciation/ capital allowances
or specific deductions for certain capital expenditure).

3.8.1.3 Step 3: Add Balancing Charges

A balancing charge arises when the sale proceeds of a capital asset (i.e. building, structure,
plant or machinery) exceeds its written-down value (cost of the asset less the amount of capital
allowances previously claimed).

3.8.1.4 Step 4: Deduct Depreciation/Capital Allowances and Specific Deduction

for Certain Capital Expenditures
Capital allowances in the form of an initial allowance and subsequent annual allowances, are
available for expenditure incurred in acquiring plant and machinery, commercial and industrial
buildings used in the production of assessable profits. Certain capital expenditures, such as
plant and machinery used for research and development, renovation and refurbishment,
prescribed fixed assets and environmental friendly machinery and installation are specifically
deductible. Those expenditures are usually included in the statement of financial position. If so,
a tax adjustment is necessary.

3.8.1.5 Step 5: Set Off Unrelieved Losses Carried Forward

Losses are the mirror image of profits. Unrelieved losses carried forward may be set off against
the future profits of a trade, business or profession. To the extent unrelieved losses are not
fully used up in being set off against assessable profits in one year of assessment, the balance
is to be carried forward to be set off against assessable profits in future years of assessment.
See Section 3.12.

Note that an adjustment factor applies when unabsorbed losses incurred from
concessionary trading receipts (trading receipts that are subject to a concessionary rate of
tax) are set off against normal trading receipts (trading receipts that are subject to a normal
rate of tax) and vice versa. Here there are two funds of taxable profits assessed at different
rates. Those rates must be ‘harmonised’ in order for the cross set off to be effective. The
adjustment factor is the ratio, which the normal and concessionary tax rates bear to each
other. In summary, where a concessionary loss is realised by the taxpayer, the arithmetical
value of that loss for set off against standard profits must be adjusted to reflect the
relationship between the concessionary tax rate and the standard rate. If the concessionary
rate is half the standard rate, then the concessionary losses must be divided by two prior to
being set off against the standard assessable profits. Similarly, where ordinary losses are set
off against concessionary trading receipts, the arithmetical value of the ordinary losses must

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be increased proportionally with the relationship between the concessionary tax rate and the
standard tax rate. Assuming, again that the concessionary tax rate is half the standard rate,
then standard losses must be multiplied by two prior to being set off against concessionary
trading receipts.

Illustrative Example 65 – Profits Tax Computation

Generation Ltd’s (GL) profits and loss account for the year ended 31 March 2019 shows
net profits before taxation of HK$5 million after charging or crediting the relevant items
below except for those specifically marked as not yet charged to the income statement.

1. A sum of HK$1 million was received for cancellation of a contract with a supplier,

being one of many suppliers of GL.

2. Investment income

HK$
Interest income from debenture listed in Luxembourg 600,000
Interest income from qualifying debt instrument, issued by 400,000
a non-associate on 1 June 2018
1,000,000

3. GL earned HK$100,000 interest income from its bank deposit in Hong Kong, which
is used to secure for a bank loan borrowed by GL’s director for personal purposes.
The director did not carry on any business in Hong Kong.

4. Profit from sale of patent right of HK$200,000

a. The patent right was purchased in 2013 from GL’s holding company, Highest
Ltd (HL) at a cost of HK$300,000. GL sold the patent right at a price of
HK$500,000 during the year.

5. Bad debts

HK$
General provision 500,000
Specific provision 200,000
Loan to a staff member written off 300,000
1,000,000

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Illustrative Example 65 (continued)

6. Interest expense

HK$
Bank overdraft interest 200,000
Interest paid on a bank loan 500,000
700,000

The bank overdraft and the bank loan were used to finance the daily operation
of GL. GL’s holding company HL pledged an overseas bank deposit of equivalent
amount as a security for the bank loan and derived interest income of HK$400,000
from the deposit.

7. GL donated HK$200,000 cash to an approved charitable organisation in Hong

Kong to purchase 100 charity concert tickets. GL also donated HK$300,000 cash to
another approved charitable institution in Hong Kong during the year.

8. Legal and professional charges:

HK$
Surcharge for late payment of profits tax 50,000
Traffic fines 100,000
Annual tax compliance fee 100,000
250,000

9. Replacements of office curtains of HK$80,000.

10. Annual contribution to MPF of HK$200,000, being provision of HK$120,000 and
payment of HK$80,000. The annual salary expense of GL was HK$1 million.

11. Accounting depreciation charged to the profits and loss account was in the amount
of HK$130,000. The tax written down values c/f per last year tax filing records are

20%: HK$200,000

30%: HK$300,000

The following plant and machinery were acquired during the year (the costs have
been recorded in the statement of financial position, not charged to the income
statement):

Computer system: HK$100,000

Electric cars: HK$200,000

Manufacturing machine: HK$100,000

The computer system and electric cars were used by GL. The manufacturing
machine was used by GL’s subcontractor in Hong Kong.

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Illustrative Example 65 (continued)

12. GL paid HK$1 million to refurbish its office during the year. Such refurbishment
cost had been recorded in the statement of financial position but not charged to
the income statement.

Prepare the profits tax computation for GL for the year of assessment 2018/19. Explain
the basis of the computation. The computation of provisional profits tax is required.

Generation Ltd
Profits Tax Computation
Year of Assessment 2018/19
Basis Period: Year Ended 31 March 2019
HK$ HK$
Net profit per account 5,000,000
Add:
General provision of bad debts 500,000
Staff loan written off 300,000
Interest paid on a bank loan – secured by HL’s deposit 400,000
Donation 500,000
Surcharge for late tax payment 50,000
Traffic fines 100,000
Annual MPF contribution in excess of 15% of salary [HK$200,000 50,000
– (15% × HK$1,000,000)]
Accounting depreciation 130,000 2,030,000
7,030,000
Less:
Debenture interest 600,000
Interest from qualifying debt instrument 400,000
Interest from Hong Kong bank deposits 100,000
Profit from sale of patent 200,000
Depreciation allowances 202,000
Computer system 100,000
Electric car 200,000
Refurbishment of office 200,000
(2,002,000)
Assessable profits before approved charitable donation 5,028,000
Less: Approved charitable donation (300,000)

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Illustrative Example 65 (continued)

Generation Ltd
Profits Tax Computation
Year of Assessment 2018/19
Basis Period: Year Ended 31 March 2019
HK$ HK$
Assessable profits 4,728,000
Profits tax payable on first HK$2 million @8.25% 165,000
Profits tax payable on remaining HK$2,728,000 @16.5% 450,120
Profit tax payable 615,120
Less: Tax reduction (100%, limited to HK$20,000) (20,000)
Profit tax payable after tax reduction 595,120

Explanation of basis of computation:

1. The sum of HK$1 million for cancellation of contract with one of many suppliers
should be revenue in nature and taxable (Kelsall Parsons & Co v CIR (1938) 21 TC 608).

2. Interest income from debenture listed in Luxembourg should be offshore in nature

and non-taxable.

Interest from qualifying debt instrument issued on or after 1 April 2018 by a

non-associate is exempt under s.14A(1B) regardless of its tenor.

3. The interest income derived from the Hong Kong bank deposit should be exempt
from profits tax. The deposit had been used as a security for a loan. The interest
expense incurred for the loan were not incurred in the production of assessable
profits because the loan was borrowed for personal purposes and the director did
not carry on business in Hong Kong. Hence, the interest exemption order would
still apply to exempt the interest income.

4. The patent right was purchased from GL’s associated company, HL. Hence, there
should be no deduction for the acquisition cost under s.16E. On sale of the patent,
the taxable amount of the sale proceeds should be limited to deduction allowed
previously (s.16E(3)). Hence, the taxable amount is zero.

The profit on sale of the patent should be capital in nature and non-taxable.

5. In general, a general provision for bad debts was not made based on substantial
evidence and the debts could not be proved to have become bad. Hence the
general provision would not be deductible under s.16(1)(d).

In general, a specific provision for bad debts was made based on substantial
evidence and the debts could be proved to have become bad. Hence, the specific
provision would be deducible under s.16(1)(d).

The staff loan was neither a trade debt nor money lent in the ordinary course of
a money lending business. Hence, the writing off of the staff loan would not be
deductible under s.16(1)(d).

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Illustrative Example 65 (continued)

6. The bank overdraft was used to finance daily operation of GL. Hence, bank
overdraft interest expense would be deductible by virtue of ss.16(1)(a) and (2)(d).
No evidence indicates the restrictions under ss.16(2A) and (2B) apply.

The bank loan was used to finance daily operation of GL. Hence, ss.16(1)(a) and
(2)(d) were satisfied. However, the bank loan was secured by a deposit placed by
GL’s associated company, HL, and interest income derived from the deposit was
not taxable, being offshore in nature. Therefore, s.16(2A) applies to restrict the
deductible amount of the interest expenses. The amount of bank loan equals
to the amount of the overseas bank deposit. Hence, the interest expense of
HK$400,000, being the same amount of the interest income derived from the
bank deposit, would be disallowed for deduction. No evidence indicates s.16(2B)
restriction applies.

7. For the donation of HK$200,000, GL obtained the benefit of 100 charity concert
tickets. Hence, it did not constitute ‘donation’ and would not be deductible under
s.16D (CIR v Sanford Yung-Tao Yung (1979) HKTC 959).

The donation of HK$300,000 was below the limit of 35% of the assessable profits
before donation and hence it would be deductible.

8. The surcharge for late tax payment and traffic fines were incurred for breaching
of law and not incurred in the production of assessable profits and hence not
deductible under s.16(1).

The annual tax compliance fee was incurred for discharging legal obligation and
hence for the purposes of GL’s trade and deductible under s.16(1).

9. The replacement costs of office curtains were deductible under s.16(1)(f).

10. The deductible amount of provision of annual contribution together with annual
payment of MPF is limited to 15% of the emoluments to the staff, i.e. HK$1 million
× 15% = HK$150,000. Hence, the excessive amount of HK$50,000 would be
non-deductible (ss.17(1)(i) and (h)).

11. Calculation of depreciation allowances

20% pool 30% pool Total

allowances
HK$ HK$ HK$
TWDV b/f 200,000 300,000
Addition:
Manufacturing machine 100,000
Less: IA (60%) (60,000) 60,000
340,000
AA (40,000) (102,000) 142,000
160,000 238,000 202,000

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Illustrative Example 65 (continued)

The manufacturing machine could not be regarded as a prescribed fixed asset
as it was used by the subcontractor, not GL. Hence, it was a ‘leased’ asset, which
was excluded as a prescribed fixed asset under s.16G. It could be ranked for
depreciation allowances.

The acquisition cost of the computer system should be fully deductible

under s.16G.

The acquisition cost of the electric car should be fully deductible under s.16H.

12. The cost of refurbishment of the office (non-domestic nature) should be

deductible over five years on a straight-line basis, each year at 20% on the cost,
i.e. HK$200,000.

3.8.2 Post-cessation Receipts and Payments and Pre-commencement

Payments
When a person ceases to carry on its trade, profession or business in Hong Kong, all of its
trading stock that is not, at that time, sold or otherwise realised is deemed to have been
disposed for market consideration (s.15C).

S.15D provides that if a person ceases to carry on a trade, profession or business, any
sums received or paid after the cessation shall be deemed to be assessable profits or allowable
expenses for the year of assessment in which the cessation occurs provided that such income
is taxable and such expenses are deductible in that tax year. Deduction is allowed for actual
payments made. It would follow that provisions after cessation are not deductible (for example,
provisions for bad debts). By concession, recovery of previously allowed bad debts after
cessation will not be assessed, whereas the general rule is that if a deduction has been allowed
for a bad debt, and a portion or all of the debt is subsequently recovered, the amount so
recovered is treated as a taxable receipt.

As with establishing whether a person is carrying on a trade, profession or business,

determining the date of cessation is a mixed question of fact and law. In essence, the same
tests are used: where a person no longer carries on the systematic or repeated activity
normally required to be found to carry on a trade or a business, it will likely be regarded as
having ceased carrying on that trade or business. Cessation should be distinguished from a
temporary suspension of a trade. The fact that a liquidator is appointed does not mean that the
business is ceased as the liquidator may continue the trade for some time after a winding-up
order has been made to protect the assets of the company or for the benefit of the creditors.
If, however, the liquidator was merely realising assets to wind-up the company, it cannot be
considered as continuing the business; the date of appointment of liquidator is the same as the
date of cessation (Overseas Textiles Ltd v CIR (1990) 3 HKTC 29).

Expenditure incurred before the commencement of a trade or business is technically

speaking not deductible as it was not incurred in the production of assessable profits. To
the extent such payments are not otherwise disallowed, however, and would normally be
allowed under s.16(1), they are treated as deductible by way of a practical concession by the

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IRD or under express provisions such as ss.16E(3A), 16EA(10), 16G(5) and 16I(6)) for the first
accounting period in which the trade, business or profession in question actually commences
though note that preliminary expenses incurred in forming a company would be barred from
deduction as capital expenditure under s.17(1)(c) (Royal Insurance Co v Watson (1897) AC 1).

3.8.3 Effect of Accounting Policies on Tax Computations

Hong Kong tax legislation requires various adjustments to be made to accounting profits
in order to arrive at assessable profits, and these are usually reflected in a separate tax
computation in the relevant tax return. It is important to bear in mind that whereas generally
accepted accounting principles are helpful and relevant in ascertaining profits chargeable to
tax in Hong Kong, the question of what an assessable profit is purely a matter of law and not of
accounting (Secan). The IRO does not lay down a complete code on how assessable profits are
to be computed as the term ‘profit’ is not defined in the IRO. It would therefore appear that the
term ‘profit’ should bear its ordinary meaning, that is, a notional unit of account to show a net,
positive change in economic position from one point of reference in time to another.

In practice, commercial principles are applied as far as they do not conflict with the statute
and taxable profits are usually computed by making adjustments to the accounting profits.
(Secan and Nice Cheer Investment Limited v CIR (2013) 16 HKCFAR 813). Where, however, the rules
of accounting conflict with the terms of the IRO, the terms of the IRO prevail. In Secan and Nice
Cheer, the Court of Final Appeal made clear that because a ‘profit’ as understood in the IRO
did not include an unrealised profit, the accounting practice of booking unrealised profits and
losses in financial statements could not displace the terms of the IRO, and accordingly, such
computations were not treated as binding in determining the taxpayer’s liability to profits tax.

Note, however, that s.15BA provides that where an asset held as trading stock is disposed
of otherwise than in the course of trade, the disposal is deemed to be a trading disposal at
market value for the purposes of s.14. Similarly, where an asset not held as trading stock is
subsequently appropriated to trading stock, the base cost of that asset – that is, the cost of
acquisition that is to be taken into account in computing any profits arising from its disposal
– will be its market value at the point when it became comprised into trading stock. This is
an important exception to the general rule that unrealised profits are not taxable. It exists to
ensure symmetry between deductions (i.e. expenditure incurred in the acquisition of trading
stock) and the fiscal consequences of a subsequent disposal of that stock. It is a codification
of the rule derived from the English tax decision in Sharkey v Wernher (1954) 2 All ER 753
(See further discussion in Section 3.10.1).

Illustrative Example 66
GSHM retains a firm of accountants, Chim, Pan & Ming (CPM), to advise on structuring
its affairs in Hong Kong. GSHM has acquired an industrial washing machine to launder
its garment prior to sale. CPM advised that generally accepted accounting principles
enabled GSHM to claim a deduction for the full purchase price of the machine in the
year of assessment in which it was acquired, notwithstanding that the machine is under
the IRO eligible only for depreciation allowances. CPM’s approach may be correct as a
matter of accounting, but it is not necessarily correct as a matter of law. The question
of whether expenditure is deductible under the IRO is purely a matter of law to be
determined by reference to the IRO.

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3.8.4 Profits Tax – Prepaid or Deferred Revenue Expenses

The accounting concept of matching revenue with expenditure is applied to the treatment
of prepaid or deferred revenue expenses (prepayments). Revenue expenses that are paid in
advance of the periods to which they are related are prepaid expenses. Common examples of
prepaid expenses are insurance premiums, car licence fees, rates and subscription fees etc.
The period or periods to which prepaid expenditure relates may extend beyond the end of the
accounting year in which it is paid, and the expense is thus to be apportioned and charged to
the profit and loss accounts of more than one year. Accordingly, a taxpayer may not claim a
deduction for the full amount of a prepaid expense in the year of prepayment if any part of the
expense relates to a subsequent year or period. Such prepaid expenditure is typically debited
to a current asset account in the balance sheet of the business as deferred expenditure, and
then amortised (i.e. written down on an annual basis until the expenditure is fully utilised) in
subsequent years of assessment by charging to the profit and loss account the amount of the
expenditure that relates to each such period. Deductions for a particular year are only available
for that part of the prepaid expenditure that is charged to the profit and loss account of that
year, provided that the accounts are prepared in accordance with acceptable financial reporting
standards. If, however, the accounting treatment adopted by a taxpayer for any prepaid
expense is inconsistent with the relevant financial reporting standard, adjustment would be
made to the accounting profit to compute the profit that should have been arrived at had the
relevant financial reporting standard been applied in the accounts. A statement of the IRD’s
policy in this regard can be found at DIPN No. 40.

Illustrative Example 67
GSHM is asked to pay HK$10 million by way of a premium for five years of fire and
accidents insurances on its retail stores in Hong Kong. Because the insurance is incurred
in the production of profits chargeable to tax, it is deductible. Although the premium is a
once and for all payment, it should not be treated as capital expenditure on the basis of
the substance over form approach: In essence, it is a recurring payment that was front-
loaded by the insurance provider. GSHM cannot deduct all HK$10 million immediately;
it may deduct HK$2 million for the first year of assessment, and HK$2 million in each
subsequent year of assessment reflecting the duration of the insurance coverage.

Knowledge Check Questions

Question 12
ABC Ltd’s draft income statement shows a net profit before taxation of HK$20 million,
after crediting or charging the following items: (i) interest from bank deposit in
Hong Kong, HK$200,000; (ii) salaries of HK$2 million; and (iii) annual MPF contribution
of HK$400,000.
Calculate ABC Ltd’s assessable profits.

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3 . 9
BASIS PERIOD

For profits tax purposes, a year of assessment runs from 1 April and ends on 31 March of the
following year. In practice, however, many taxpayers make up their accounts on a calendar
year basis (i.e. from 1 January to 31 December) or on some other basis that is not congruent
with the standard tax year in Hong Kong. In those cases, the period that is used to compute
the assessable profits for a year of assessment is called the basis period, which is normally
the financial year of the taxpayer ended in the year of assessment. The basis period is the
common basis as between the taxpayer and the IRD for the computation of assessable profits.
The relevant provisions governing the relationship between a taxpayer’s basis period and the
standard year of assessment are ss.18–18E.

3.9.1 Normal or Continuing Business

The term basis period is used to refer to the period covered by an assessment.

The basis period is:

• The year ended 31 March during the relevant year, the basis period is the year of
assessment;

• Where the annual accounts are made up to any day other than 31 March, the year
ended on that day in the relevant year; or

• Where the accounts are made up for each lunar year, the lunar year ended in the
relevant year.

Illustrative Example 68 – Normal or Continuing Business

Accounting year end Year of assessment Basis period
31/3/2019 2018/19 1/4/2018–31/3/2019 (s.18B(1))
1/4/2019 2019/20 2/4/2018–1/4/2019 (s.18B(2))
31/12/2019 2019/20 1/1/2019–31/12/2019 (s.18B(2))

3.9.2 Commencement of Business

A newly incorporated business in Hong Kong usually receives its first profits tax return around
12 to 18 months from the date of commencement of business or the date of incorporation. If a
corporation’s accounts for this period have not been prepared, the profits to be returned may
be calculated by apportioning the profits shown by the accounts which cover the period.

The basis period of the year of assessment in which a business commences depends on
whether the first accounting date ends in the year of commencement or the following year of
assessment.

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There are three possible situations for commencement of business.

Situation 1: If the first accounting date ends in the year of commencement, the basis period
is the period from the date of commencement to the first accounting date.

Illustrative Example 69 – Business Commenced in Year 1 and First Set

of Accounts Ended in Year 1
Good Start Ltd commenced business on 1 May 2019 and closes its accounts on
31 December each year. Its adjusted profits for the first two accounting periods are
as follows:

1/5/2019–31/12/2019 (8 months) HK$1,000,000

1/1/2020–31/12/2020 HK$2,000,000

The year of commencement is 2019/20 (based on that the date of commencement

1 May 2019 fell in the financial year ended 31 March 2020). The basis period and
assessable profits for the relevant years of assessment are as follows:

Year of assessment Basis period Assessable profits

2019/20 1/5/2019–31/12/2019 HK$1,000,000 (s.18C(1)(a))
2020/21 1/1/2020–31/12/2020 HK$2,000,000 (s.18B(2))

Situation 2: If the first accounting period ends in the year of assessment following the year
of commencement, and is less than or equal to 12 months, there will not be any basis period
for the year of commencement, and the assessable profit for the year of commencement is nil
(s.18C(2)).

Illustrative Example 70 – Business Commenced in Year 1 and First Set

of Accounts (Less than 12 months) Ended in Year 2
Wonderful Start Ltd commenced business on 1 February 2019 and closes its accounts
on 31 December each year. Its adjusted profits for the first two accounting periods are
as follows:

1/2/2019–31/12/2019 (11 months) HK$1,100,000

1/1/2020–31/12/2020 HK$2,200,000

The year of commencement is 2018/19 (based on that the date of commencement 1

February 2019 fell in the year ended on 31/3/2019). The basis period and assessable profits
for the relevant years of assessment are as follows:

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Illustrative Example 70 (continued)

Year of assessment Basis period Assessable profits

2018/19 Nil Nil (s.18C(2))
2019/20 1/2/2019–31/12/2019 HK$1,100,000 (s.18B(2))
2020/21 1/1/2020–31/12/2020 HK$2,200,000 (s.18B(2))

Situation 3: If the first accounting period is more than 12 months (i.e. must be ended in
the year of assessment following the year of commencement), the basis period for the first
two years of assessment will be determined at the Commissioner’s discretion (s.18C(1)(b)).
Usually, the basis period for the second year of assessment is a period of 12 months counted
backward from the end of the first accounting period while the basis period for the year of
commencement is the remaining accounting period counted from the date of commencement.

Illustrative Example 71 – Business Commenced in Year 1 and First Set

of Accounts (More than 12 months) Ended in Year 2
Marvelous Start Ltd commenced business on 1 November 2018 and closes its accounts
on 31 December each year. The first accounts were closed on 31 December 2019. Its
adjusted profits for the first two accounting periods are as follows:

1/11/2018–31/12/2019 (14 months) HK$2,800,000

1/1/2020–31/12/2020 HK$4,500,000

The year of commencement is 2018/19 (based on that the date of commencement

1 November 2018 fell in the year ended 31 March 2019). The basis period and assessable
profits for the relevant years of assessment are as follows:

Year of assessment Basis period Assessable profits

2018/19 1/11/2018–31/12/2018 HK$400,000 (2,800,000 (s.18C(1)(b))
× 2 ÷ 14)
2019/20 1/1/2019–31/12/2019 HK$2,400,000 (s.18B(2))
(2,800,000 × 12 ÷ 14)
2020/21 1/1/2020–31/12/2020 HK$4,500,000 (s.18B(2))

3.9.3 Cessation of Business

There are four possible situations for a cessation of business.

Situation 1 – a new business (i.e. business commenced on or after 1 April 1974) ceases
business.

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The basis period for the year of cessation is from the date following the end of the basis
period of the preceding year of assessment to the date of cessation. The basis period may be
less than or exceed 12 months (s.18D(1)).

Illustrative Example 72 – New Business, Last Basis Period More

than 12 Months
End Day-1A Ltd commenced business on 1 May 1974 and closed its accounts on
30 September each year. It ceased business on 31 December 2020.

The year of cessation is 2020/21. The basis period for the year of cessation and the
preceding year is determined as follows:

Year of assessment Basis Period

2019/20 1/10/2018–30/9/2019 (s.18B(2))
2020/21 1/10/2019–31/12/2020 (15 months) (s.18D(1))

Illustrative Example 73 – New Business, Last Basis Period Less

than 12 Months
End Day-1B Ltd commenced business on 1 May 1974 and closed its accounts on
30 September each year. It ceased business on 31 August 2020.

The year of cessation is 2020/21. The basis period for the year of cessation and the
preceding year is determined as follows:

Year of assessment Basis Period

2019/20 1/10/2018–30/9/2019 (s.18B(2))
2020/21 1/10/2019–31/8/2020 (11 months) (s.18D(1))

Situation 2 – an old business (i.e. business commenced before 1 April 1974) ceases business
not due to death and with succession.

If the cessation of business is not due to the death of the sole proprietor and the business is
transferred to or carried on by any other person as his business, the treatment is the same as
Situation 1, i.e. a new business case as mentioned above (s.18D(2) proviso).

Situation 3 – an old business (i.e. business commenced before 1 April 1974) ceases
business, where Situation 2 does not apply.

a. If the accounts are closed on 31 March, the basis period for the year of cessation is
from 1 April in the year of cessation to the date of cessation (s.18D(2)).

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b. If the accounts are not closed on 31 March and (i) the cessation is due to the death
of the sole proprietor, or (ii) the business is not transferred to any other person, the
basis period for the year of cessation is from 1 April in the year of cessation to the date
of cessation (s.18D(2)). The excess of (i) profits for the period from the end of basis
period of the preceding year of assessment to the following 31 March (i.e. the drop-out
profits) over (ii) drop-out profits of the equivalent period in 1974/75 (i.e. the transitional
amount) will be added to the assessable profits of the year of cessation as follows:
s.18D(2A).

Assessable profits for the year of cessation under ss.18D(2) and (2A):

Basis period: 1 April in the year of cessation to date of cessation

Assessable profits from 1 April to date of cessation A

Add: Assessable profits of the ’relevant period’ B
(i.e. drop-out period in year of cessation)
Less: Transitional amount (i.e. profits of the equivalent (C)a D
drop-out period in 1974/75)
Assessable profits for the year of cessation A+D
a
C is limited to B, i.e. no loss can be allowed for D; and equals zero if C is a loss.

Illustrative Example 74 – Old Business, Closing Accounts on 31 March,

Ceased Business
End Day-3A Ltd commenced business on 1 March 1974 and closed its accounts on
31 March each year. It ceased business on 31 August 2020.

The year of cessation is 2020/21. The basis period for the year of cessation and the
preceding year is determined as follows:

Year of assessment Basis Period

2019/20 1/4/2019–31/3/2020 (s.18B(1))
2020/21 1/4/2020–31/8/2020 (5 months) (s.18D(2))

Illustrative Example 75 – Old Business, Closing Accounts Not on

31 March, Ceased Business, Without Succession
End Day-3B Ltd commenced business in 1971. Its closed account on 31 December every
year. It ceased business on 31 August 2020, and the business was not transferred to any
other person. Its adjusted profits for the relevant years were as follows:

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Illustrative Example 75 (continued)

1/1/2020–31/8/2020 HK$2,160,000
1/1/2019–31/12/2019 HK$2,940,000
1/1/1975–31/12/1975 HK$450,000
1/1/1974–31/12/1974 HK$360,000

The year of cessation is 2020/21. The basis period and assessable profits for the year of
cessation are ascertained as follows:

Assessable profits for the year of cessation 2020/21

Basis period: 1 April 2020–31 August 2020

HK$ HK$
Assessable profits from 1/4/2020 to 31/8/2020 1,350,000
(HK$2,160,000 × 5 ÷ 8)
Add: Assessable profits from 1/1/2020 to 31/3/2020 810,000
(HK$2,160,000 × 3 ÷ 8)
Less: Transitional amount from 1/1/1975 to 31/3/1975 (112,500) 697,500
(HK$450,000 × 3 ÷ 12)
Assessable profits for 2020/21 2,047,500

Situation 4 – Short life business under s.18D(5)

If a business is ceased within the year of assessment following the year of commencement,
and there has been deemed to be no assessable profits for the year of commencement under
s.18C(2), the basis period for the year of cessation is from the date of commencement to the
date of cessation (s.18D(5)).

Illustrative Example 76 – Short Life Business

Happy Life Ltd commenced business on 1 October 2019 and closed its first set of
accounts on 30 April 2020. It ceased business on 31 December 2020.

Happy Life Ltd commenced business in 2019/20 and ceased business in 2020/21. The
basis period is determined as follows:

Year of assessment Basis period

2019/20 Nil (s.18C(2))
2020/21 1/10/2019–31/12/2020 (15 months) (s.18D(5))

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3.9.4 Change of Accounting Date

When there is a change in accounting date, the Commissioner is empowered to compute
the profits for the year of change and the previous year on such basis as he thinks fit under
s.18E(1). The Commissioner will normally choose a basis which will not unduly prejudice either
the taxpayer or the IRD.

For these purposes, the following situations are considered as a change in accounting date:

• Failure to make up an account on the corresponding day in the following year of

assessment; or

• Accounts are made up to more than one day in the following year of assessment.

The rules are set out below:

(1) Old business (i.e. commenced business before 1 April 1974)

The normal basis period cannot exceed 12 months. The IRD’s objectives/principles
for selecting the new basis period are:

(a) Adopt the new accounting date as soon as possible; and

(b) Ensure that the period dropped out of assessment should not be of ’high profit’.

(2) New business (i.e. commenced business on or after 1 April 1974)

The basis period for the year of change may exceed 12 months (s.18E(2)(b)).
The IRD’s objectives/principles for selecting the new basis period are:

(a) Adopt the new accounting date as soon as possible;

(b) Ensure that no profit made over the life of the business is dropped out of
assessment;

(c) Accept a basis period of less than 12 months if there is compelling reason for
the change (e.g. to conform to accounting date of holding company); and

(d) Otherwise, adhere to a 12-month basis period and some profits may be
double assessed.

Illustrative Example 77 – Change of Accounting Date, New Accounting

Date More than 12 Months
Never Ever Ltd closes account on 30 September every year. In 2020, it changed its
accounting date to 31 December not for the sole or dominant purpose of obtaining a tax
benefit. Its assessable profits for the relevant years were as follows:

Year ended 30/9/2019 HK$2,400,000

15 months to 31/12/2020 HK$4,800,000

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Illustrative Example 77 (continued)

Since accounts are not made up to the corresponding day of 30 September in 2020,
there is a change of accounting date in 2020/21. The basis period and assessable profits
for the relevant years of assessment are ascertained as follows:

If Never Ever Ltd is a new business

Year of assessment Basis Period Assessable profits

2020/21 1/10/2019–31/12/2020 HK$4,800,000
(15 months)
2019/20 Year ended 30/9/2019 HK$2,400,000

As no profits have been dropped out of assessment, the IRD normally would not
re-compute the assessable profits for the year preceding the year of change (i.e. 2019/20).

If Never Ever Ltd is an old business

Year of assessment Basis period Assessable profits

2020/21 1/1/2020–31/12/2020 HK$3,840,000
(HK$4,800,000 × 12 ÷ 15)
2019/20 Original Accounting date: HK$2,400,000
1/10/2018–30/9/2019
New Accounting date: HK$2,760,000
1/1/2019–31/12/2019 (HK$4,800,000 × 3 ÷ 15 +
HK$2,400,000 × 9 ÷ 12)

As three months’ profits would have been dropped out of assessment, the IRD
will likely re-compute the assessable profits, which would be HK$2,760,000 for the
year preceding the year of change; and profits for the period from 1/10/2018 to
31/12/2018 would be dropped out of assessment.

Illustrative Example 78 – Change Accounting Date, New Accounting

Period Less than 12 Months
Transformation Ltd closed account on 31 December every year normally. In 2020, it
changed its accounting date to 31 October. Its assessable profits for the relevant years
were as follows:

Year ended 31/12/2019 HK$12,000,000

10 months to 31/10/2020 HK$4,000,000

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Illustrative Example 78 (continued)

Since accounts are not made up to the corresponding day of 31 December in 2020,
there is a change of accounting date in 2020/21. The basis period and assessable profits
for the relevant years of assessment are ascertained as follows

If Transformation Ltd is a new business

Year of assessment Basis period Assessable profits

2020/21 1/11/2019–31/10/2020 HK$6,000,000 (HK$12,000,000
(12 months) × 2 ÷ 12 + HK$4,000,000)
2019/20 Year ended 31/12/2019 HK$12,000,000

If there is a compelling reason for the change of accounting date (e.g. to conform to the
accounting date of the new ultimate holding company), the IRD may accept a basis period
of less than 12 months, i.e. ten months to 31/10/2020 as the basis period for the year of
change (2020/21). As no profits have been dropped out of assessment, the IRD normally
would not re-compute the assessable profits for the year preceding the year of change
(i.e. 2019/20).

If Transformation Ltd is an old business

Year of assessment Basis period Adjusted profits

2020/21 1/11/2019–31/10/2020 HK$6,000,000 (HK$12,000,000
(12 months) × 2 ÷ 12 + HK$4,000,000)
2019/20 Year ended 31/12/2019 HK$12,000,000

The basis period for old business must be 12 months (see CIR v Yick Fung Estates Ltd
(1999) 5 HKTC 52). Hence, profits for the period from 1/11/2019 to 31/12/2019 will be
double assessed. As no profits have been dropped out of assessment, the IRD normally
would not re-compute the assessable profits for the year preceding the year of change
(i.e. 2019/20).

Illustrative Example 79 – Change of Accounting Date, Two Sets

of Account for the Year of Change
Evolution Ltd closed accounts normally on 30 June. In 2020, for a compelling reason,
it changed its accounting date to 30 October and prepared two sets of accounts. Its
adjusted profits for the relevant years were as follows:

Year ended 30/6/2019 HK$14,000,000

Year ended 30/6/2020 HK$32,000,000
4 months to 30/10/2020 HK$18,000,000

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Illustrative Example 79 (continued)

Since accounts are made up to more than one day in 2020, the year of change of
accounting date is 2020/21. The basis period and adjusted profits for the relevant years of
assessment are ascertained as follows:

If Evolution Ltd is a new business

Year of assessment Basis period Adjusted profits

2020/21 1/7/2019–30/10/2020 HK$50,000,000 (HK$32,000,000
(16 months) + HK$18,000,000)
2019/20 Year ended 30/6/2019 HK$14,000,000

As no profits have been dropped out of assessment, the IRD normally would not
re-compute the assessable profits for the year preceding the year of change (2019/20).

If Evolution Ltd is an old business

Year of assessment Basis period Adjusted profits

2020/21 1/11/2019–30/10/2020 HK$39,333,333 (HK$32,000,000
(12 months) × 8 ÷12 + HK$18,000,000)
2019/20 Original basis period: HK$14,000,000
1/7/2018–30/6/2019
New basis period: HK$20,000,000 (HK$14,000,000
1/11/2018–30/10/2019 × 8 ÷ 12 + HK$32,000,000
× 4 ÷ 12)

As four months’ profits would have been dropped out of assessment, the IRD will
likely re-compute the assessable profits, which would be HK$20,000,000, for the year
preceding the year of change (i.e. 2019/20); and profits for the period from 1/7/2018 to
31/10/2018 would be dropped out of assessment.

Knowledge Check Question

Question 13
Describe a basis period in a normal case.

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3 . 1 0
SPECIAL TRANSACTIONS AND BUSINESSES

There are specific rules governing the taxability of profits arising in specified circumstances, or
to specific classes of taxpayer.

3.10.1 Stock Taken for Own Use (Sharkey v Wernher Principle)

You will recall that disposal of trading stock in the ordinary course of business gives rise to
assessable profits. Assets held otherwise than as trading stock are either capital assets or
non-trading assets, and any gains realised from the disposal of such assets will therefore
not be taxable under s.14. Where, however, an item of trading stock is appropriated by the
taxpayer – that is, it is taken out of trading stock, and applied to some other purpose – that
event is treated as a deemed disposal of that asset for tax purposes, giving rise to a charge
to profits tax on the gains, if any, that would have been realised had the asset taken out of
trading stock been realised at open market value (Sharkey v Wernher (1956) AC 58). The policy
principle behind this rule is that a trader should not be able to benefit from a deduction in the
acquisition of trading stock without a corresponding charge to tax on the item of stock itself.
A deduction on acquisition without a corresponding charge on sale would give rise to a tax
asymmetry. That so-called ‘Sharkey v Wernher’ principle has now been codified in s.15BA, which
provides as follows:

• S.15BA(2) provides that where an asset used to be trading stock and is at any time
appropriated by the taxpayer for a non-trade purpose, then in calculating the profits of
the taxpayer from that trade the amount of the trading stock so appropriated is treated
as having been sold at open market value. The value of anything in fact received from
the appropriation of trading stock (e.g. by way of consideration) is left out of account
and so ignored for fiscal purposes. The taxable receipt is treated as arising in the year
of assessment in which the appropriation takes place. S.15BA(4) provides that those
same principles of valuation and deemed disposal apply where trade stock is disposed
of otherwise than in the course of trade and s.15BA(2) does not apply (e.g. by way of a
gift or at undervalue).

• S.15BA(3) provides that where an asset that had previously not been trading stock is at
any time appropriated as trading stock by the taxpayer, then the cost of acquisition of
that asset is treated as the open market value of that asset at the time it commenced
being held as trading stock. The value of anything in fact given for the appropriation of
the asset into trading stock (e.g. by way of consideration) is left out of account and so
ignored for fiscal purposes. The cost of the asset is treated as having been incurred in
the year of assessment in which the appropriation took place. S.15BA(5) provides that
those same principles of valuation and deemed acquisition apply where the non-trading
stock is acquired otherwise than in the course of trade and s.15BA(3) does not apply
(e.g. by way of gift or at undervalue).

Trading stock is defined for the purposes of s.15BA as meaning: (i) anything (whether
movable property or immovable property) that is sold in the ordinary course of the taxpayer’s
trade or (ii) would be so sold if it were mature or its manufacture, preparation or construction

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were complete. In essence, limb (ii) of the definition enables ‘work in progress’ stock to be
treated as trading stock. Trading stock, however, does not include: (i) materials used in the
manufacture, preparation or construction of any trading stock; (ii) any services performed in
the ordinary course in trade (hence services ‘work in progress’ does not qualify); or (iii) any
article produced or any material used in the performance of such services.

Ss.15BA(4) and 15BA(5), which cover a disposal or an acquisition respectively otherwise

than in the course of trade, do not apply where s.15C applies with respect to the trading stock
in question i.e. where a taxpayer ceases to carry on a trade or business in Hong Kong.

Illustrative Example 80 – Trading Stock Changed as Long-term

Investment
Successful Forever Ltd was holding a trading property, with acquisition cost of
HK$10 million. On 1 June 2020, Successful Forever Ltd changed its intention on holding
the property from trading to long-term investment for rental income. The market value
of the property on 1 June 2020 was HK$20 million.

Under s.15BA(2), there would be a deemed taxable receipt of HK$20 million

to Successful Forever Ltd for its appropriation of trading stock for long-term
investment purpose.

The net taxable amount would be HK$10 million (HK$20 million − HK$10 million).

However, the future gain/loss on disposal of the property would be capital in nature and
not taxable/not allowable.

Illustrative Example 81 – Long-term Investment Changed

as Trading Stock
Successful Forever Ltd was holding a long-term investment property for many years,
with acquisition cost of HK$1 million. On 1 June 2019, Successful Forever Ltd changed
its intention on holding the property from long-term investment to trading. The market
value of the property on 1 June 2019 was HK$20 million. On 1 February 2020, the
company sold the property at a price of HK$25 million.

Under s.15BA(3), there would be a deemed cost of HK$20 million for the property, for
computing the future taxable amount on sale of the property. The net taxable amount of
the subsequent sale on 1 February 2020 is HK$5 million (HK$25 million − HK$20 million).

Key Learning Point

Where an asset is acquired as trading stock but is subsequently appropriated to the
capital or otherwise ceases to be held as trading stock, there will be a deemed taxable
disposal at market value. Similarly, where an asset is acquired as capital and subsequently
appropriated to trading stock, it will be treated as having been acquired at market value as
trading stock on the date of the appropriation.

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3.10.2 Stock Borrowing and Lending Transactions

A stock borrowing and lending transaction (SBLT) is a transaction where a person borrows
stock (generally, shares, units in a trust scheme, or other securities) (the borrower) from a
person who holds such stock (the lender). Under an SBLT, the lender transfers the legal and
beneficial ownership of the borrowed stock to the borrower. The lender loses legal ownership
rights to the stock in exchange for collateral from the borrower (usually cash, but can be
debt or equity securities). Title to the collateral passes from the borrower to the lender.
The borrower agrees to return stock equivalent to the borrowed stock to the lender upon
the lender’s demand or within a certain period of time, at which time the lender returns the
collateral to the borrower. The lender remains entitled to the economic benefits (and risk
of loss) of the stock during the period the stock is lent, i.e. the borrowing period. If either
party becomes insolvent, the other party may retain the borrowed stock or collateral as the
case may be.

The lender generally receives a borrowing fee from the borrower in respect of the
borrowed stock. In addition, if any interest, dividend or other distribution is made in respect
of the borrowed stock during the borrowing period, the lender receives from the borrower
the distribution (or identical property) or a compensatory payment, sometimes called a
manufactured dividend if paid in place of a dividend, equal to the value of the distribution. In
the other direction, if the borrower provides cash to the lender as collateral, the lender will
pay the borrower a so-called loan rebate fee which is generally calculated with reference to
published inter-bank interest rates.

S.15E provides for a conditional exemption from profits tax for lenders under certain
SBLT. A lender under an arm’s length SBLT, which complies with the requirements of the
Stamp Duty Ordinance (Cap.117) and is thus subject to the rules and practices of a recognised
stock exchange, is treated as having retained the stock during the borrowing period;
accordingly there would be no trading disposal of the stock loaned under the SBLT for profits
tax purposes and, it would follow, no charge to profits tax would arise from the SBLT itself.

DIPN No. 27, which sets out the Commissioner’s policy on the scope and application of
s.15E, states that the IRD accepts that ‘repo’ transactions are in general treated as SBLT for tax
purposes since both have broadly the same economic effect. DIPN No. 26 further sets out the
IRD’s guidance on the definition of the term ‘specified securities’ in s.15E.

S.15E(3) provides that payments of dividends and interest made by the borrower to
the lender and also the receipt by the lender of rights and options are to be treated for tax
purposes as they would have been treated had the lender never parted with the stock. Such
payments will be treated for s.14 purposes as having the same nature and the same source
for profits tax purposes as the original payment would have had it been received directly by
the lender.

S.15E(4) addresses the issue of manufactured dividends and other compensatory payments
made by the borrower to the lender; it again puts the lender in the same position as it would
have been if it had retained ownership of the stock and received the original distribution. If,
however, the compensatory payment exceeds the distribution or other payment or right to
which the lender would have been entitled had it retained control of the stock, the excess may
be taxable under ordinary s.14 principles.

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3.10.3 Financial Instruments and Foreign Exchange Differences

It is, as a general rule, rare for individuals, in particular, to be found to be trading in financial
instruments for the purposes of s.14 (Lee Yee Shing v CIR (2008) 3 HKRD 51). The reasons for
this are, in part, pragmatic since if it were relatively easy for a person to claim to be trading
in securities, that person would be able to set off any losses arising from dealing in securities
against future profits, a result which may ultimately be undesirable from the IRD’s perspective.
That being said, institutional investors and financial institution plainly carry on the business of
buying and selling securities and other financial instruments.

The IRD’s practice in taxing financial instruments is set out in DIPN No. 42. In summary, the
IRD will seek to apply the Court of Final Appeal decision in CIR v Secan Ltd & Another (2000) 3
HKCFAR 411 that the ascertainment of profits or the timing of income accrual follow ordinary
principles of commercial accounting, as modified to conform with the IRO. Profits will therefore
only be taxed to the extent they are realised: Neither profits nor losses can be anticipated
(Nice Cheer Investment Ltd v CIR (2014) 2 HKC 112). The accounting treatment cannot, however,
change an asset from being trading stock to a capital asset (or vice versa), or the fundamental
characteristics of the financial instrument itself: that is, whether it should be treated as debt
or equity.

The IRD is of the view that a financial asset or financial liability at fair value through profit
or loss includes a financial asset or financial liability that is held for trading. It is classified as
trading if it is acquired or incurred principally for the purpose of selling or repurchasing, or
there is a pattern of short-term profit-taking. Typically, unless it is a designated and effective
hedging instrument, a derivative will be classified as held for trading. Thus, the change in fair
value and the gain or loss on disposal, recognised in the profit and loss account, are prima facie
taxable or deductible as the case may be. Furthermore, loans and receivables, held-to-maturity
investments and available-for-sale financial assets are trading assets where the taxpayer is a
financial institution or it carries on an insurance, money lending, securities dealing or finance
business because financial assets are often acquired in the course of the business with a view
to resale at a profit and will in general be treated as trading assets (CIR v Sincere Insurance &
Investment Co Ltd (1973) 1 HKTC 602).

This leads to the vital question as to how hybrid instruments, that is, instruments with
both debt and equity-like characteristics, should be treated for tax purposes. In that regard,
the IRD’s policy is to follow the legal form and not the economic substance of the financial
instrument. This is an important exception to the general principle that as a matter of statutory
construction one looks to substance over form and has been criticised by some practitioners as
being a dubious approach.

An embedded derivative is a component of a hybrid instrument that contains a non-

derivative host contract. Embedded derivatives can be found in a number of financial
instruments, including put options in bonds, callable bonds, put options on preference shares,
etc. The IRD is of the view that the revenue/capital character of an embedded derivative and its
source for the purposes of the application of s.14 must be the same for both the non-derivative
host contract and the embedded derivative.

Foreign exchange gains and losses are in principle taxable under s.14 to the extent that the
taxpayer carries on a trade or business dealing either in foreign currency (CIR v General Garment
Manufactory (Hong Kong) Ltd (1997) 4 HKTC 532) or otherwise carry on the trade or business of

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making loans or advances of money, wherein foreign exchange differences can either increase
or decrease returns (CIR v Hang Seng Bank Ltd (1972) 1 HKTC 583). Pursuant to the decision
in Nice Cheer, however, it is not possible to anticipate profits or losses arising from foreign
exchange differences. Only when such profits or losses are realised will the profits become
taxable or the losses utilisable for set off, as the case may be.

Ss.18G–18L align the tax treatment of financial instruments with their accounting treatment
in certain circumstances. As you will recall, the general rule in Secan and Nice Cheer is that
accounting treatment is not dispositive when it comes to taxation; whether a profit is an
assessable profit is purely a question of law. Certain specified financial instruments as defined
in s.18G are an exception to this rule. A specified financial instrument for those purposes
means a financial instrument to which the Hong Kong Financial Reporting Standard 9 (Financial
Instruments) – or an equivalent foreign accounting standard – applies. S.18H enables a
taxpayer to make an election to utilise the specified financial reporting standards as defined
in s.18G as a basis for ascertaining the tax treatment of the specified financial instruments in
question in accordance with those reporting standards. Thus, the amount of any profit, gain,
loss, income, or expense brought into account for computing the taxpayer’s assessable profits
for a year of assessment in which the election is made to be computed on the basis is deemed
to be as required by the relevant accounting treatment. A taxpayer may in subsequent years of
assessment refuse to renew an election made under this section, and if it does so, the specific
regime in ss.18G–18L will cease to apply.

Key Learning Point

There are specific rules and IRD’s practices regarding taxation of financial instruments and
foreign exchange differences. The specific provision in the IRO and DIPN No. 42 should be
referred to.

3.10.4 Alternative Bond Schemes

The Muslim religion prohibits the charging of interest. Observant Muslims accordingly avoid
charging interest in financial transactions. This has led to the emergence of a specific Islamic
financing sector, which is based on the issue of Islamic financial instruments known as ‘sukuk’,
which are usually asset-backed and avoid the charging of interest by involving an element of
profit participation or otherwise synthesise interest in the guise of lease or rental payments.
Alternative bond schemes (ABS) are arrangements designed to synthesise debt securities or
loan arrangements but which do not generate interest.

S.40AB and Schedule 17A contain provisions relating to the tax treatment of specified
ABS. This schedule enables particular arrangements in a specified ABS to be regarded as
debt arrangements for the purposes of the IRO if the conditions set out in Schedule 17A are
met. The objective of treating ABS as debt securities is to provide that their tax treatment is
consistent with their function in the context of Islamic finance. Thus, as regards ABS:

• Money paid by the bond holder to the bond issuer is regarded as money borrowed by
the bond issuer from the bond holder (s.21 of Schedule 17A).

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• Coupon payments made to the bond holders by the bond issuer is deductible under
s.16(2)(f) on the same footing as though it were a conventional debenture.

• ABS are treated as debt instruments and, if transferable upon delivery, are for the
purposes of s.15(1)(j)–(la) treated as certificates of deposit.

As regards the ABS issuer:

Investment returns payable to the issuer are treated as interest for tax purposes. Further
IRD guidance on ABS may be found in DIPN No. 50.

3.10.5 Regulatory Capital Securities

Banks are required to maintain capital adequacy as part of the overall regulation of the
financial services industry. The Basel Committee on Banking Supervision requires that banks
hold a certain amount of regulatory capital as a percentage of their assets. A regulatory
capital security (RCS) is a security qualifying as Additional Tier 1 capital or Tier 2 capital for
those purposes and generally speaking has characteristics of a debt security. S.17A provides
that this definition does not include shares or other securities that constitute equity, or have
predominant equity-like characteristics, irrespective of whether or not they are structured
as debt instruments. A bond convertible into shares – that is, a convertible bond – would not
therefore qualify as an RCS.

Consequently, s.17B of the IRO provides that an RCS is in substance to be treated as a debt
security for tax purposes, which means that any sum payable in respect of a RCS by its issuer,
other than a repayment of the paid-up amount of the security, is to be treated as interest
payable on money borrowed by the issuer of an amount equal to the paid-up amount of the
security. S.15(1C) provides that subject to ss.17B to 17G, s.15(1) paras (f), (g), (i), (ia), (j), (k), (l)
and (la) apply to an RCS; in other words, the ordinary rules applicable to ascertaining whether
an interest or other relevant receipt not chargeable to profits tax under s.14 is nonetheless
taxable, apply with respect to payments derived from RCS.

By the same token, s.17F generally excludes the deductibility of payments under s.16(1)
made with respect to RCS by an issuer where the RCS is held by or issued to a person
connected to the issuer. The purpose of this restriction is, evidently, to prevent aggressive tax
planning by way of the issuing of regulatory capital securities with a view to securing specified
deductions in Hong Kong. The harshness of that general restriction is, however, mitigated by an
exception allowing for deductibility where:

(a) The money paid by or on behalf of the specified connected person (SCP) for the issue
of RCS has been entirely funded, either directly or indirectly, by the proceeds of an
external issue of a RCS or debenture or debt instrument by the SCP or an associated
corporation of the issuer; and

(b) The externally issued RCS or debenture or debt instrument is not, at any time during
the basis period of the issuer for the year of assessment concerned, held by or for the
benefit of a SCP of the issuer.

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S.17F(5) further provides for an arm’s length limitation, stipulating that the amount of the
deduction allowable is to be reduced by any amount by which the sum payable to, or for the
benefit of the connected person exceeds a reasonable commercial return on money borrowed
of an amount equal to the paid-up amount for the externally issued RCS or debenture or debt
instrument. An analogous transfer pricing provision in s.17G requires the profits of a PE of a
non-resident financial institution to be computed as though they were two separate enterprises
specifically in the context of payments made with respect to RCS.

DIPN No. 53 provides official IRD guidance and commentary on the application of the
specific regime for the taxation and deduction of payments made with respect to RCS.

3.10.6 Special Classes of Business

Certain kinds of business are subject to specific tax regimes.

3.10.6.1 Financial Institutions
As you have seen from the Orion Caribbean decision, where a person carries on the trade
or business of extending finance or credit, the ‘operations test’ will be utilised to determine
the source of its profits, as opposed to the deeming provision in s.15(1)(f). In most cases,
financial institutions, such as banks, will borrow and lend money in the ordinary course
of their business and, it would follow, profits arising from such activities, including where
appropriate the buying and selling of financial instruments, will be chargeable under the
default charging provision in s.14. To ensure, however, that interest income is taxable in the
hands of a financial institution irrespective of where it is sourced, s.15(1)(i) deems sums not
otherwise chargeable to profits tax received by or accrued to a financial institution by way of
interest arising from the carrying on by that financial institution of its business in Hong Kong
to be taxable in all circumstances. Similar rules in s.15(1)(l) deem gains or profits arising from
the disposal by a financial institution carrying on its business in Hong Kong of certificates of
deposits, bills of exchange and regulatory capital securities to be taxable. Such transactions
generally occur in the ordinary course of a financial institution’s business and, accordingly, it is
arguable that these deeming provisions merely codify the likely position as it would have been
under s.14, applying the ‘operations test’ principle in Orion Caribbean. In CIR v Sincere Insurance
and Investment Co Ltd (1973) HKTC 602, the court opined that the realisation by an insurance
company of assets was more likely to constitute a revenue rather than capital receipt. The
ratio of that decision seems to suggest that in the context where investments are held as part
of the day-to-day conduct of a trade or business, the realisation of the same to fund that trade
or business is more likely to be treated as a trading receipt than would otherwise be the case.
By the same token, interest expenditure incurred by a financial institution will in general be
deductible (s.16(2)(a)).

By virtue of their trade, financial institutions present particular characteristics when it

comes to the taxation of certain financial transactions:

1. Exchange differences: Financial institutions often enter into transactions denominated

or expressed in a variety of currencies; however, CIR v Malaysian Airline System Berhad 3
HKTC 775 is the authority for the proposition that assessable profits or losses for each

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year must be expressed in Hong Kong dollar terms. The general rule is that exchange
gains or losses are neither taxable nor allowable if they are of a capital nature;
however, if foreign currency is acquired as trading stock or otherwise for the purposes
of a trade or business, any gains or losses may in principle be respectively taxable or
deductible (CIR v General Garment Manufactory (Hong Kong) Ltd (1997) 4 HKTC 532 and
CIR v Li & Fung (1980) 1 HKTC 1193). The conventional rules to establishing whether
foreign exchange is acquired on capital or revenue apply. A gain or loss of fixed capital
is an item on capital account, while a gain or loss of circulating capital is an item
on revenue account. Thus, where exchange losses are incurred in respect of funds
borrowed by a person who carried on business of borrowing and lending money or
dealing in foreign exchange (such as a financial institution), those were inherently on
revenue account unless the funds were used to strengthen that person’s profit-making
capital base (Avco Financial Services Ltd v FCT (1982) 13 ATR 63). Thus, unless the foreign
currency is held by the financial institution as part of its capital structure because, for
example, they constitute a long-term loan (CIR v Chinachem Finance Co Ltd (1989) 3
HKTC 529), gains and losses will in the ordinary course be treated as revenue gains and
losses, as the case may be.

2. Foreign taxes: Interest payments received by financial institutions in Hong Kong may
be subject to foreign withholding tax. The effective rate of foreign withholding tax
may be reduced by the operation of a double taxation agreement. That, however,
may nevertheless leave the financial institution receiving the interest payment with
both a foreign tax liability (i.e. the withholding tax) and a domestic one (i.e. profits
tax payable on interest receipts). If a double taxation treaty is in force, double
taxation will be prevented by the grant of a credit for any tax paid in the jurisdiction
of source to the exclusion, however, of any deduction under domestic Hong Kong
law for foreign tax paid (s.16(2J)). When it comes to jurisdictions of source that do not
have a double taxation agreement with Hong Kong, s.16(1)(c) applies, allowing for a
deduction for foreign taxes of the same nature as those charged by the IRO shown
to the satisfaction of the Commissioner to have been paid in a non-DTA jurisdiction.
S.16(1)(c) is, however, limited to deductions for foreign tax paid on interest receipts.
Other foreign taxes on income or profits are now regarded by the IRD as being non-
deductible (DIPN No. 28).

3. Bad debts: The rules governing the deduction of bad debts in s.16(1)(d) are generally
restrictive, but, specifically as regards financial institutions, they have broad application.
You will recall the primary conditions for a bad debt to be deductible is that the debt
must be shown to have become bad and to have been incurred in the course of a trade,
business or profession. The proviso in paragraph (i) requires the bad debt to have been
contracted in the ordinary course of the lender’s business and that condition should in
general apply to a financial institution claiming a deduction for the said bad debt.

The IRD takes the approach in DIPN No. 21 to the taxability of profits arising to financial
institutions (See Exhibit 3.10).

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Types of Income Tax treatment

1. Interest from loans
(a) Offshore loans initiated, negotiated, approved and documented 100% Non-taxable
by an associated party outside Hong Kong and funded outside
Hong Kong, i.e. funds raised and loaned direct to the borrower by
a non-resident, e.g. head office, branch, or subsidiary, etc. albeit
through or in the name of the Hong Kong institution.
(b) Offshore loans initiated, etc. by the Hong Kong institution and 100% Taxable
funded by it in/from Hong Kong.
(c) Offshore loans initiated, etc. by an associated party outside 50% Taxable
Hong Kong but funded by the Hong Kong institution.
(d) Offshore loans initiated, etc. by a Hong Kong institution but funded 50% Taxable
by offshore associates. It is considered that this category only
applies to start-up positions where the Hong Kong institution has
yet to establish a market presence.
Note on ‘Funding’
For claims concerning loans funded by offshore associates, two
essential requirements will have to be satisfied, namely,
(i) That the Hong Kong institution does not have the authority to seek
its own source of funds in respect of the loans; and
(ii) There must be documentary evidence to show that funds have
been directly provided by an offshore associate even though
such funds may have been routed through another vehicle in
Hong Kong. In other words, arbitrary funding by another group
vehicle in Hong Kong will not satisfy this requirement.
Note on ‘Initiation’
‘Initiation’ refers to the efforts exerted in obtaining the particular
business including solicitation, negotiation and structuring of the
loans. The financial institution must be able to substantiate that the
mandate or invitation to participate was secured as a direct result of
the activities of an associated party outside Hong Kong for an offshore
claim to succeed.
2. Interest on Certificates of Deposit (CDs)
Acquisition of CDs will be treated in a similar fashion to deposit 100% Taxable
placements. This treatment is predicated on the fact that the
Hong Kong institution operates within previously approved parameters
as to credit limits and prime banks with whom it may operate. In
other words, there is an obvious distinction to be drawn between CDs
and loans.
3. Interest from securities other than CDs
A similar approach to be adopted as for interest from loans. If there See (1) above
is to be any attribution of interest to offshore intervention, the role of
the Hong Kong institution must be that of a mere intermediary in the
purchase and sale of securities with no discretion in the matter. It is
unlikely that any claim for exemption will be entertained in instances
where the Hong Kong institution possesses its own security dealing
capability and is active in this capacity.

EXHIBIT 3.10 Tax treatment of profits according to DIPN No. 21

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Types of Income Tax treatment

4. Participation, Commitment, etc. fees
To follow the tax treatment accorded to related loans. See (1) above
5. Active fee
To be determined by reference to the ‘Activity Test’, i.e. services Depends on the
performed to earn the fee. particular facts of the
case – s.14 principles
and operations
test apply
6. Guarantee/underwriting fees
A principal consideration of source is related to whether or not the risk Depends on the
under the guarantee or underwriting commitment is evaluated and particular facts of the
is to be borne by the Hong Kong institution. In instances where the case – s.14 principles
Hong Kong institution has no discretion on the acceptance or rejection and operations
of offshore instructions, and undertakes no risk, such fees will be test apply
accepted as merely ‘booked’ and not assessable.

EXHIBIT 3.10 (Continued)

Rule 3 of the IRR provides that the assessable profits of a Hong Kong branch of a
non-resident financial institution – i.e. a financial institution whose head office is outside
Hong Kong – are in the first instance to be computed in accordance with its accounts, provided
always that such accounts are a true reflection of profits imputable to the Hong Kong branch.
Where no accounts are prepared which disclose the true profits of the Hong Kong branch, the
following provisions shall apply in the determination of such profits:

• The same proportion of the total profits of the non-resident financial institution as the
assets of the Hong Kong branch bear to the total assets of the non-resident financial
institution shall be treated as profits made from transactions in Hong Kong and shall be
assessed accordingly; and

• For the purposes of determining the total profits of the non-resident financial
institution, similar adjustments for tax purposes will be made in the accounts of the
non-resident financial institution as would have been necessary had the whole of those
profits been liable to tax under this ordinance.

where the assessor is of the opinion that it would be impracticable or inequitable to adopt
the above method, they may estimate the amount of the profits of the Hong Kong branch, and
assess such profits accordingly. Rule 3 of the IRR is, however, subject to: (i) the application of
any DTA having effect; (ii) s.50AAK on the allocation of profits between a PE and its head office;
and (iii) ss.17B–17G.

3.10.6.2 Insurance Companies
S.23 makes special provision for the ascertainment of the assessable profits of life insurance
corporations. Non-life insurance corporations are covered by s.23A and mutual insurance
corporations by s.23AA. That discrete taxing regime operates to the exclusion of other
provisions of the IRO, including the deeming provisions of s.15 (CIR v Carlingford Life and
General Assurance Co Ltd (1989) 3 HKTC 229), though note the concessionary taxing regime
in s.14B for qualifying reinsurance and captive insurance businesses, such businesses being

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in substance reinsurance and captive insurance companies authorised under the Insurance
Ordinance (Cap.41).

Life Insurance Business

For life insurance companies, there are two alternative methods of computing assessable
profits. Under the first method, which is the most used in practice, assessable profits
are deemed to be 5% of the premiums from life insurance business in Hong Kong of the
corporation during the basis period. Relevant premiums for those purposes are defined in
s.23(9) as including all premiums received or receivable in Hong Kong from both residents
and non-residents, and also all premiums receivable outside Hong Kong from residents of
Hong Kong where the premiums relate to policies the proposals for which were received
by the corporation in Hong Kong. In the change to ‘second method’, the taxpayer may elect
for the actuarial value of all life policies held be utilised as a basis of the computation of
assessable profits.

Details of the assessment methods are set out below:

Method A – S.23(1)(a)

It is also known as ‘% premium’ method. It is simple and applied automatically by default.

Assessable profits 5% of `premiums from life insurance business in

Hong Kong´ during the basis period

‘Premiums from life insurance business in Hong Kong’ includes:

• All premiums received or receivable in Hong Kong from both residents and non-
residents; and

• All premiums receivable outside Hong Kong from residents of Hong Kong where such
premiums are in respect of policies the proposals for which were received by the
corporation in Hong Kong.

There are limited deductions. That is only returned and reinsurance premiums are
deductible.

Illustrative Example 82 – Method A

Number One Life Insurance Company Limited received during the year ended
30 September 2020 the followings:

(a) Premiums received in Hong Kong from both HK and HK$ 90,000,000

non-HK residents
(b) Premiums received in Canada from HK residents 30,000,000
(the policies concerned were proposed in Canada)
Total premiums HK$120,000,000

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Illustrative Example 82 (continued)

Under method A, assessable profits = 5% × HK$90,000,000 = HK$4,500,000

Profits tax liability for 2020/21 is (HK$2,000,000 × 8.25%) + (2,500,000 × 16.5%) =

HK$577,500

Method B – S.23(1)(b)

It is comparatively more complicated and is only used upon election by the taxpayer.
Election is irrevocable. There is no time limit, for election but a certified true copy of the
latest abstract of the actuarial report is required to be submitted within two years of the
date to which the report is made up in order to validate an election. Tax filing is made
based on figures in the actuarial report which may cover more than one accounting year.

Assessable profits = ‘that part of the adjusted surplus’

= ‘Adjusted surplus’ apportioned to onshore
relating to the relevant basis period (3 steps)

Step 1: ‘Adjusted surplus’ = Surplus (i.e. the amount by which the life insurance fund
exceeds the estimated liability of the corporation on the life insurance fund at the end of the
period in respect of which the actuarial report is made) adjusted by:

Additions Subtractions
+ Deficits of previous period − Surplus of previous period
+ Disallowable expenses under − Allowable expenses not yet
ss.16 and 17 deducted
+ Income (except non-life − Capital receipts included
business) not credited
+ Transfer to reserve from the − Transfer from reserve to the fund
fund
+ Balancing charge under − Depreciation allowances under
Part 6 Part 6

Step 2: Apportion ‘Adjusted surplus’ to onshore by:

HK premiums for the report period (A)

Adjusted surplus
Worldwide premiums for the report period (B)

Step 3: Apportion ‘onshore adjusted surplus’ to relevant basis period by:

HK premiums for relevant basis perriod (C)

Onshore adjusted surplus
HK premiums for the report period (A)

i.e. Steps 2 + 3:
(C)
Adjusted surplus
(B)

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Illustrative Example 83 – Method B

Hong Kong Supreme Life Insurance Ltd commenced a life insurance business in
Hong Kong on 1 January 2017. It submitted its first actuarial report for the period from
1 January 2017 to 31 December 2020 and elected its assessable profits to be ascertained
under s.23(1)(b) of the IRO. The following information is provided:

HK$
Value of life fund at 31 December 2020 3,600,000
Actual liability on policies comprising life fund at 31 December 2020 2,800,000
Premium received (evenly distributed over the four years)
From Hong Kong 4,000,000
From overseas 2,000,000
Management expenses not yet charged to the fund 200,000
Profits on disposal of fixed assets 120,000
General provision for doubtful debts 240,000
Transfer from contingent reserves 160,000
Transfer to contingent reserves 200,000
Depreciation allowances (for four years) 160,000

Surplus for the period from 1 January 2017 to 31 December 2020:

Life fund at 31 December 2020 HK$3,600,000

Liability at 31 December 2020 (2,800,000)
Surplus HK$ 800,000

Adjusted surplus for the period from 1 January 2017 to 31 December 2020:

Surplus HK$800,000
Add: Provision for doubtful debts 240,000
Transfer to contingent reserves 200,000 440,000
1,240,000
Less: Management expenses 200,000
Profits on disposal of fixed assets 120,000
Transfer from contingent reserves 160,000
Depreciation allowances 160,000 (640,000)
Adjusted surplus HK$600,000

4 , 000, 000
Onshore adjusted surplus: HK$600, 000 = HK$400,000
6, 000, 000

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Illustrative Example 83 (continued)

Assessable profits for: 2017/18 (Y/E 31 December 2017) HK$400,000 × ¼ = HK$100,000

2018/19 (Y/E 31 December 2018) HK$400,000 × ¼ = HK$100,000
2019/20 (Y/E 31 December 2019) HK$400,000 × ¼ = HK$100,000
2020/21 (Y/E 31 December 2020) HK$400,000 × ¼ = HK$100,000

Non-life Insurance Business

S.23A(1) provides that the assessable profits of a non-life insurance business are ascertained by
adding to and subtracting from the gross premiums from its business in Hong Kong.

‘Premiums from non-life insurance business in Hong Kong’ includes:

• All premiums in respect of contracts of insurance, other than life insurance, made in
Hong Kong; and

• All premiums on contracts of insurance, other than life insurance, the proposals for
which were made to a corporation in Hong Kong.

The assessable profits of a non-life insurance company are ascertained by aggregating

gross premiums with interest, other incomes having a Hong Kong source and balancing
charges, and then deducting returned premiums, reinsurance premiums, actual losses, Hong
Kong agency expenses and a fair proportion of head office expenses, computed as follows

Gross premiums from non-life insurance business in HK A

Add: Reserve for unexpired risk at beginning of the period
Balancing charge
Interest or other incomes sourced in HK B
Less: Premiums returned to the insured
Corresponding reinsurance premium
Actual losses less reinsurance recoveries
Reserve for unexpired risk at end of the period
Agency expenses in HK
Depreciation allowances under Part 6
Fair share of head office administration expenses C

Assessable profits D

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For non-residents, the assessable profits may be computed by the following

apportionment formula:

Premiums from non-life insurance buusiness in HK

Total Worldwide Profits
Worldwide premiums from non-life insurance buusiness

Illustrative Example 84 – Non-life Insurance

The following information is extracted from the profit and loss account of Elephant
Insurance Ltd for the year ended 31 December 2020:

(a) Gross premiums received or receivable amounted to HK$55,500,000. All insurance

contracts were executed in Hong Kong.

(b) Reinsurance premiums paid were HK$2,640,000 and recoveries received were
HK$3,150,000.

(c) Commissions and discounts paid to agents were HK$18,360,000.

(d) Claims paid or payable were HK$20,700,000. The amount payable refers to claims
reported before 31 December 2020.

(e) As at 1 January 2020, the reserve fund stood at HK$18,750,000. The management
of the company had decided that, effective from 31 December 2020, the reserve
ratio for unexpired risks should be reduced from 50% to 45% of the gross
premiums earned less reinsurance premiums.

(f) Other incomes of the company includes:

(i) Profits from sales of properties which were acquired 15 years ago for rental
income: HK$1,500,000.

(ii) Dividends from listed shares: HK$735,000.

(iii) Interest on a loan to an associate company in Hong Kong: HK$450,000.

(g) Administration and management expenses were HK$7,035,000; depreciation

charges of HK$1,371,000 and stamp duty on the initial tenancy agreement of the
company’s new office HK$120,000 were also incurred.

(h) The agreed depreciation allowances are HK$435,000.

Tax computation of Elephant Insurance Ltd for 2020/21 (Basis period: Year ended
31.12.2020) (HK$)

Gross premiums received or receivable 55,500,000

Add: Reserve fund as at 1 January 2020 18,750,000
Recoveries from reinsurance 3,150,000
Profits from sales of propertiesa 1,500,000

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Illustrative Example 84 (continued)

Interest from associateb 450,000 23,850,000

79,350,000
Less: Reserve fund as at 31 December 2020c 23,787,000
Reinsurance premiums 2,640,000
Commission and discounts 18,360,000
Claims 20,700,000
Administration and management expenses 7,035,000
Depreciation allowances 435,000 (72,957,000)
Assessable profits 6,393,000

a
In this case, investment in properties was obviously held as part of the insurance reserve. Following the
principle established in the CIR v Sincere Insurance and Investment Co Ltd,, profits on disposal of properties
are of revenue in nature.
b
As the loan was made to an associate company in Hong Kong, it was assumed that the provision of credit
was in Hong Kong and interest income is taxable.
c
Reserve fund as at 31 December 2020 is given by: (HK$55,500,000 − HK$2,640,000) × 45% =
HK$23,787,000
d
The stamp duty was paid on the initial tenancy agreement. It is a capital expenditure. Moreover,
depreciation charges are also capital in nature. Both expenses are not deductible.

Reinsurance of Offshore Risk, Professional Reinsurer and Authorised Captive Insurer

Effective from 1998/99, where a corporation carrying on a non-life business in Hong Kong is
authorised to carry on the business of reinsurance of offshore risks as a professional reinsurer,
the assessable profits attributable to the business of reinsurance of offshore risks may be
taxed at a concessionary rate of one-half of the normal profits tax rate. Election is required by
the corporation (s.14B) for the concession.

The assessable profits from the business of reinsurance of offshore risks are computed by
the following formula:

B
Assessable profits D
C

B means the assessable profits of that corporation during the basis period for that year of
assessment as computed in accordance with s.23A(1).

C means the aggregate of the total income earned by or accrued to that corporation during
the basis period for that year of assessment.

D means the aggregate of offshore reinsurance income earned by or accrued to that

corporation during the basis period for that year of assessment. Offshore reinsurance
income includes (i) premiums from reinsurance of offshore risks and (ii) gains or profits
from offshore reinsurance investments.

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From the year of assessment 2013/14 onward, the assessable profits derived from the
business of insurance of offshore risk as an authorised captive insurer within the meaning of
s.23A(2A) is also entitled to tax relief of profit being taxed as half of the profits tax rate.

S.14B has been revised and s.23A(2A) has been repealed subsequently. The one-half
concessionary tax rate is now applied to the assessable profits of a professional reinsurer or
authorised captive insurer.

Effective 13 July 2018, the assessable profits of a corporation shall be chargeable at one-half
of the normal profits tax, to the extent to which those profits are:

(a) The assessable profits derived from the business of reinsurance as a professional
reinsurer; or

(b) The assessable profits derived from the business of insurance as an authorised
captive insurer.

In order to be entitled to the one-half concessionary tax rate, the activities that produce the
corporation’s assessable profits must be

(i) Carried out in Hong Kong by the corporation; or

(ii) Arranged by the corporation to be carried out in Hong Kong.

Also, to enjoy the one-half concessionary rate, the corporation must make an election in
writing. The election, once made, is irrevocable.

Mutual Insurance
S.23AA concerns the taxation of mutual insurance companies. This section is an exception to
the general rule that mutual dealings with respect to a fund contributed by a closed group of
members cannot give rise to taxable profits because a person cannot profit from himself. This
section, however, deems a mutual insurance corporation to carry on an insurance business,
such that any surplus thereof is taxable under s.14. The computation of assessable profits,
however, must be carried out in accordance with ss.23 or 23A, as the case may be, depending
on whether the insurer is a life insurance or non-life insurance business.

3.10.6.3 Privately Offered Funds

In order to encourage the development of the investment funds industry in Hong Kong, there
are certain generous exemptions from profits tax available for collective investment schemes
that operate in or through Hong Kong. Historically, it was the case that non-resident persons
with no other trade or business in Hong Kong effecting specified transactions (as defined in
Schedule 16 of the IRO) through or arranged by specified persons in Hong Kong were not
chargeable to profits tax on the profits of such transactions under s.20AC. Specified persons
were, in general, banks or persons licensed under the Securities and Futures Ordinance
(Cap.571). This meant that collective investment schemes operating in Hong Kong through
a specified person as defined in the statutory regime could do so without any Hong Kong
tax leakage. Further note that the exemption form profits tax applies only to the specified
transactions, which Schedule 16, Part 1, lists as follows:

1. A transaction in securities.

2. A transaction in futures contracts.

3. A transaction in foreign exchange contracts.

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4. A transaction consisting in the making of a deposit other than by way of a

moneylending business.

5. A transaction in foreign currencies.

6. A transaction in exchange-traded commodities.

7. A transaction in an investee company’s shares carried out through or arranged by a

specified person for, or carried out by, a non-resident partner fund.

Other transactions that are operations not specifically specified may nevertheless give rise
to profits chargeable to Hong Kong tax.

However, because, under the new BEPS rules, privileging non-residents over residents is
considered a harmful tax practice, as such preferential tax regimes are in practice aimed at
drawing investment and capital away from other jurisdictions, the regime has been reformed
effective from February 2019. The tax exemption is now available to all funds, whether resident
or non-resident, but in practice applies only to bona fide collective investment schemes,
which are defined in the legislation as ‘funds’ (s.20AM). S.20AN is the operative provision that
exempts profits of a fund as defined in s.20AM (i.e. a bona fide collective investment scheme)
from profits tax irrespective of where that fund is resident to the extent such profits arise
from transactions in assets of a class specified in Schedule 16C or otherwise are incidental to
such transactions. As in the ‘classic’ offshore funds exemption regime, specified transactions
still need to be carried out through or arranged by specified persons or, otherwise, the fund
in question must be a qualified investment fund as defined in s.20AN(6), that is, a widely held
collective investment scheme. Schedule 16C specifies the following 11 classes of asset:

1. Securities.
2. Shares, stocks, debentures, loan stocks, funds, bonds or notes of, or issued by, a
private company.

3. Futures contracts.

4. Foreign exchange contracts under which the parties to the contracts agree to exchange
different currencies on a particular date.

5. Deposits other than those made by way of a money lending business.

6. Deposits (as defined by s.2(1) of the Banking Ordinance [Cap.155]) made with a bank
(as defined by Part 1 of Schedule 1 to the Securities and Futures Ordinance [Cap.571]).

7. Certificates of deposit (as defined by Part 1 of Schedule 1 to the Securities and Futures
Ordinance [Cap.571]).

8. Exchange-traded commodities.

9. Foreign currencies.

10. OTC derivative products (as defined by Part 1 of Schedule 1 to the Securities and
Futures Ordinance [Cap.571]).

11. An investee company’s shares co-invested by a partner fund and the Innovation and
Technology Venture Fund Corporation under the Innovation and Technology Venture
Fund Scheme.

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The exemption extends to special purpose entities – that is, entities constituted for the
purposes of the fund’s collective investment scheme operations – from paying profits tax on
their assessable profits in relation to transactions in shares in private companies.

As is the case with many tax incentive regimes, there are anti-avoidance measures in
place to prevent misuse of the exemption. Ss.20AP and 20AQ establish certain limitations
on investments a fund has to meet for it to remain exempt from profits tax. These
relate to investments, known in the funds exemption regime as ‘specified securities’ in
private companies. Specified securities for these purposes are not limited to shares,
but include stocks, debentures, loan stocks, funds, bonds, or notes of or issued by the
investee company.

1. The immovable property test, which does not exempt from profits tax any transaction
whereby a fund disposes of an interest in an investee private company that holds more
than 10% of its assets in immovable property (excluding infrastructure) in Hong Kong
or otherwise even if not more than 10% of its asset value is derived from Hong Kong
immovable property, the interest in the investee company in question has been held by
the fund for less than two years prior to its disposal (s.20AP); and

2. The short-term asset tests, which provides that where the subject matter of the
disposal is an interest in a private company, the fund must have held that interest for at
least two years unless the fund does not have a controlling stake in the private company
or the fund has a controlling stake but the private company in question does not hold
more than 50% value of its assets in short-term assets (being those assets held for
fewer than three years at the time of the transaction) (s.20AQ).

The purpose of those provisions is to encourage a diversified and long-term approach to

investment in private companies. It was considered contrary to public policy to extend the
exemption to disposals of interests in private companies on a speculative or short-term basis,
or otherwise to companies that are in essence Hong Kong real estate companies.

S.20AS provides for a further specific limitation to the scope of the exemptions in s.20AN,
where the fund in question is an open-ended fund company and it trades directly in Hong Kong
assets that are not assets specified in Schedule 16C or otherwise holds such assets to generate
income. This is in essence an anti-avoidance provision, aimed at preventing an open-ended
fund company from directly dealing in or holding by way of revenue generation Hong Kong
situs assets other than the assets designated as ‘appropriate’ collective investment scheme
assets in Schedule 16C and avoiding Hong Kong tax thereon.

Under s.20AU, losses arising to a fund or an exempt special purpose entity from
transactions in specified assets as defined in Schedule 16C will not be available for set off
against the taxable profits, if any, of such fund or special purpose entity. This is a tax symmetry
provision; you will recall that losses are the mirror image of profits. It would follow that if the
profits of a given transaction are not taxable, losses arising from the same class of transactions
should not be available for set off against assessable profits.

3.10.6.4 Corporate Treasury Centres

A corporate treasury centre (CTC) is in summary an intra-group bank. It is a company within
a group that exercises the function of financing other group companies: It borrows from and
lends to other group companies, often at interest. Note that pursuant to the introduction

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of transfer pricing rules in Hong Kong, there is an expectation on the part of the IRD that
arrangements between associated companies, relevantly including loan relationships, be made
on an arm’s length basis (s.50AAF).

An intra-group financing business is when a corporation borrows money from and lends
money to its associated corporations in the ordinary course of its business. This means that the
corporation borrows money from and lends money to its associated corporations regularly as a
business with a view to earning an interest margin. An associated corporation is a corporation,
which is either controlled by or the controller of the putative CTC, or where both the CTC and
its corporate borrower / lender are under the control of the same third corporation (s.14C).
Whether a corporation is carrying on an intra-group financing business is a mixed question
of fact and law to be determined following the same principles outlined earlier in this chapter
to establish whether a person carries on a trade, profession or business. See, for example,
Shun Lee Investment Co Ltd v CIR (1967) HKLR 712 and CIR v Chinachem Finance Co Ltd (1993)
1 HKLR 136.

The concessionary tax regime for CTC applies to CTCs that meet the statutory requirements
for the concession and are so termed ‘qualifying CTCs’ (QCTC). Qualifying profits derived from
CTC activities carried on by QCTCs are subject to profits tax at one-half of the standard rate
(currently 8.25%) as stipulated in s.14D(1). The concession applies only to such profits as are
generated from intra-group lending transactions or provision of corporate treasury services
or are derived from corporate treasury transactions as defined in Schedule 17B. S.14C is the
relevant definitional section and defines a corporate treasury activity as one of: carrying on
an intra-group financing business; providing a corporate treasury service; or entering into a
corporate treasury transaction. An intra-group financing business is defined in s.14C as the
business of borrowing money from and lending money to associated corporations. That same
section defines an intra-group lending transaction as a transaction under which a corporation
lends money in the ordinary course of its intra-group financing business to an associated
corporation. A corporate treasury service is defined in s.1 of Schedule 17B and a corporate
treasury transaction is defined in s.2 of Schedule 17B.

An intra-group lending transaction in relation to a corporation means a transaction under

which the corporation lends money, in the ordinary course of its intra-group financing business,
to its associated corporation (s.14C(1)).

Corporate treasury services are defined in s.1 of Schedule 17B as:

a. Managing the cash and liquidity position, including cash forecasting or pooling, of the
associated corporation and providing related advice;

b. Processing payments to the vendors or suppliers of the associated corporation;

c. Managing the associated corporation’s relationships with financial institutions;

d. Providing corporate finance advisory service, including

(i) Activities supporting the raising of capital, such as by way of debt or equity, by the
associated corporation; and

(ii) Capital budgeting for the associated corporation;

e. Advising on the management of the investment of the funds of the associated

corporation;

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f. Managing investor relations regarding the investors in the debt or equity instruments
issued by the associated corporation;

g. Providing service in relation to

(i) The provision of guarantees, performance bonds, standby letters of credit or other
credit risk instruments to or on behalf of the associated corporation; or

(ii) Remittances to or on behalf of the associated corporation;

h. Providing advice or service in relation to the management of interest rate risk, foreign
exchange risk, liquidity risk, credit risk, commodity risk or any other financial risk of the
associated corporation;

i. Providing assistance in the merger or acquisition of a business by the associated

corporation;

j. Providing advice or service in relation to the associated corporation’s compliance with

(i) Accounting standards;

(ii) Internal treasury policies; or

(iii) Regulatory requirements in relation to treasury management;

k. Providing advice or service in relation to the operations of the treasury management

system of the associated corporation;and

l. Providing business planning and co-ordination, including economic or investment

research and analysis, for the associated corporation in connection with any of the
activities specified in paragraphs (a) to (k).

Illustrative Example 85 – Corporate Treasury Services

(Adapted from DIPN No. 52, Example 20)

CTC-HK is a QCTC within a multinational group of companies. It provided to its associated

corporations the following services:

a. Providing advice in relation to the management of the associated corporation’s

bank accounts and related documentation;

b. Providing advisory service to the associated corporation on its asset-liability

management and formulation of dividend policy; and

c. Providing assistance to the associated corporation in relation to its acquisition of

another associated corporation’s business.

All the above services could be treated as corporate treasury services:

(i) Item (a) was related to the management of the cash and liquidity position of the
associated corporation and therefore was covered by s.1(1)(a) of Schedule 17B.

(ii) Item (b) was a normal activity in capital budgeting falling within s.1(1)(d) of
Schedule 17B.

(iii) The service in item (c) was related to the acquisition of a business by CTC-HK’s
associated corporation and was covered by s.1(1)(i) of Schedule 17B.

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A corporate treasury transaction is defined in s.2 of Schedule 17B as any of the following
transactions that is entered into by the corporation on its own account and related to the
business of an associated corporation:

a. A transaction in relation to the provision of guarantees, performance bonds, standby

letters of credit, or other credit risk instruments in respect of the borrowing of money
by the associated corporation.

b. A transaction investing the funds of the corporation or the associated corporation in

any of the following financial instruments for managing the cash and liquidity position
of the corporation or the associated corporation:

(i) Deposits;

(ii) Certificates of deposit;

(iii) Bonds;

(iv) Notes;

(v) Debentures;

(vi) Money-market funds; and

(vii) Other financial instruments (except securities issued by a private company as

defined by s.20ACA(2)).

c. A transaction in respect of any of the following contracts that are entered into for the
purpose of hedging interest rate risk, foreign exchange risk, liquidity risk, credit risk,
commodity risk, or any other financial risk of the associated corporation:

(i) Contracts for difference;

(ii) Foreign exchange contracts;

(iii) Forward or futures contracts;

(iv) Swap contracts; and

(v) Options contracts.

d. A factoring or forfaiting transaction.

In practice, this means that most transactions and operations relating to the management
of intra-group loan relationships, liquidity, hedging etc. will be treated as CTC qualifying
activities and therefore in principle eligible for the reduced rate of profits tax.

The concessionary rate of tax is available to the extent the CTC is a QCTC by meeting one of
the following conditions:

• It has carried out in Hong Kong one or more corporate treasury activities AND has not
carried out in Hong Kong any activity other than a corporate treasury activity;

• It falls within the safe harbour rule in s.14E (see below) by virtue of a specified minimum
threshold of its profits from all sources arising from corporate treasury profits or a
specified minimum threshold of its assets being corporate treasury assets; or

• It has been determined to be a CTC by the Commissioner under s.14F – in order to be

eligible for such a determination the CTC cannot be a financial institution and it must
not otherwise be eligible for treatment as a qualifying CTC.

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There is also the central management and control requirement, which ensures that
the executive officers and senior management employees of the QCTC exercise day-to-day
responsibility for more of the strategic, financial and operational policy decision-making for the
QCTC in Hong Kong and conduct more of the day-to-day activities necessary for preparing and
making those decisions in Hong Kong, than in any other jurisdiction.

Safe Harbour Rule Under s.14E

Even though a CTC carries out other activities in Hong Kong, it may still be regarded as a
QCTC for a year of assessment if it satisfies either one of the prescribed safe harbour rules
as follows.

a. 1-year safe harbour – the percentages of its corporate treasury profits (CTP
percentage) and corporate treasury assets (CTA percentage) are not lower than the
prescribed percentages as set out in ss.3 and 4 of Schedule 17B (i.e. 75%) (ss.14E(1)(a)
and (2)); or

b. Multiple-year safe harbour – the average percentages of the CTP and CTA for the
subject year of assessment and the preceding one* or two years of assessment are not
lower that the prescribed percentages as set out in ss.3 and 4 of Schedule 17B (i.e. 75%)
(ss.14E(1)(b), (3) and (4)).
(* if the CTC carries on a business in Hong Kong for less than two years)

‘Corporate treasury profits’ means any profits that are derived from a corporate treasury
activity. In general, corporate treasury profits will be based on the accounting profits per
audited statement of income irrespective of the source of the profits. The IRD expects the CTC
would fulfil the transfer pricing rules laid down in DIPN No. 46. The IRD might exclude loss
incurred from a corporate treasury activity in computing the CTP percentage if it considers such
loss is resulted from a non-arm’s length transaction.

‘Corporate treasury assets’ mean assets used to carry out a corporate treasury activity,
which may include the following:

a. Interest-bearing intercompany loans and receivables;

b. Cash and cash equivalents;

c. Investments made out of surplus fund for liquidity management;

d. Contracts for difference, foreign exchange contracts, forward or futures contracts, swap
contracts, options contracts for hedging financial risks of associated corporation; and

e. Fixed assets such as business premises and office equipment, used to carry out
corporate treasury activities.

The asset values will be based on the audited statement of position, regardless of the
location of the assets. Generally, intangible assets, which are not recorded in the statement of
position will not be included as corporate treasury assets. Apportionment may be accepted if
only part of the assets is used for carrying out a corporate treasury activity.

If a holding company also acts as a CTC, the Commissioner is prepared to exclude the
equity investments in associated corporations and dividends from the denominators (i.e. total
profits or assets) in calculating the CTP and CTA percentages.

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Illustrative Example 86 – Safe Harbour Rule

(Adapted from DIPN No. 52, Example 21)

QCTC-HK claimed the half rate concession for Year 4. It had the following track record:

Year Business activity in Hong Kong

Year 1 Active business
Year 2 Dormant business
Year 3 Active business
Year 4 Active business

Though QCTC-HK had three years of active business operations in Hong Kong, it
was dormant in Year 2, leaving it with just one year prior to the subject year. Therefore,
QCTC-HK would be regarded as having two years of track record. The average CTP and
CTA percentages would be computed based on the audited financial statements for
Years 3 and 4.

CTP percentage CTP/P

Where:

CTP means the aggregate amount of the corporate treasury profits of the
corporation in the basis period for the year of assessment; and
P means the aggregate amount of profits accruing to the corporation from
all sources, whether in Hong Kong or not, in the basis period for the year of
assessment.

CTA percentage CTA/A

CTA means the aggregate value of the corporate treasury assets of the corporation
as at the end of the basis period for the year of assessment; and
A means the aggregate value of all assets, whether in Hong Kong or not, of the
corporation as at the end of the basis period for the year of assessment.

Deduction of interest expenses

Borrowing by a corporation carrying an intra-group financing business guarantees the
deductibility of interest payable in respect of that borrowing for the purposes of s.16(1), subject
to the following specified conditions in s.16(2)(g):

(i) The deduction claimed is in respect of interest payable by it on money borrowed from a
non-Hong Kong associated corporation (lender) in the ordinary course of that business;

(ii) The lender is, in respect of the interest, subject to a similar tax in a territory outside
Hong Kong at a rate that is not lower than the reference rate; and

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(iii) The lender’s right to use and enjoy that interest is not constrained by a contractual or
legal obligation to pass that interest to any other person unless the obligation arises
as a result of a transaction between the lender and a person other than the borrower
dealing with each other at arm’s length.

For the purposes of s.16, an intra-group financing business is defined as, in relation to a
corporation, a business of the borrowing of money from and lending of money to an associated
corporation (i.e. in effect a CTC, though note that the two definitional criteria do not always
coincide).

With a view to securing tax symmetry, s.15(1)(ia) deems to be chargeable to profits tax
sums not otherwise chargeable under s.14 received by or accrued to a corporation (other than
a financial institution) by way of interest that arises through or from the carrying on in Hong
Kong by the corporation of its intra-group financing business within the meaning of s.16(3) even
if the moneys in respect of which the interest is received or accrues are made available outside
Hong Kong (i.e. not Hong Kong source).

Illustrative Example 87 – Exclusion from Qualifying Profits

(Adapted from DIPN No. 52, Example 23)

QCTC is a corporation resident in Hong Kong with corporate treasury activities carried
out or arranged to be carried out in Hong Kong. The profits of the QCTC for a particular
year of assessment comprised the following items:

HK$m HK$m
Profits from corporate treasury activities relating to HK associated 20
corporations
Qualifying profits
• Interest derived from bonds issued by a company carrying 5
on business in HK with funds obtained from non-Hong Kong
associated corporations
• Interest derived from overseas bank deposit placements with 8
funds obtained from non-Hong Kong associated corporations
• Dividends derived from securities listed in HK with funds obtained 12
from non-Hong Kong associated corporations
25
Total profits 45

Since the Hong Kong company would claim deduction of the interest payable under
the bonds issued to the QCTC under profits tax, the interest received of HK$5 million
would be taxed at full rate. The interest derived from overseas bank deposit placements
of HK$8 million would be taxed at half rate while the dividends of HK$12 million would
remain exempt from profits tax under s.26(a).

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3.10.6.5 Ship and Aircraft Owners

Shipowners
There is a specific taxing regime for ship and aircraft owners. This section does not, apparently,
apply to ship leasing. There is a separate tax code for qualifying ship leasing and ship leasing
management activities in ss.14O–14ZB, which provide for tax concessions and exemptions,
subject to the qualifying conditions stipulated therein. S.23B otherwise governs the taxability of
shipping income. Generally speaking, the following sources of income are not taxable:

1. Income arising from the carriage on board a Hong Kong registered ship of passengers,
mail, livestock and goods on an ocean-going voyage;

2. Towage received by a Hong Kong registered ship embarking on an ocean-going voyage

from Hong Kong;

3. All charter hire from the operation of ships outside the waters of Hong Kong and the
Pearl River Delta; and

4. Profits which qualify for the reciprocal exemption provided by s.23B(4A).

Taxable shipping income defined in s.23B(12) as ‘relevant sums’ in general includes:

1. Carriage income referable to uplifts of passengers, mail, livestock and goods (but
excluding goods in transit and re-embarking passengers) derived from Hong Kong;

2. Towage income attributable to towage within Hong Kong waters and from Hong Kong
waters to places within the Pearl River Delta;

3. Dredging operation undertaken by a ship within the waters of Hong Kong;

4. Charter hire income earned from charters within and between places located within
Hong Kong waters; and

5. Half the total charter hire income received from the operation of ships between
Hong Kong waters and places within the Pearl River Delta.
In determining the relevant sums earned or accrued to a person during a basis period for
a year of assessment, the exempt sums are to be excluded if in that period the activities that
produce the exempt sums are carried out in Hong Kong by that taxpayer or otherwise arranged
by the taxpayer to be carried out in Hong Kong (s.23B(4AA)).

Note that shipowners resident or incorporated in the United States, Germany, Netherlands,
Norway, Denmark, Sri Lanka, Singapore and the United Kingdom (as well as other jurisdictions
with which Hong Kong has concluded DTAs) may benefit from exemption from Hong Kong tax
by virtue of the relevant DTA or shipping income agreement.

The chargeable person is either the owner or the charterer of a ship who carries on a
business of chartering or operating ships in Hong Kong.

A shipowner is deemed to be carrying on a business of chartering or operating ships in

Hong Kong if:

a. The business is normally controlled or managed in Hong Kong;

b. The person is a company incorporated in Hong Kong; or

c. Is, in any other case, any ship owned by the shipowner calls at any location within the
waters of Hong Kong (For non-resident, casual calls may be ignored).

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Shipping dealing business or shipping agency business are excluded under s.23B but
calculated under s.14.

• Assessable Hong Kong Shipping profits under s.23B is:

Relevant sums
Total shipping profits
Total shipping income

• Or, if not satisfactory:

Relevant sums fair % to be determined by CIR

• Total shipping profits is the worldwide shipping profits adjusted by the provisions under
Part 4 where appropriate.

• Total shipping income refers to the worldwide income from the operation of a
shipping business but excludes ship dealing income, ship agency income and other
investment income.

The quantum of the relevant sum (RS) and its tax treatment depend on whether the ship is
registered in Hong Kong or overseas, for which see Exhibit 3.11.

HK Overseas
registered registered
(i) Any sums derived from:
(a) Goods/passengers shipped in HK and RS RS
transported to other locations in HK
(b) Goods/passengers shipped in HK and transported to RS RS
ports within river trade limitsa but excludes re-embarking
passengers and goods in transit
(c) Goods/passengers shipped in HK and transported to Non-RS RS
foreign ports but excludes re-embarking passengers and
goods in transit
(d) Goods/passengers shipped in ports outside HK and Non-RS Non-RS
transported to HK
(e) Any voyage(s) of a ship commencing from any location RS RS
within the HK waters re charter hire income relates to
only part of a ship
(f) Any voyage(s) of a ship commencing from any location Non-RS Non-RS
outside HK waters re charter hire income relates to only
part of a ship

EXHIBIT 3.11 Relevant sum and tax treatments for ships registered in Hong Kong or overseas

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HK Overseas
registered registered
(ii) Any sums derived from:
(a) Towage operations within the HK waters RS RS
(b) Towage operations from HK to locations RS RS
within river trade limits
a

(c) Towage operations from HK to overseas Non-RS RS

locations outside river trade limits a

(d) Towage operations from overseas locations to HK Non-RS Non-RS

(iii) Any sums derived from:
(a) Dredging operations within the HK waters RS RS
(b) Dredging operations outside the HK waters Non-RS Non-RS

(iv) Any sums derived from any charter hire relating to whole of a
ship in respect of
(a) Operation of a ship solely/mainly in HK waters RS RS
(b) Charter party with limited partnership RS RS
(c) Operation of a ship between HK waters and 50%RS 50%RS
those within the river trade limitsa

(d) Operation of a ship between HK waters and those Non-RS Non-RS

outside the river trade limitsa or solely
or mainly outside HK waters

a
river trade limits refers to ports within the Pearl River Delta including Macau

EXHIBIT 3.11 (Continued)

Definitions of the relevant terms are as follows:

• ‘Shipped in HK’ means embarked or loaded within the waters of HK.

• ‘Charter hire’ means any sums earned by or accrued to a shipowner under a charter
party for the operation of the ship. Sums earned or accrued under a charter party
which does not extend to the whole of ship are not ‘charter hire’, but nevertheless
would be regarded as ‘carriage receipts’.

• Note that under the s.23B(4A), a person who has ‘reciprocity status’ is entitled to a
tax exemption, similar to HK registered ships, on those shipping incomes mentioned
in (i)(c) and (ii)(c) above. People have ‘reciprocity status’ if it is resident in any territory
outside Hong Kong, and is subject to Hong Kong profits tax under s.23B(2) (i.e. solely
because they own ships which call at Hong Kong) plus the person’s home territory
offers a tax exemption of substantially the same nature as Hong Kong profits tax to
shipowners controlled, managed or incorporated in Hong Kong in respect of income
derived from a shipping business carried on in that territory.

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Illustrative Example 88 – Shipping Business

Future Shipping Ltd is a shipping company incorporated in Hong Kong, which owns and
operates a fleet of cargo ships. All the company’s ships are registered in Hong Kong.
Future Shipping also runs shipping agencies in Hong Kong, Tokyo and Taiwan. The
Taiwan agency has no autonomy to negotiate and conclude contracts.

The accounts of the company for the year ended 31 December 2020 show:

(i) Total receipts for the carriage of goods:

Goods shipped in HK and transported to ports within river trade HK$15,000,000
limits
Goods shipped outside HK and transported to HK HK$15,000,000
Goods shipped in HK and transported to foreign ports HK$6,000,000
(ii) Charter hire receipts for ships operating in HK waters:
Charter parties arranged by HK office HK$1,500,000
Charter parties arranged by Tokyo office (a PE outside HK) HK$750,000
Charter parties arranged by Taiwan office HK$750,000
(iii) Charter hire receipts for ships operating between Hong Kong HK$600,000
waters and the Pearl River – charter parties arranged by HK office
(iv) Deductible expenses HK$15,000,000

1. Total shipping profits:

Total shipping income HK$39,600,000

Less: Deductible expenses (15,000,000)
Total shipping profits HK$24,600,000

2.

Relevant Shipping
sums income
Receipts for the carriage of goods:
Goods shipped in HK and transported to ports within
river trade limits HK$15,000,000 HK$15,000,000
Goods shipped outside HK and transported to HK – HK$15,000,000
Goods shipped in HK and transported to foreign ports – HK$6,000,000
Charter hire receipts for ships operating in HK waters:
For charter parties arranged by HK office HK$1,500,000 HK$1,500,000
For charter parties arranged by Tokyo office HK$750,000 HK$750,000
For charter parties arranged by Taiwan office HK$750,000 HK$750,000
For ships operating between Hong Kong waters and
the Pearl River HK$300,000 HK$600,000
HK$18,300,000 HK$39,600,000

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Illustrative Example 88 (continued)

3. Assessable shipping profits:

HK$18, 300, 000

HK$24 , 600, 000 HK$11,368,182
HK$39, 600, 000

Aircraft Owners
The taxation of the profits of aircraft owners is set out in s.23C for resident aircraft owners
and in s.23D for non-resident aircraft owners. Conceptually, those regimes are similar to that
which applies to shipowners to the extent that assessable profits consist of a proportion of
worldwide profits arrived at by the formula in s.23C(2) for resident airlines and s.23D(2) for
non-resident airlines. A resident aircraft owner is defined as a person whose business of being
an aircraft owner is normally controlled or managed in Hong Kong or the aircraft owner is a
company incorporated in Hong Kong. A non-resident aircraft owner for the purposes of the
IRO is a person other than a resident aircraft owner whose aircraft land at any aerodrome
or airport in Hong Kong. There is no equivalent to the exemption in s.23B for Hong Kong
registered ships.

The chargeable person is either the owner or the charterer of an aircraft who carries on a
business of chartering or operating aircraft in Hong Kong.

S.23C applies to a ‘resident’ aircraft business. An aircraft owner is deemed to be carrying on

a business of chartering or operating aircraft in Hong Kong if:

(a) The business is normally controlled or managed in Hong Kong; or

(b) The person is a company incorporated in Hong Kong.

S.23D applies to ‘non-resident’ aircraft business of any aircraft landing at any aerodrome or
airport within Hong Kong. Casual landing may be ignored by the CIR.

Aircraft business excludes aircraft dealing or agency business.

The assessable profits is calculated by the following formula:

Relevant sums
Total aircraft profits
Total aircraft income

• Total aircraft profits are the worldwide aircraft profits adjusted by the provisions under
Part 4 where appropriate.

• Total aircraft income refers to the worldwide income from the operation of an aircraft
business but excludes aircraft dealing income, aircraft agency income and other
investment income.

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Relevant sums mean sums derived from:

a. The carriage of passengers and/or shipped in Hong Kong,# but excludes the carriage of
goods or passengers in transit, including the following sums from a charter party:

(i) Where the charter party (whether by demise* or not) does not extend to the whole
of the aircraft and the sums are derived from outward flights commencing in
Hong Kong.

(ii) Where the charter party is a flight charter but is not by demise* and the sums are
derived from flights commencing in Hong Kong.

(iii) Where the charter party is a time charter but is not by demise* and the sums are in
respect of outward flights commencing in Hong Kong. The sums are computed as a
portion of the total income under the charter party by:

Total flying hours for outward

flights commencing in Hong Kong
Total income from the charter-party
Total flying hourss

b. Charter hire under a charter-party by demise* which extends to the whole of the
aircraft in respect of:

(i) Flights between aerodromes or airports within Hong Kong; and

(ii) Flights between Hong Kong and Macau but only at 50%.

c. Charter hire excludes those in (ii) above and other than that attributable to a
permanent establishment outside Hong Kong in respect of a charter party by demise*
which extends to the whole of the aircraft.

Note that for ‘non-resident’, the charter hire under item (iii) is limited to that
attributed to a permanent establishment in Hong Kong.

d. For ‘resident’ aircraft business only, the relevant sums include:

(i) Any sums derived from carriage of passengers and/or goods shipped aboard an
aircraft at any aerodrome or airport within an ‘arrangement territory’;

(ii) Any relevant charter hire attributable to an ‘arrangement territory’; and

(iii) Charter hire in respect of the operation of an aircraft flying between aerodromes or
airports within an ‘arrangement territory’.

e. ‘Arrangement territory’ means a territory outside Hong Kong which:

(i) Has entered into a double taxation agreement/arrangement with Hong Kong
pursuant to s.49; and

(ii) Under which an aircraft owner to which s.23C applies is exempt from tax in that
territory on sums derived from the uplift of goods and passengers in that territory
and charter hire income attributable to that territory.*

#
‘Shipped in Hong Kong’, means shipped abroad an aircraft at any aerodrome or airport within Hong Kong.
*
‘A charter party by demise’ means a charter party under which the charterer has the possession of the
aircraft and has sole control of all matters relating to the flying and operation of the aircraft including the
employment of the air crew members.

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Illustrative Example 89 – Aircraft Business

Trust Aircraft Ltd is an aircraft company incorporated in Hong Kong, which owns a fleet
of passenger aircraft, including a helicopter, which the company charters under time
charter parties from time to time. During year ended 31 December 2020, the helicopter
flew for a total of 2,000 hours with 1,500 hours included therein were flown on time
charter commencing from Hong Kong. Trust Aircraft Ltd had appointed a fully authorised
agent in Korea to negotiate and conclude contracts on its behalf.

The following information is extracted from the accounts of Trust Aircraft Ltd for the
year ended 31 December 2020:

(i) Total income for the carriage of passengers:

Passengers embarked in HK HK$30,000,000

Passengers embarked outside HK HK$15,000,000

(ii) Charter hire income:

Charter parties concluded by HK office for aircraft operating HK$30,000,000

within HK
Charter parties concluded by HK office for aircraft operating HK$30,000,000
between HK and Macau
Charter parties concluded by Korean agent HK$15,000,000
Time charter of helicopter HK$3,000,000

(iii)

Deductible expenses HK$12,000,000

Profits Tax computation for the 2020/21 (basis period: Year ended 31.12.2020):

(1) Total aircraft profits:

Total aircraft income HK$123,000,000

Less: Deductible expenses (12,000,000)
Total aircraft profits HK$111,000,000

(2)

Relevant Aircraft
sums income
Income for carriage of passengers HK$ HK$
Passengers embarked in HK 30,000,000 30,000,000
Passengers embarked outside HK — 15,000,000
Time charter (3,000,000 × 1,500 ÷ 2,000 hours) 2,250,000 3,000,000

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Illustrative Example 89 (continued)

Relevant Aircraft
sums income
Charter hire income
Charter party concluded by HK office and aircraft 30,000,000 30,000,000
operating within HK
Charter party concluded by HK office and aircraft 15,000,000 30,000,000
operating between HK and Macau
Charter party concluded by Korean agent — 15,000,000
77,250,000 123,000,000

(3) Assessable profits:

HK$77, 250, 000

HK$111, 000, 000 HK$69,713,415
HK$123, 000, 000

3.10.6.6 Aircraft Leasing Company and Aircraft Leasing Manager Company

Qualifying Aircraft Leasing Company
As regards the concession for aircraft leasing profits, the policy basis for this was the centrality
of air travel to Hong Kong’s economy: The city is one of the major global transit hubs. The
purpose of the concession was to make aircraft leasing activities carried on in Hong Kong more
attractive relative to competitors such as Singapore.

Under the profits tax concession for aircraft leasing, the profits derived by: (i) qualifying
aircraft lessors and (ii) qualifying aircraft leasing managers from qualifying activities, as defined,
are eligible to be taxed at the concessionary rate and any profit arising from the sale of an
aircraft is exempt from profits tax where the aircraft has been used to carry out qualifying
aircraft leasing activities for a continuous period of no less than three years immediately prior
to its disposal.

A qualifying aircraft lessor is defined as a corporation of which the central management

and control is exercised in Hong Kong, whose activities, from which qualifying profits are
derived, are carried out in Hong Kong or otherwise arranged by the corporation to be carried
out in Hong Kong and not in any event carried out by a PE outside of Hong Kong (s.14H(4)).
A qualifying aircraft lessor cannot be an aircraft operator (as defined in s.14G)), and its
activities in Hong Kong must exclusively be qualifying aircraft leasing activity (s.14H(2)).
Further note that a qualifying lease for these purposes is limited to a ‘dry lease’, which
in aerospace jargon refers to a bona fide lease of the aircraft itself, not including crew,
insurance and maintenance.

S.14H provides that a corporation that is a qualifying aircraft lessor for a year of assessment
is entitled to have its profits derived from its qualifying aircraft leasing activity (and not,
therefore, its profits generally) for that year of assessment charged at one-half of the profits tax
rate specified in Schedule 8 to the Ordinance (i.e. the concessionary rate). Since tax is charged

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on a deemed 20% taxable basis, the net effect of the concession is that net lease rentals are
charged at an effective profits tax rate of 1.65% (s.14I and Schedule 17F). In addition, given
that depreciation allowances are not available on the cost of the aircraft under s.14G(7), no
balancing charge arises on the disposal of the aircraft. S.14G(6) provides that an aircraft leasing
activity is a qualifying aircraft leasing activity only if the activity is carried out in the ordinary
course of the lessor’s business carried on in Hong Kong and the aircraft in question is owned by
the corporation when the activity is carried out; hence, an arrangement including outright sale
would fall outside the scope of the concessionary regime.

Qualifying Aircraft Leasing Manager Company

S.14J specifies that a corporation that is a qualifying aircraft leasing manager for a year
of assessment is entitled to have its profits derived from its qualifying aircraft leasing
management activity (and not, therefore, its profits generally) for that year of assessment
charged at the concessionary rate, that is 8.25%. As is the case for the aircraft leasing regime,
the concession is subject to certain conditions, the most relevant of which are that the central
management and control of the corporation be exercised in Hong Kong, the activities that
produce its qualifying profits in that year are carried out in Hong Kong by the corporation or
arranged by the corporation to be carried out in Hong Kong and in any event not be carried out
by a PE outside of Hong Kong.

An applicable aircraft leasing management activity is defined in s.1(1) of Schedule 17F.

Such activities are qualifying aircraft leasing management activities for the purposes of the
concession if the following conditions in s.14G(7) are met:

(i) The activity is carried out in the ordinary course of the corporation’s business carried on
in Hong Kong;

(ii) The activity is carried out for another corporation in the basis period of the other
corporation for a year of assessment;

(iii) The other corporation is a qualifying aircraft lessor for that year of assessment; and

(iv) The aircraft is owned by the other corporation, and is leased to an aircraft operator,
when the activity is carried out.

By way of tax symmetry provisions, s.15(1)(n) deems sums received by or accrued to a

corporation from carrying on certain businesses in connection with aircraft as being chargeable
to profits tax, even if the aircraft in question is used outside Hong Kong.

Further guidance on the application of the concessionary regime for aircraft leasing may be
found in DIPN No. 54 – Taxation of Aircraft Leasing Activities, issued in October 2017.

3.10.6.7 Clubs and Associations
S.24 provides for the taxation of clubs and other associations. The IRO does not contain a
definition of a ‘club ’. In general, a club is a voluntary association of persons who agree to
maintain for their common personal benefit, and not for profit, an establishment the expenses
of which are to be defrayed by equal contributions of an amount estimated to be sufficient to
defray those expenses and the management of which is entrusted to a committee chosen by
themselves (Bohemian Club v FCT (1918) 24 CLR 334). In Kowloon Stock Exchange Ltd v CIR (1985)
2 HKC 421, the Privy Council concluded that an association that aimed to make a profit for its
members could not be a club within the meaning of s.24.

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The taxation of clubs follows the basic rule that if it receives from its members not less than
half of its gross receipts on revenue account (including entrance fees and subscriptions), the
club or association in question is deemed not to carry on a business. Under s.24(3), ‘members’
means those persons entitled to vote at a general meeting of the club, or similar institution, or
trade, professional or business association. Nevertheless, if less than half of its gross receipts
are received from members, the whole of the income from transactions both with members
and others (including entrance fees and subscriptions) are deemed to be receipts from a
business, and such person shall be chargeable to profits tax in respect of the profits therefrom.
There is a tax symmetry provision in s.24(2), which provides that where a person carries on
a trade, professional or business association in such circumstances that more than half its
receipts by way of subscriptions are from persons who claim or would be entitled to claim
that such sums were allowable deductions for the purposes of s.16, the club or association
in question is deemed to carry on a business, and the whole of the income of such club or
association from transactions both with members and others (including entrance fees and
subscriptions) are deemed to be chargeable to profits tax.

Even if a club is not subject to profits tax pursuant to s.24, it may still be chargeable to other
taxes (e.g. property tax on rental income derived from property situated in Hong Kong).

Illustrative Example 90
The Honey Producers Sports Club owns a block of flats in Yuen Long, which is used
partly for club activities and partly for leasing out to the public. The treasurer of the club
provides you with a summary of the gross receipts from members and non-members for
the year ended 31 March 2019:

Voting Non-voting Non-members

members members
HK$ HK$ HK$
Entrance fees 1,950,000
Annual subscriptions 1,021,500 810,000
Revenue from café 1,004,400 740,100
Rental from property 772,350
Hire of hall and equipment 141,000
Miscellaneous sales 20,250 11,700 _______
3,996,150 1,561,800 913,350

Total gross receipts from voting members = HK$3,996,150

Total gross receipts of the Club = HK$6,471,300

% of gross receipts from voting members = 61.8%

As the club received more than half of the gross revenues from voting members, it
is deemed not to carry on business and is not chargeable to profits tax under s.24(1).
However, it is still liable to property tax in respect of rental income from non-members.

Property tax payable: HK$772,350 × 80% × 15% = HK$92,682

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Key Learning Point

Special classes of business such as financial institutions, aircraft and shipowners, and
insurance companies are taxed according to discrete taxing regimes specifically for those
industries. These are important derogations from the general charging provision in s.14.

3.10.6.8 Hong Kong Branch of an Overseas Company

As we have already discussed in Section 3.2.4, a branch is a PE. Generally, transfer pricing
rules apply to PEs in Hong Kong by virtue of either a DTA (generally Article 7, known as the
business profits article) having effect or under Rule 2 of the domestic transfer pricing regime in
s.50AAK. That means that profits and losses should be allocated to the PE for tax computation
purposes on the basis that the PE and the head office of the overseas company are two
separate enterprises, acting independently. The allocation of profits will reflect, among other
things, the functions undertaken by each of the head office and PE, the level of value addition,
the assumption of risk, the ownership of capital etc. In arriving at the computation of profits
to allocate to a Hong Kong PE, so much expenditure as is attributable to the PE is allowable as
a deduction under the general rules in ss.16 and 17. It is important to note that s.50AAK and
the relevant business profits articles in DTAs operate to allocate taxing rights. Merely because
taxing rights are allocated to Hong Kong does not mean that Hong Kong must tax those profits.
It must independently be determined whether such profits are chargeable to tax under the IRO.

Ss.49(1A) and 49(1C) together provide for a treaty override of Hong Kong domestic
legislation. That means that where a person is resident in a jurisdiction which has a DTA with
Hong Kong and its presence in Hong Kong does not amount to a PE, the profits of that person
will never be taxable in Hong Kong, because the DTA will allocate the taxing rights exclusively to
the jurisdiction of residence in the absence of a Hong Kong PE. This is an important exception
to the general charging provision in s.14.

Key Learning Point

A PE is treated as a separate taxable entity even if it is not a separate taxable person.
You should refer either to the relevant DTA or to s.50AAK to determine the basis on which
profits should be allocated to a Hong Kong PE of a non-resident person.

Illustrative Example 91
Ah Toh Ltd (ATL), a company incorporated in Singapore, deals in high street and casual
fashion. Having gained some success in South East Asia, it wishes to expand into
Hong Kong and, for those purposes, establishes a retail branch in Wanchai. That branch
is a PE of ATL in Hong Kong. Because there is no DTA between Hong Kong and Singapore,
the domestic PE and transfer pricing rules apply. That means that so many of the profits
as are attributable to the Hong Kong branch of ATL on an arm’s length basis will be
regarded as generated by the Hong Kong branch and, assuming that meet the three
conditions in s.14, will accordingly be charged to profits tax. Similarly, such expenditure
as is attributable to the operations of the Hong Kong branch of ATL will be allowable as a
deduction in computing the liability of the branch to profits tax.

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Knowledge Check Questions

Question 14
List the businesses where special rules are applied to determine the chargeable profits.

Question 15
Identify which of the following statements is accurate.
A Profits from dealings with mutual entities (like member clubs or mutual businesses) are
not taxable in Hong Kong, because it is impossible to make a profit from oneself.
B Mr. Wong, the CEO of GSHM Ltd, supplies GSHM Ltd’s products to his niece for free as
a gift. That transfer is tax neutral because it is not a trading disposal, and therefore falls
outside s.14.
C The specific rules for computing the assessable profits of insurance companies derogate
from the general rules in Part 4 of the IRO.
D The two-tiered profits tax regime applies generally to charge the first HK$2 million of
assessable profits at half the standard rate of profits tax.

3 . 1 1
PARTNERSHIPS AND JOINT VENTURES

Partnerships – whether they be general partnerships or limited partnerships, and whether

they be established in Hong Kong or abroad – are not in general separate legal persons in
the way companies are. Partnerships are therefore not persons distinct from their partners.
With common law, a partnership arises where a group of persons, whether individuals or
companies, carry on a trade, profession or business together with a view to profit from it.
Partners are entitled to a share of a partnership’s profits, but are jointly and severally liable
for partnership debts, that is, debts incurred by the partnership business, as opposed to their
own private debts. Limited partnerships are similar to general partnerships, but there is an
important distinction in that a limited partner’s liability is limited to the extent of his capital
contribution to the partnership, and he does not carry on any part of the trade or business of
the partnership – that is done by the general partner, who in the ordinary course has unlimited
liability for the partnership’s debts. Joint ventures are distinct from partnerships in that they
are commercial arrangements that contractually provide for profit and risk sharing between
the joint venturers but fall short of partnerships. There is no technical, legal definition of a joint
venture. Accordingly, a number of arrangements are termed joint ventures despite the fact that
some may, at law, be partnerships.

Because partnerships are generally formed with a view to profit and joint ventures are
by definition business activities, both partners and joint venturers will in the ordinary course
be regarded as carrying on a trade or business with respect to their partnership interest or
joint venture participation. That being said, there are exceptions to this general rule. Limited
partnerships are partnerships often used in investment structures where the general partner
is unlimitedly liable for the debts of the partnership, whereas limited partners are liable only

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up to the extent of their capital contribution. The general partner is the only person authorised
to carry on the business of the limited partnership; if a limited partner intermeddles with
the carrying on of the trade or business of the limited partnership, it becomes liable to the
extent of a general partner for partnership debts. It would follow that in a limited partnership
scenario, the limited partners would not be regarded as carrying on a trade or business for the
purposes of s.14.

A general comparison between a partnership and a joint venture is shown in Exhibit 3.12.

Partnership Joint venture

• May have a large number of partners • Usually consists of a small number of
venturers
• Each partner is regarded as an agent of • The acts of a joint venturer will not bind the
the partnership and his acts will bind the joint venture
partnership
• All partners (other than a limited partner) are • Each joint venturer is liable for its own stake
jointly and severally liable
• Usually for long-term purposes • Usually for short-term purposes
• Have a whole set of books of account • May not have separate books of account
• Assessments issued in the partnership name • Separate assessments on individual venturers

EXHIBIT 3.12 Comparison of partnerships and joint ventures

3.11.1 Partnerships
S.2(1) defines a taxable person as including a partnership. A partnership is therefore treated as
a separate chargeable person for profits tax and property tax purposes, so tax is chargeable
at the partnership level, and not on the individual partners. Although a partnership is assessed
as a separate legal entity under the IRO for profits tax purposes, its liability to profits tax is
determined by aggregating the tax liabilities of each partner with respect to their share of the
assessable profits or losses of the partnership. Accordingly, the amount of tax payable on the
partnership profits is affected by the tax profiles of the individual partners, that is, whether the
partners have unrelieved losses carried forward that may be set off against their profits and
whether the partners are corporate entities (such that the profits tax rate of 16.5% and 8.25%
will apply) or individuals (such that the standard tax rate of 15% and 7.5% will apply). S.26(b)
provides that profits that have borne tax at the partnership level are not again taxed when
distributed or allocated to partners.

The taxation of the partnership is divided between the existing partners in such a manner
that each one is taxed according to their share of the profits and losses and by reference to
the fiscal attributes of each. The share is equal to the contributions made to the partnership’s
capital. Each partner submits self-assessment tax returns. A Profits Tax Return (BIR52) is issued
for partnerships in Hong Kong.

3.11.2 Profits Tax Computation for a Partnership Business

S.22(1) of the IRO provides that where a trade, profession or business is carried on by two
or more persons jointly, the assessable profits therefrom shall be computed in one sum

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and the tax in respect thereof shall be charged in the partnership name. In general, the
computation of the profits tax liability of a partnership follows similar rules as for a sole
proprietor or a corporation, but an allocation of profit or loss among the partners may be
required. The default position is that partners in a general partnership share equally in the
losses and profits of the partnership though a partnership deed may provide for variations to
that general rule. The allocation of profit or loss among the partners for tax purposes must
be made in accordance with s.22A of the IRO. Because a partnership is treated as a taxable
person in its own right, expenditure incurred by individual partners with respect to matters
other than the partnership business are not deductible in the hands of the partnership.
(Exhibit 3.13).

Specific rules applicable to partners/partnership IRO Section

Rent paid by a partnership to any partner or his spouse is restricted to the assessable s.16(1)(b)
value of the property in question
Mandatory contribution to MPF by a self-employed person (sole proprietor or a s.16AA
partner in a partnership) is deemed as deductible, provided that it is not otherwise
deductible and not exceeding HK$18,000 per annum (for the year of assessment
2015/16 onward)
Salaries or other remuneration paid to any partner or his spouse, interest on capital s.17(2)
or loan from any partner or his spouse, and MPF contribution in respect of any
partner’s spouse are disallowed. These payments are regarded as appropriation
of profits to the partners, and therefore need to be adjusted and allocated to each
relevant partner before the general sharing of profit/loss
Salaries or remuneration paid by a person subject to profits tax which was not s.8(2)(k)
deductible under s.17(2), would be excluded from salaries tax
Non-corporate partner’s share of profit from a partnership is subject to the standard s.14
rate, while that of corporate partner is subject to corporate profits tax rate
When there are changes in partnership, e.g. admission or retirement of partner(s), s.22(3)
s.22(3) treats the partnership as continuing if at least one partner stays

EXHIBIT 3.13 Specific rules for partnerships in IRO

3.11.3 Allocation of Profit/Loss

Profits tax is charged in the name of the partnership and, it would follow, liability on
assessment is not in the name of the individual partners. As a general rule, however, allocation
of profit and loss as between the partners is required when any of the following occurs:

• An individual partner elects for personal assessment (PA), in which case the profit or
loss in question is treated as part of their PA (see Chapter 6 for a discussion on PA);

• A corporate partner is taxed at the standard corporate rate or the concessionary

corporate rate with respect to its allocated profits, in which case tax charged on its
share of the partnership profits must be reduced accordingly; and

• Unrelieved losses are notionally allocated to partners to be carried forward.

The general rule is that where the partnership is profit-making, no partner in that
partnership should be making a loss. Conversely, when the partnership itself is loss-making, no
partner should derive assessable profits from that partnership. When either of these situations
occurs, there must be a reallocation of profit or loss. The share of profit or loss of each partner

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is ascertained in accordance with their entitlement to participate in the profit or loss of the
partnership in the year of assessment in question. If there is a change in the composition of the
partnership, the basis period of the partnership must be sub-divided accordingly.

Illustrative Example 92
Example 1 – Allocation of Profits

Peter, Paul and Sally are in a partnership carrying on business in Hong Kong. The draft
income statement for the partnership for the year ended 31 December 2020 shows a net
profit before taxation of HK$1,712,000 after charging the followings:

1. Salary to partners: Peter – HK$720,000; Paul – HK$480,000; and Sally – HK$360,000.

2. Meal allowance for Peter – HK$72,000.

3. Depreciation – HK$476,000.

4. Bad debt written off for a staff loan – HK$480,000.

Other information:

1. Depreciation allowances agreed with the IRD – HK$300,000.

2. Profits/loss sharing ratio for Peter, Paul and Sally:

2 : 1 : 1.

3. Only Peter elected personal assessment for the year.

Step 1

Compute the assessable profit of the partnership for the year.

Peter, Paul and Sally Partnership

Computation of assessable profits for the year of assessment 2020/21

Basis Period: year ended 31 December 2020

HK$ HK$
Net profits per account 1,712,000
Add:
Salaries to partners 1,560,000
Meal allowance – Peter 72,000
Accounting depreciation 476,000
Bad debt – staff loan 480,000
2,588,000
Less:
Depreciation allowance (300,000)
4,000,000

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Illustrative Example 92 (continued)

Step 2

Allocate the assessable profit of the partnership to the partners.

Statement of Allocation of Profit/Loss

Total Peter Paul Sally

HK$ HK$ HK$ HK$
Salaries 1,560,000 720,000 480,000 360,000
Meal allowance 72,000 72,000
Balance (2 : 1 : 1) 2,368,000 1,184,000 592,000 592,000
4,000,000 1,976,000 1,072,000 952,000
Transfer to personal assessment 1,976,000 1,976,000 Nil Nil
Assessable profits 2,024,000 1,072,000 952,000
Tax thereon
First HK$2,000,000 (@7.5%) 150,000
Next HK$24,000 (15%) 3,600
153,600

Example 2 – Allocation with Changes in Partners

Boris and Donald established a partnership namely, Boris & Donald, which carried on a
business in Hong Kong. Boris and Donald shared profits and losses equally. Salaries per
month received by Boris and Donald was HK$60,000 and HK$40,000 respectively. On
1 October 2020, Matt was admitted as a new partner, who received a monthly salary of
HK$30,000. The new profit and loss sharing ratio for Boris, Donald and Matt is 2 : 2 : 1.
The assessable profits for the partnership for the year ended 31 December 2020 was
HK$4,800,000. Boris and Donald elected personal assessment for 2020/21.

Year of assessment 2020/21

Basis period: Year ended 31 December 2020

Period 1 (1 January–30 September 2020, AP = HK$4,800,000 × 9 ÷ 12 = HK$3,600,000)

Total Boris Donald

HK$ HK$ HK$
Salary 900,000 540,000 360,000
Balance (1 : 1) 2,700,000 1,350,000 1,350,000
Subtotal 3,600,000 1,890,000 1,710,000

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Illustrative Example 92 (continued)

Period 2 (1 October–31 December 2020, AP = HK$4,800,000 × 3 ÷ 12 = HK$1,200,000)

Total Boris Donald Matt

HK$ HK$ HK$ HK$
Salary 390,000 180,000 120,000 90,000
Balance (2 :  2 : 1) 810,000 324,000 324,000 162,000
Subtotal 1,200,000 504,000 444,000 252,000

Overall allocation (Periods 1 and 2)

Total Profit/Shared profit 4,800,000 2,394,000 2,154,000 252,000
Transfer to personal assessment (4,548,000) (2,394,000) (2,154,000) Nil
Assessable profits 252,000 Nil Nil 252,000
Profits tax payable @7.5% 18,900

Example 3 – Reallocation

Derek, Eliza and Flower Ltd started a partnership business on 1 January 2018. Derek
and Eliza received salaries per year of HK$280,000 and HK$80,000 respectively, and the
partners shared profits and losses equally.

For the year ended 31 December 2018, the agreed loss of the partnership is
HK$240,000. The assessable profit for the year ended 31 December 2019 is HK$480,000.
Derek has elected personal assessment for 2019/20 only. Flower Ltd has an agreed
assessable profit of HK$50,000 on its own trade for 2019/20.

Year of assessment 2018/19 (Basis period: Year ended 31 December 2018)

Agreed loss is HK$240,000.

Total Derek Eliza Flower Ltd

HK$ HK$ HK$ HK$
Salary 360,000 280,000 80,000 -
Balance (600,000) (200,000) (200,000) (200,000)
Subtotal (240,000) 80,000a (120,000) (200,000)
Reallocation Nil (80,000) 30,000a 50,000a
Net total (240,000) Nil (90,000) (150,000)
a
reallocated according to the ratio of Eliza’s and Flower Ltd’s shared losses.
For Eliza: HK$80,000 × 120,000 ÷ (120,000 + 200,000) = HK$30,000
For Flower Ltd: HK$80,000 × 200,000 ÷ (120,000 + 200,000) = HK$50,000

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Illustrative Example 92 (continued)

Year of assessment 2019/20 (Basis period: Year ended 31 December 2019)

Assessable profit is HK$480,000.

Total Derek Eliza Flower Ltd

HK$ HK$ HK$ HK$
Salary 360,000 280,000 80,000 -
Balance (1 : 1 : 1) 120,000 40,000 40,000 40,000
Subtotal 480,000 320,000 120,000 40,000
Loss b/f set off (130,000) Nil (90,000) (40,000)
350,000 320,000 30,000 Nil
Transfer to personal assessment (320,000) (320,000) Nil Nil
Net assessable profits 30,000 Nil 30,000 Nil
Profits tax thereon @7.5% 2,250

Statement of loss for 2019/20

Total Derek Eliza Flower Ltd

HK$ HK$ HK$ HK$
Balance b/f from 2018/19 240,000 Nil 90,000 150,000
Less:
Set off against profit shared from (130,000) Nil (90,000) (40,000)
the partnership for the year
(s.19C(2))
Set off against profit from own (50,000) N/A N/A (50,000)
trade (s.19C(5))
Balance c/f to 2020/21 60,000 Nil Nil 60,000

3.11.4 Joint Ventures

The term ‘joint venture’ does not carry a specific legal meaning under Hong Kong law. It is used
as a generic term to describe a variety of situations in which two or more parties co-operate
with one another by pooling resources together in a mutual business endeavour with a view
to achieving certain business goals or to achieve a commercial objective. Resources include
capital, know-how, marketing and management (HKSAR v Gammon (2003) 3 HKC 276).

The exact legal relationship between the joint venturers is determined by reference to the
joint venture agreement. In Hong Kong, incorporated, unincorporated (or contractual) and
partnership joint ventures are possible. The juristic character of the relationship between joint
venturers must be determined by reference to a combination of common law and legislation
(for example, company and partnership law, competition law, and laws governing intellectual
property, commerce, trade and tax).

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A joint venturer is not responsible in law for acts of its co-venturers unless, of course,
the joint venture constitutes a partnership at law. A joint venture as such is therefore not a
legal person and is not deemed to be a chargeable person for the purposes of the IRO. The
assessable profits and expenses of the joint venture is reported in the joint venturer’s own
profits tax returns. Whether and to what extent a joint venturer is taxable will therefore depend
on what it does in the context of a joint venture. Arguably, entering into a joint venture by
its very nature constitutes the carrying on of a trade or a business. Accordingly, if the joint
venturer operates in or through Hong Kong with respect to the joint venture, it would likely be
regarded as carrying on, in part, the trade or business of the joint venture. It should separately
be ascertained whether the profits of the joint venture are sourced in Hong Kong and, for those
purposes, the conventional rules for the determination of the locality of profits will apply.

Illustrative Example 93
GSHM enters into a joint venture agreement with Gyaru Inc, a company incorporated
in Japan, to develop a line of clothing aimed at young women in the 18–25 age range in
Hong Kong. The terms of the joint venture agreement provide for the allocation of capital
investment and profit shares but, taken in the round, does not constitute a partnership
under the Partnership Ordinance (Cap.38). GSHM and Gyaru Inc will therefore fill
tax returns separately. If, however, the joint venture agreement was in substance a
partnership agreement, the partnership so constituted would be a separate taxable
person under the IRO. Assuming GSHM were the principal partner, it would be required
to file a partnership tax return in the name of the partnership and the tax liabilities of
GSHM and Gyaru Inc would be computed accordingly.

3.11.5 Entity Choice for Business and Tax Purposes

The main types of investment vehicles used to carry on business in Hong Kong are a
body corporate, a PE in Hong Kong whose head office is situated outside of Hong Kong, a
partnership or unincorporated joint venture. Rarely, businesses may be carried on by way of
a trust. Generally, any person carrying on a trade, profession, or business in Hong Kong will
be required to register under the Business Registration Ordinance (Cap.310), and to file an
annual tax return, even if it has no assessable profits in that year of assessment. Hong Kong is
considered a relatively ‘light-touch’ jurisdiction from a tax compliance standpoint. That being
said, the reporting requirements for all business vehicles in Hong Kong are essentially the same
and need to be substantiated by reference to financial statements and accounts drawn up to
acceptable accounting standards.

The choice of business vehicle will depend on the specific commercial priorities of an
enterprise. An important advantage a company incorporated or resident in Hong Kong has
is that dividends are generally not taxable upon receipt, and there is no withholding tax on
dividends. This is in contrast with the position in other jurisdictions, where dividends are
taxable both upon receipt and subject to withholding tax when declared to non-residents.
Hong Kong is therefore a convenient tax planning jurisdiction for companies acting to channel
dividends between one jurisdiction and another. In that regard, Hong Kong has a growing
network of double taxation agreements, which can make it a convenient jurisdiction through

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which to channel income sourced abroad: offshore income to a Hong Kong resident person
will be subject to lower rates of withholding as established under the relevant double taxation
agreement and will, in general, not be taxable upon receipt in Hong Kong.

Key Learning Point

Subject to controlled foreign company rules (CFC) in other jurisdictions, dividends can be
accumulated in a local holding company without further tax burden.

CFC regimes are anti-avoidance provisions that are in force in certain jurisdictions
outside of Hong Kong. In essence, CFC rules provide that where a resident person has an
interest or participation in a company resident offshore, any passive income (dividends,
interest, royalties etc.) arising to that offshore company will be imputed to the resident
person, irrespective of whether or not they are actually distributed.

Another advantage of setting up a holding company in Hong Kong is that any profit derived
from the subsequent exit by sale or disposal of the shares in that holding company should
generally be treated as exempt from profits tax because Hong Kong does not tax profits
derived from the sale of capital assets though the disposal of shares in a company incorporated
in Hong Kong does trigger a charge to ad valorem stamp duty levied at the aggregate rate of
0.2% on the higher of the transfer consideration or the value of the shares under the s.4 and
Head 2 of the First Schedule of the Stamp Duty Ordinance (see Chapter 7). Similarly, and for
the same reasons, the disposal of any shares in subsidiary companies held by the Hong Kong
holding company will not in the ordinary course be taxable in Hong Kong. Chapter 10 will
elaborate more on the tax planning opportunities associated with incorporating a company in
Hong Kong.

A foreign purchaser may decide to acquire business assets through a Hong Kong branch.
A branch will in the ordinary course be a PE under domestic law and for the purposes of any
double taxation agreement to which Hong Kong is party. In the latter case, treaty benefits could
be accessed to eliminate double taxation as between the branch and the head office.

Hong Kong does not impose additional taxes on branch profits remitted to an overseas
head office. Generally, Hong Kong’s profits tax rules apply to foreign persons carrying on
business in Hong Kong through a branch in the same way that they apply to Hong Kong
incorporated entities. Compliance costs associated with maintaining a Hong Kong branch
are therefore lower relative to a Hong Kong incorporated holding company. Transfer pricing
provisions apply between a PE and its head office in a manner analogous to their application as
between associated companies.

Key Learning Point

DTAs are important tools in tax structuring because they allocate taxing rights between
jurisdictions and generally provide for lower rates of withholding tax for passive income.
Hong Kong’s growing DTA network is therefore an important resource to determine a tax-
efficient cross-border arrangement.

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Knowledge Check Question

Question 16
Identify which of the following statements most accurately describes the distinction
between a partnership and a joint venture.
A A partnership and a joint venture are legal terms of art, with well-defined meanings in
common law and statute law.
B A partnership deed will always set out the ratio of profit and loss sharing between
the partners.
C Profits tax is assessed in the name of the partnership, but recoverable from the assets of
the several partners; conversely, profits tax is assessed in the name of the several joint
venturers and is recoverable from the assets of the joint venture.
D A partnership is treated as a separate taxable person under the IRO, while not
abrogating the fiscal characteristics of the several partners; conversely a joint venture is
not necessarily a separate taxable person under the IRO, and joint venturers are fiscally
separate from one another.

3 . 1 2
LOSS RELIEF FOR INDIVIDUAL,
PARTNERSHIP AND CORPORATION

Unrelieved trading losses may be carried forward indefinitely, to be set off against assessable
profits. That means that unrelieved losses may be deducted from assessable profits in order to
arrive at the amount actually chargeable to profits tax. Losses are in effect the mirror image of
profits and are computed in the same manner and over the same basis periods. Because losses
are the mirror image of profits, it would follow that in order to be an allowable loss available
for set off against future profits, the loss in question must be a trading loss, that is, a loss that
arose in the course of a trade, profession or business carried on in Hong Kong. Non-trading
losses (such as losses arising from the sale of a capital asset), or losses sourced from outside
of Hong Kong are not allowable losses and are therefore unavailable for utilisation. Similarly,
losses arising prior to the commencement of a trade or business are not utilisable following
such commencement. Losses are treated differently depending on whether the taxable entity is
a body corporate, partnership, or an individual.

Illustrative Example 94
In the year of assessment 2016/17, GSHM realised a loss of HK$25 million and in the year of
assessment 2017/18, it realised a loss of HK$75 million. In the year of assessment 2018/19, it
realised a profit of HK$80 million. The full amount of accumulated losses of HK$100 million
are to be set off against that amount; however, even reducing the amount of assessable
profit to zero, there remains HK$20 million of unrelieved, unutilised losses to be carried
forward GSHM may therefore carry such losses forward to be applied against profits (if any)
in the years of assessment 2019/20 onward.

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3.12.1 Individual
Under s.19C(1), any loss incurred by an individual is carried forward and set off against future
assessable profits of the same trade carried on by the same individual unless PA is elected and
the loss is transferred and set off under the rules governing PA under s.19C(3). If no PA is made,
unrelieved losses are surrendered upon cessation of the trade carried on by the individual with
respect to which they were first incurred. There is no sideways relief, which means that losses
of one trade or business cannot be set off against the losses of another trade or business
carried on by the same individual. The question of whether a given trade is the same trade
for the purposes of the carry forward of losses is a question of fact (Rolls-Royce Motors Ltd v
Bamford (1976) STC 162).

Illustrative Example 95
Mr. Theodore Eugenides carries on the trade of distributing Macedonian wine as a
sole proprietor, and has accumulated unrelieved losses of HK$1 million for the year
of assessment 2017/18. In the year of assessment 2018/19, he realised an assessable
profit of HK$1.2 million. He must set off the full amount of losses carried forward against
his assessable profits from that same trade or business, thereby leaving HK$200,000
as taxable profits. If, however, in the year of assessment 2018/19, he ceased to be a
wine merchant and began a separate trade as a fruit merchant realising in that year an
assessable profit of HK$500,000, the HK$1 million loss would be surrendered and the full
HK$500,000 would be chargeable to profits tax.

3.12.2 Partnership
Under s.22A(1), any loss incurred by a partnership is to be allocated to the partners in
accordance with the profit or loss sharing ratio during the basis period for the year of
assessment concerned. Therefore, losses are allocated individually to each partner. Under
s.19C(2), the amount of loss allocated to a partner who is an individual is carried forward and
set off against its share of future assessable profits of the partnership from the same trade or
business in which the said loss was incurred unless PA is elected and the loss is transferred to
and dealt with under PA under s.19C(3). If PA is not elected, unrelieved losses are surrendered
when the individual ceases to be a partner. Bodies corporate that are partners in a partnership
follow the same rules that apply generally to corporations (see Section 3.12.3).

3.12.3 Corporation
S.19C(4) provides that losses arising to a corporation must be set off against assessable profits
arising in the current year of assessment and any unutilised losses carried forward to the
next years of assessment indefinitely until fully set off against assessable profits. Loss carried
forward for corporations operates irrespective of the trade or business carried on by that
corporation. In this case, unlike individuals and partnerships, sideways loss relief is available.
That means that unutilised losses carried forward incurred in one trade or business carried on
by the corporation may be freely utilised and set off against the profits of any other trade or
business carried on by that corporation.

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S.19C(5) provides that where a corporation is a partner and the partnership suffers a
loss, the share of the partnership loss attributable to the corporation is required to be set off
against the corporation’s assessable profits for the current year of assessment and any excess
loss carried forward and set off, first, against any future share of partnership profits and,
second, against its own assessable non-partnership profits for that year including profits from
a new trade, profession or business. If the corporation withdraws from the partnership, it can
continue to utilise unrelieved partnership losses carried forward.

Key Learning Point

Losses are the mirror image of process. Trading losses incurred in the course of a trade,
profession or business carried on in Hong Kong may be set off against assessable profits.

3.12.4 Cross Set Off

Certain concessionary receipts are taxed at half the normal rate: 8.25% for bodies corporate
and 7.5% for all other businesses. A taxable person under the IRO may derive certain profits
that are concessionary and others that are taxed at the standard rate and, similarly, may incur
certain losses in the course of a concessionary trade or business and others in the course of
a trade or business taxed at the standard rate. That mismatch in tax rates must be reflected
in the set-off of unrelieved losses. This is achieved by way of the application of an ‘adjustment
factor’. Generally, the applicable adjustment factor is two because that is the ratio between
the standard tax rate and the concessionary tax rate in the IRO. Ss.19CA and 19CB provide for
the cross set off of unabsorbed losses from normal trading receipts and concessionary trading
receipts. As defined in s.19CA(5), ‘concessionary trading receipts’ (or, otherwise, ‘concessionary
profits’) means the trading receipts and other sums in respect of which assessable profits are
chargeable to tax at half the normal rate and ‘normal trading receipts’ are all other receipts,
with the corresponding term for losses being ‘normal losses’.

As you would expect, the cross set off provisions aim for tax symmetry. A concessionary
receipt must correspond with a proportionately reduced allowance for loss if that loss is to be
set off against normal trading receipts.

3.12.4.1 Computation by Reference to Normal Profits

S.19CA deals with the cross set off of normal profits or loss and concessionary profits or loss
within the same year of assessment for the same business. S.19CA(2) applies when a taxpayer
has unabsorbed concessionary loss and normal profits whilst s.19CA(3) applies when a
taxpayer has unabsorbed normal loss and concessionary profits.

Where a normal profit exceeds a concessionary loss, for each notional HK$1 of loss arising
from a trade or business that would give rise to concessionary trading receipts only HK$0.5 of
loss would be available for set off against normal trading receipts. Of course, the set off would
remain 1 to 1 if it were losses from a concessionary trade or business being set off against the
profits of that trade or business or otherwise against other concessionary trading receipts.

Conversely, where a normal profit does not exceed a concessionary loss, the normal profit
will be fully set off by the concessionary loss, which will be reduced by an amount equal to the
normal profit multiplied by 2.

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Illustrative Example 96
(Adapted from DIPN No. 8, Example 4)

Example 4 – Normal profits exceed concessionary loss/factor, s.19CA(2)(a) scenario

Normal trading Concessionary

receipts trading receipts
HK$ HK$
Profit/(loss)a 10,000 (18,000)
Reduced by
Concessionary loss divided by the adjustment factor (9,000) 18,000
(i.e. HK$18,000 ÷ 2)
Assessable profitsb 1,000
Unabsorbed loss c
NIL

a
S.19CA(2)(a) applies as the amount of concessionary loss does not exceed the amount of normal profits as
multiplied by the adjustment factor (i.e. HK$18, 000 HK $10, 000 2).
b
The assessable profits from normal trading receipts shall be taxed at the normal tax rate.
c
The unabsorbed loss from concessionary trading shall be deemed to be nil.

Illustrative Example 97
(Adapted from DIPN No. 8, Example 5)

Example 5 – Normal profits do not exceed concessionary loss/factor, s.19CA(2)(b) scenario

Normal trading Concessionary trading

receipts receipts
HK$ HK$
Profit/(loss)a 10,000 (24,000)
Reduced by
Normal profits multiplied by the (10,000) 20,000
adjustment factor
(i.e. HK$10,000 × 2)
Unabsorbed lossb (4,000)
Assessable profitsc NIL

a
S.19CA(2)(b) applies as the amount of concessionary loss exceeds the amount of normal profits as
multiplied by the adjustment factor (i.e. HK$24,000 > HK$10,000 × 2).
b
The unabsorbed loss from concessionary trading receipts shall be carried forward for set off under Ss.19C
and 19CB.
c
The assessable profits from normal trading receipts shall be deemed to be nil.

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3.12.4.2 Computation by Reference to Normal Loss

The same logic applies to where the point of reference is the quantum of normal loss. Where a
normal loss does not exceed a concessionary profit, the normal loss is multiplied by a factor of
two, and then set off against the concessionary profit in full.

Conversely, where a normal loss exceed a concessionary profit, the concessionary profit
will be fully set off by the normal loss, which will be reduced by an amount equal to the
concessionary profit divided by 2.

Illustrative Example 98
(Adapted from DIPN No. 8, Example 6)

Example 6 – Normal loss does not exceed concessionary profits/factor, s.19CA(3)(a) scenario

Normal trading Concessionary

receipts trading receipts
HK$ HK$
Profit/(loss) a
(10,000) 24,000
Reduced by
Normal loss multiplied by the adjustment factor 10,000 (20,000)
(i.e. HK$10,000 × 2)
Assessable profitsb 4,000
Unabsorbed loss c
NIL
a
S.19CA(3)(a) applies as the amount of normal loss does not exceed the amount of concessionary profits as
divided by the adjustment factor (i.e. HK$10, 000 HK$24 , 000 2).
b
The assessable profits from concessionary trading receipts shall be taxed at the concessionary tax rate,
i.e. one-half of the normal tax rate.
c
The unabsorbed loss from normal trading receipts shall be deemed to be nil.

Illustrative Example 99
(Adapted from DIPN No. 8, Example 7)

Example 7 – Normal loss exceeds concessionary profits/factor, s.19CA(3)(b) scenario

Normal trading Concessionary

receipts trading receipts
HK$ HK$
Profit/(loss) a
(10,000) 18,000
Reduced by
Concessionary profits divided by the adjustment factor 9,000 (18,000)
(i.e. HK$18,000 ÷ 2)
Unabsorbed lossb (1,000)
Assessable profitsc NIL
a
S.19CA(3)(b) applies as the amount of normal loss exceeds the amount of concessionary profits as divided by the
adjustment factor (i.e. HK$10,000 > HK$18,000 ÷ 2).
b
The unabsorbed loss from normal trading receipts shall be carried forward for set off under ss.19C and 19CB.
c
The assessable profits from concessionary trading receipts shall be deemed to be nil.

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Knowledge Check Question

Question 17
Identify which of the following statements about losses is correct.
A In the year of assessment 2018/19, Lord Soth has HK$1 million of accumulated,
unrelieved losses from his profession as an investment advisor and receives a profit of
HK$3 million for his expertise in the field of investment advice for acting as an expert
witness in court. Lord Soth must set off the HK$1 million of unrelieved losses against his
HK$3 million profit.
B Gai Lan Ltd decides to establish a business farming organic vegetables in the New
Territories and incurred accumulated losses of HK$10 million in surveying farmland and
clearing this in preparation for cultivation. Such accumulated unrelieved losses may be
set off against the future assessable farming profits derived by Gai Lan Ltd.
C GSHM Ltd incurs a loss of HK$15 million on the sale of one of its Thai 100% subsidiaries
to a third-party buyer. That loss may be set off against the assessable profits of GSHM
Ltd from apparel retail.
D Rupert St John, a partner in the Hong Kong law firm Pitt & Rottweiler, has unrelieved
partnership losses of HK$200,000 allocated to him for the year of assessment 2018/19,
which he may set off against any future profits of the firm allocated to him in subsequent
years of assessment.

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SUMMARY

Charge under s.14

• Profits tax is Hong Kong’s principal charge to tax on corporate profits. S.14 of the IRO sets out
a three-limbed test: (i) a person must carry on a trade, profession or business in Hong Kong;
(ii) it must derive Hong Kong source profits; and (iii) those Hong Kong source profits must be
the profits of that particular trade, profession or business.

• The standard rate of profits tax is 16.5% for corporations and 15% in all other cases.

• Generally, the threshold for being found to carry on a business is low. Any gainful use to
which taxpayers put their assets is in principle capable of amounting to the carrying on of a
business. Conversely, as regards trade, the question is a mixed matter of fact and law. Each
case is unique, but the badges of trade are a useful guide.

• A permanent establishment is the fixed presence of a non-resident enterprise in Hong Kong

through which the business of that enterprise is wholly or partly exercised. A Hong Kong
permanent establishment by definition amounts to the carrying on of a trade or business in
Hong Kong, but it does not necessarily follow that simply because one carries on a trade or
business in Hong Kong one derives Hong Kong source profits from that trade or business.

• The broad guiding principle provides that the source of profits is a hard, practical matter of
fact. One looks to what the taxpayer has done to earn its profits, and where it has done it,
discounting antecedent or incidental matters. A corollary of the broad guiding principle is the
operations test. When considering what the taxpayer has done to earn its profits, one has to
focus on the operations in substance giving rise to those profits.

• The general rules applicable to the source of profits in a number of industries may be found in
DIPN No. 21. These are general indications and should not be taken to be definitive or binding.

• Manufacturing profits in a contract processing scenario may in certain cases be apportioned

on a 50 : 50 basis; however, the IRD does not accept the same basis of apportionment for
import processing businesses.

• Certain receipts, termed concessionary receipts, are taxed at half the standard profits tax
rate. Notable examples include profits of a corporate treasury centre business and the first
HK$2 million of assessable profits where no associated person claims the reduced rate.

• Gains arising from the sale of capital assets are expressly exempt from profits tax under
s.14(1) of the IRO. What constitutes a capital asset for those purposes will in large part depend
on the specific trade or business carried on by the taxpayer. In certain cases, assets generally
regarded as capital assets, such as immovable property, are in fact and law trading stock
where, for example, the taxpayer is a developer holding such immovable property on revenue
account (i.e. as stock-in-trade).

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Incomes

• Certain amounts, albeit not chargeable under s.14, are deemed to be chargeable to profits
tax under s.15. In particular, Hong Kong source interest arising to a corporation carrying on
a trade or business in Hong Kong and royalties for the use or the right to use intellectual
property rights in Hong Kong are taxable notwithstanding that they do not fall within s.14.

• Passive interest is sourced in Hong Kong if the principal with respect to which it is payable was
first made available in Hong Kong. This is the so-called ‘provision of credit test’. In the case of
interest derived in the ordinary course of a trade or business, however, the ‘operations test’
will apply.

• Interest paid on bank deposits is in general not taxable though it notably is in the hands of
other financial institutions.

Deductions

• Expenditure and outgoings incurred in the production of taxable profits are deductible under
s.16. Capital expenditure, however, is expressly barred from deduction under s.17(1)(c). What
constitutes revenue as opposed to capital expenditure will in part depend on the specific
trade or business carried on by the taxpayer.

• In distinguishing between capital and revenue expenditure, consider whether the expenditure
was once and for all (capital) or recurring (revenue) or whether the expenditure has brought
about an enduring benefit to the trade or business of the person incurring it, or opened up
new avenues of trade or business; if so, it is likely to be capital in nature.

• Interest is deductible only in certain circumstances. For example, interest paid to a financial
institution or to a person that is chargeable to profits tax in Hong Kong with respect to that
interest is deductible.

• S.17 contains deductions that are expressly not allowed for the purposes of s.16. Deductions
that are expressly barred under that section may nonetheless be allowable under s.16A and
following sections.

• An important exception to the general rule excluding deductions for capital expenditure is
the capital allowances regime, which enables taxpayers to claim periodic – or, in some cases,
one-off – deductions for expenditure incurred in, variously, the construction of industrial or
commercial buildings or the acquisition or plant and machinery.

• It is now conventional to aggregate plant and machinery eligible for capital allowances into
‘pools’ with the same writing-down periods.

• Losses are the mirror image of profits. Unrelieved losses must be set off against the profits of
a given year of assessment in full and any balance must be carried forward and set off against
the profits of any future year of assessment.

Miscellaneous Matters

• Accounting policies are relevant in ascertaining the assessable profits of a taxpayer to the
extent that they are consistent with the statutory provisions of the IRO; however, where
there is dispute between the two, the terms of the IRO prevail. It is accordingly not possible
to tax unrealised profits (even if treated as profits for accounting purposes) or to set off
unrealised losses.

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• Transfer pricing is an anti-avoidance regime that requires transactions and arrangements

made between associated persons or between a head office and its permanent establishment
to be made on an arm’s length basis.

• There are special rules for computing the assessable profits of taxpayers in certain special
classes of business such as insurance companies, ship and aircraft owners, and clubs and
associations.

• Certain activities are expressly exempt from profits tax. Commercially speaking, the most
important exemption is that for funds – that is, collective investment schemes – carrying out
specified transactions through regulated persons in Hong Kong.

• A partnership is not separate legal person at law: it is a business association where two or
more persons together carry on a trade or business. A partnership is nevertheless treated
as a separate taxable person for the purposes of the IRO. The partner in the first instance
responsible for discharging the partnership’s tax liabilities is known as the principal partner.

• A joint venture is a contractual arrangement for two or more persons to carry on an

adventure in the nature of trade or a transaction. It is distinct from a partnership in that each
joint venturer is treated as a separate person for tax purposes.

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MIND MAP

PROFITS TAX OVERVIEW DISTINCTION BETWEEN CAPITAL AND

REVENUE ITEMS
Scope of charge
Chargable persons and tax rate Capital Receipts and Revenue Receipts
Capital Expenditure and Revenue Expenditure
TRADE, PROFESSION OR BUSINESS
DEPRECIATION ALLOWANCES
Trade
Profession Depreciation Allowance for Machinery
or Plant
Business
Industrial Building Allowance
Permanent Establishments
Commercial Building Allowance
SOURCES OF PROFITS
PREPARATION OF THE PROFITS TAX
Traditional Tests of Sources of Profits COMPUTATION
Source of Trading Profits
Preparing a Profits Tax Computation
Source of Manufacturing Profits
Post-cessation receipts and payments
Source of Commissions and Service Fees
Effect of Accounting Policies on Tax
Interest income
Computations
Rental income
Profits tax - Prepaid or deferred revenue
Income from e-commerce expenses
Royalties or Licence Fees
BASIS PERIOD
Underwriting income PROFITS TAX
Normal or Continuing Business
Cross-border land transportation income
Commencement of Business
Current Developments in Source Issues
Cessation of Business
Transfer Pricing
Change of Accounting Date
MISCELLANEOUS INCOME AND EXEMPTIONS
OTHER PROFITS
Sums Specifically Chargeable to Profits Tax
Stock Taken for Own Use (Sharkey v Wernher
Concessionary Trading Receipts Chargeable
principle)
to Tax at Half of the Profits Tax Rate
Stock Borrowing and Lending Transactions
Sums Specifically Exempt from Profits Tax
Financial Instruments and Foreign Exchange
GENERAL DEDUCTIONS AND SPECIFIC Differences
DEDUCTIONS Alternative Bond Schemes
General Deduction Rule Regulatory Capital Securities
Deductible Items Special Classes of Business
Deductible Interest
PARTNERSHIPS AND JOINT VENTURES
Deductions Not Allowed
Partnerships v Joint Ventures
Profits Tax Computation for a Partnership
Business
Allocation of Profit/Loss
Entity Choice for Business and Tax Purposes
LOSS RELIEF FOR INDIVIDUAL, PARTNERSHIP
AND CORPORATION
Individual
Partnership
Corporation
Cross set-off

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Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Profits tax is charged on Hong Kong source profits.
Answer B is incorrect. The Hong Kong source profits must be the profits of the particular
trade, profession or business carried on in Hong Kong.
Answer C is incorrect. Profits tax is a charge on profits, and not on income.
Answer D is correct. The sentence accurately summarises s.14, and does not contain any
material error or ambiguity.

Question 2
Answer A is correct. A natural resource extraction facility with some element of fixity is by
definition a PE.
Answer B is incorrect. A showroom does not in general amount to a PE.
Answer C is incorrect. While it is arguable that the CFO may conduct some element of the
company’s business in Hong Kong, their presence in Hong Kong appears to be intermittent
and the meetings they conducts there exploratory or preparatory rather than part and
parcel of their company’s trade or business.
Answer D is incorrect. The principal trade or business of the bank is to provide banking and
other financial services and a call centre is therefore likely has an auxiliary character.

Question 3
Answer A is incorrect.: Montgomery Withnail QC carries on a profession in Hong Kong as
he is physically present in Hong Kong offering legal services.
Answer B is correct. This is an example of trade with Hong Kong as opposed to trade in
Hong Kong.
Answer C is incorrect. A manufacturing facility clearly meets the threshold for carrying on a
trade in Hong Kong.
Answer D is incorrect. Although the volume of transactions may be low, any gainful use to
which a company puts its assets is in principle capable of amounting to the carrying on of
a business.

Question 4
Strategy I: The establishment of a retail branch will be a PE, which, by virtue of making
sales in Hong Kong, will likely generate Hong Kong source profits.
Strategy II: Generally, entering into a joint venture will amount to carrying on a trade or
business in Hong Kong, and the profits of the joint venture sourced in Hong Kong will
thereby be taxable in the hands of ATL.
Strategy III: Although, the trading subsidiary will be taxable, ATL itself will not. Dividends
are generally tax neutral in Hong Kong.
Strategy IV: A sales office will be a PE, per Strategy I above.
In conclusion, Answer C is correct.

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Question 5
Scenario I: Foreign exchange differences are taxable to the extent they are the profits of a
trade, profession or business carried on in Hong Kong.
Scenario II: S.15(1)(g) provides that a person other than a corporation carrying on a trade
profession or business in Hong Kong is chargeable to profits tax on interest income where
the interest is Hong Kong source and in respect of the funds of that trade profession or
business.
Scenario III: Branch profits will be sourced in Taiwan and therefore not taxable in
Hong Kong.
Scenario IV: Sales of securities listed on the Seoul Stock Exchange are not sourced in Hong
Kong, as it is the country of listing which is critical.
Scenario V: The general rule is that logistics or transport profits are sourced in the
jurisdiction where the goods or passengers are first uplifted.
In conclusion, Answer A is correct.

Question 6
Answer A is incorrect. Mist Ltd does not carry on a trade, profession, or business in
Hong Kong. The mere maintenance of a server in Hong Kong does not, with nothing more,
amount to the carrying on of a trade or business in Hong Kong or to the formation of a
Hong Kong PE.
Answer B is correct. Suzie Wong carries on the profession of being a writer in Hong Kong
and exercised her wit and labour in writing the novel in Hong Kong such that the royalties
she receives with respect thereto are Hong Kong source and accordingly chargeable to
profits tax.
Answer C is incorrect. Bank deposit interest is exempt from profits tax unless the deposit
has been pledged as a security for any borrowing and the interest from the borrowing is
deductible.
Answer D is incorrect. The sale of shares in a subsidiary is almost certainly a sale of a
capital asset and therefore expressly exempt from profits tax under s.14.

Question 7
There are two principal transfer pricing rules in Hong Kong: Rule 1 and Rule 2. Rule 1
relates to transfer pricing between associated persons. In summary, it provides that
all arrangements or transactions between associated persons, broadly defined, must
take place on an arm’s length basis, which is on a basis that one would expect to find
between independent persons acting commercially with respect to the same or similar
transactions or arrangements. Rule 2 provides that the allocation of profits or losses
between a head office and a permanent establishment must also be on an arm’s length
basis. Failure to comply with these provisions may lead to a transfer pricing adjustment,
that is, the non-arm’s length price will be substituted by the IRD with an arm’s length
price for tax purposes, thereby negating any Hong Kong tax advantage that would have
otherwise arisen.

Question 8
Answer A is incorrect. The royalty is deemed chargeable under s.15(1)(b).
Answer B is incorrect. The royalty is deemed chargeable under s.15(1)(ba).

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Answer C is correct. The royalty is not deemed chargeable under s.15(1)(ba) because no
deduction can be claimed on the royalty.
Answer D is incorrect. The royalty is deemed chargeable under s.15(1)(ba) (re Turner
Entertainment Networks Asia, Inc for Muse Communication Co, Ltd case (2015): change to “The”
‘use’ of, or the ‘right to use’ any copyright materials stipulated in s.15(1)(b) and (ba) cover
‘media work’ (and not just patent, design, trademark, etc.).

Question 9
Answer A is incorrect. Financial institutions are taxable with respect to bank interest
receipts on the terms of the Exemption from Profits Tax (Interest Income) Order 1998.
Answer B is incorrect. The interest expenditure was incurred with respect to the financing
of a capital asset and is therefore barred from deduction under s.17(1)(c).
Answer C is correct. The receipt of the interest will be taxable in the hands of Red Lantern
Limited on the terms of s.15(1)(f); accordingly, the interest expense will be deductible by
virtue of s.16(2)(c).
Answer D is incorrect. The IRD’s policy is to treat hybrid instruments according to their
form and not their substance for tax purposes.

Question 10
Answer A is incorrect. The compensation is capital in nature.
Answer B is incorrect. The compensation is capital in nature because the sole sale contract
would amount to the entire operating structure.
Answer C is correct. The compensation is trading in nature given that the loss is temporary.
Answer D is incorrect. The 10-year lease is a capital asset and hence the compensation is
also capital in nature.

Question 11
Answer A is incorrect. Only specified classes of capital asset are subject to depreciation
allowances, and even then only if such assets are utilised in the production of
assessable profits.
Answer B is incorrect. The rates of depreciation are specified in the Inland Revenue Rules.
Answer C is incorrect. Only certain specified classes of capital assets are eligible for
depreciation allowances.
Answer D is correct. Plant and machinery is a specified class of capital asset with respect to
which depreciation allowances are available.

Question 12
Non-deductible MPF contribution in excess of 15% of salaries = HK$400,000 −
(HK$2,000,000 × 15%) = HK$100,000
Assessable profits = Net profit − exempted Hong Kong bank deposit interest + Non-
deductible MPF contribution in excess of 15% of salaries = HK$(20,000,000 − 200,000 +
100,000) = HK$19,900,000

Question 13
A basis period in a normal case is the accounting period that ends within a year of
assessment.

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Question 14
• Ship and aircraft businesses
• Financial institutions
• Insurance companies
• Clubs and associations

Question 15
Answer A is incorrect. Clubs and mutual insurance companies are in principle chargeable
to profits tax under s.24 and s.23AA respectively.
Answer B is incorrect. S.15BA would treat the appropriation of GSHM’s trading stock as a
trading disposal, and tax it accordingly.
Answer C is correct.
Answer D is incorrect. The application of the two-tiered profits tax regime is subject to a
number of conditions, the most important of which is that in any given set of associated
persons only one such person can avail itself of the two-tiered profits tax rates regime.

Question 16
A is incorrect: a joint venture has no well-established meaning either in Hong Kong statute
law or at common law.
B is incorrect: a partnership deed may but does not necessarily have to set out profit and
loss sharing ratios.
C is incorrect: the tax liabilities of a joint venture are not recoverable out of the assets of a
joint venture generally but only out of the personal assets of the joint venturer.
D is correct.

Question 17
Answer A is incorrect. There is no sideways loss relief for individuals. Losses sustained by
individuals may only be set off against profits of the same trade or business. The ‘same’
in this context is to be construed narrowly. That means that it is not sufficient that the
individual in question carry on a similar trade or business (i.e. in the same industry or
market), but the trade or business in question must be identical to the trade or business
with respect to which the loss was incurred.
Answer B is incorrect. Losses incurred prior to the commencement of a trade or business
are not trading losses and are therefore not available for set off against future profits.
Answer C is incorrect. The loss was almost certainly a capital loss and, accordingly, cannot
be set off against trading profits.
Answer D is correct. Partnership losses are notionally allocated to individual partners
for tax purposes and can only be set off against partnership profits of the same trade
or business.

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EXAM PRACTICE

QUESTION 1
(Adapted from HKICPA Module D Exam (May 2008))

Boxer Production Ltd (BPL) carried on production and distribution of films in Hong Kong.
Mr. Boxer is the major shareholder and director of BPL. BPL’s draft income statement for
the year ended 31 December 2019 shows a net profit of HK$1,000,000 after crediting and
charging the following items of income and expenses:

Income
Royalty income (Note 1) 360,000
Rental income (Note 2) 480,000
Compensation received (Note 2) 60,000
Expenses
Auditor’s remuneration 3,000
Bank charges 150
Legal fee on transfer of the company’s shares 4,800
Staff salary 2,000,000
Regular contributions to MPFS
Mandatory 100,000
Voluntary 250,000
Property tax paid (Note 2) 57,600
Compensation payment (Note 3) 180,000
Staff loan written off (Note 4) 52,000
Late tax payment surcharge 20,000

Notes

1. BPL acquired the right to use copyright of certain films from Mr. Boxer in the year
2018. In January 2019, Mr. Boxer, on behalf of BPL negotiated and concluded a license
agreement in Hong Kong with ABC Ltd (ABC), which is based and carried on business
in Country A, whereby BPL sub-licensed the right to use the copyright of the films in
Country A to ABC. During the year 2019, BPL received a royalty fee of HK$360,000 (net
of withholding turnover tax of HK$40,000 being 10% on the gross royalty fee) through
its bank account in Country A.

2. BPL and Dee Ltd (Dee) had entered into a tenancy agreement whereby BPL leased
four shop units located in Tsim Sha Tsui, Hong Kong to Dee for a term of three years,
starting from 1 January 2018, at a monthly rent of HK$10,000 per shop. During the year
2019, BPL received rental income of HK$480,000 and paid property tax of HK$57,600.
By an agreement dated 25 November 2019, BPL and Dee agreed to terminate the
tenancy agreement of one shop prematurely on 31 December 2019. Dee paid BPL a
sum of HK$60,000 as compensation based on 50% of the last year’s rental income of
the tenancy agreement. BPL signed a new tenancy agreement for the shop on 1 January
2020 with a monthly rental of HK$12,000.

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3. A senior manager, Mr. Holmes, of BPL resigned in July 2019. BPL paid the compensation
payment in consideration of his agreeing not to enter the same industry for three years
from the date of his resignation.

4. BPL lent the loan to one staff member, Mr. Chan, in the year 2018. The money was
deposited in Mr. Chan’s bank account in Hong Kong. Mr. Chan was bankrupted in the
year 2019 and BPL wrote off the loan principal and interest of HK$50,000 and HK$2,000
respectively.

5. Depreciation allowances as agreed by the assessor for the year is HK$150,000.

Required:

(a) Explain the profits tax position of BPL in respect of:

(i) The royalty income derived from ABC; and

(ii) The compensation received from Dee for the premature termination of the tenancy.

(b) Assuming that the royalty income and the compensation are both chargeable to
profits tax, prepare, with explanations, BPL’s profits tax computation for the year of
assessment 2019/20.

QUESTION 2
(Adapted from HKICPA Module D June 2016 Exam)

Ace Ltd (Ace) is a Hong Kong company, which has been carrying on a trading and
manufacturing business in Hong Kong for years. For the accounting year ended 30 June
2019, Ace’s draft income statement shows a profit before taxation of HK$8,000,000 after
crediting and charging, inter alia, the following items of income and expenditure:

(i) Income:
Compensation for early termination of a contract with a supplier (the company 200,000
has 10 suppliers)
Share of profits from a partnership 350,000
Exchange gain from bank deposit of trade receipts 38,000
Interest income from a loan advanced to a director (provided to the director’s 8,000
bank account in Macau)
Interest income from a Hong Kong bank deposit (not secured for any borrowing) 5,000
Interest income from trade debts due from overseas customers 8,000
General provision of uncollectible trade debts written back 200,000
Deposit forfeited by customers due to cancellation of service engagement 100,000
(ii) Expenditure:
Interest expense on a trade debt due to an overseas supplier 2,600
Interest expense on a bank loan from Hang Seng Bank guaranteed by shares of 88,000
Ace’s director (the loan was exclusively used for Ace’s daily business activities).
The shares were listed on Shanghai Stock exchange. The director received
dividend of HK$60,000 from the shares during the year ended 30 June 2019.
Interest expense on an unsecured bank loan from Standard Chartered 90,000
Bank (the loan was exclusively used for the acquisition of certain listed shares for
long-term investment purposes)

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Special contribution paid to Ace’s recognised occupational retirement scheme 200,000

covering previous investment loss
Annual contribution to Ace’s recognised occupational retirement scheme 800,000
(20% of each employee’s annual remuneration)
Refurbishment expense for a residential property currently used by Ace’s 300,000
director as quarters
Refurbishment expense for a retail shop of Ace 1,000,000
Tax payment (salaries tax of Ace’s director) 150,000
Accounting depreciation 180,000
(iii) Ace Ltd also provided information on fixed assets movement and other tax
information as follows:
Addition of office furniture 100,000
Addition of manufacturing machine (used by subcontractor in mainland China) 90,000
Addition of a motor vehicle 200,000
Tax written-down value for 20% pool brought forward 90,000
Tax written-down value for 30% pool brought forward 120,000
Qualifying expenditure claiming for commercial building allowance brought 400,000
forward (all expenditure referred to the shops and director’s quarters’ decoration
incurred in prior years. Such properties were all demolished during the year due
to refurbishment as per item (ii) above)
Tax written-down value brought forward attributable to qualifying expenditure 304,000
claiming for commercial building allowance for the shop and director’s quarters
as per above

Required:

Pertaining to the above information, in respect to Ace for the year of assessment
2019/20, compute:

(a) The total amount of taxable and non-taxable income respectively.

(b) The total amount of deductible and non-deductible expenses respectively.

(c) The total amount of allowances for deduction under Part 6 of the IRO.

(d) The profits tax liabilities. Ignore provisional profits tax.

QUESTION 3
Yellow (HK) Ltd (YHKL) was incorporated and carried on moneylending business within
Rainbow Group. Rainbow (UK) Ltd is the ultimate holding company of the Group. YHKL was
acting as the groups’ financing company by borrowing money from banks and on-lending
the money to other companies within the Rainbow Group. All interest income derived from
YHKL’s moneylending business is regarded as derived from Hong Kong and hence returned
as assessable profits. In the past, YHKL tried to avoid borrowing money from overseas
related companies because the interest expense would not be allowed under s.16(2)(c) on
the basis that the corresponding interest income received by the overseas lending company
would not be taxable in Hong Kong. YHKL only borrowed money from overseas related
party, where the loan funds were raised by way of issuance of debenture (i.e. s.16(2)(f)
could be satisfied). The management of YHKL was aware of that the law governing interest

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deduction has been changed in recent years and that interest expenses on borrowings from
overseas associated companies may also be tax deductible. However, there are specific
limitations in relation to such deduction rule.

Required:

(a) Advise the management of YHKL the relevant rule allowing deduction on interest
expense in relation to borrowing from overseas related parties (except by way of
issuance of debenture or other marketed securities).

(b) Advise the management of YHKL the relevant specific limitations on the deduction rule
you discussed in (a).

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) The profits tax position of BPL

(i) Under s.14, profits tax shall be charged on every person carrying on a trade,
profession, or business in Hong Kong in respect of their assessable profits arising
in or derived from Hong Kong. The broad guiding principle is that ’one looks to see
what the taxpayer has done to earn the profit in question and where they have
done it’ (see Hang Seng Bank and TVBI). It is only the operations of the taxpayer
which are the relevant consideration.

BPL was carrying on business in Hong Kong. There is no evidence that it had any
PE outside Hong Kong. Therefore, the issue is whether the royalty income arose in
or was derived from Hong Kong.

Pursuant to DIPN No. 21, the locality of royalties other than those deemed
chargeable under s.15(1)(a), (b), or (ba) would be the place of acquisition and
granting of the licence or right of use. Similarly, pursuant to of DIPN No. 49, para.
75, if a taxpayer obtains a licence to use an intellectual property right (IPR) from
its owner and then sub-licences the IPR to another party, the IRD would take the
place of acquiring and granting the licence as the source of income. BPL acquired
the licence rights from Mr. Boxer in Hong Kong and negotiated and concluded
a licensing agreement in Hong Kong to grant a licence in respect of the films. As
the acquisition and granting of the copyrights were carried out in Hong Kong, the
source of the royalties was in Hong Kong. The place of payment has no bearing
in determining the locality of profit. Although the films right would be used in
overseas, they were not relevant considerations.

(ii) The question to be considered is whether the compensation was a trading receipt
or a capital receipt. S.14 excludes from profits tax charge profits, which are capital
in nature. The early termination of the tenancy agreement did not destroy BPL’s
profit-making apparatus. The property was let to another tenant soon after BPL had
taken possession of the property. The compensation was not a capital receipt for
the loss of a capital asset.

BPL has been carrying on the business of property letting as it leased out a
number of shops during the relevant times. The tenancy agreement with Dee was

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entered into in the ordinary course of its business. The compensation for releasing
the parties from their respective responsibilities and liabilities under the tenancy
agreement in the ordinary course of business was revenue in nature.

As a general principle in common law, a compensation payment usually takes

the character of the item which it replaces. The compensation was for the failure to
receive, or for the loss of, trading receipts, i.e. 50% rental income for the unexpired
period covered in the tenancy agreement. The compensation was therefore a
trading receipt.

(b) Profits tax computation for Boxer Production Ltd

Year of assessment 2019/20

Basis period: year ended 31 December 2019

Profit per account 1,000,000

Add:
Legal fee on transfer of the company’s shares 4,800
Regular contributions to MPFS (in excess of 15% of salaries) 50,000
Property tax paid 57,600
Compensation payment 180,000
Staff loan (principal) written off 50,000
Late tax payment surcharge 20,000
362,400
1,362,400
Less:
Depreciation allowances (150,000)
Assessable profits 1,212,400
Profits tax payable @8.25% 100,023
Less:
Property tax paid (57,600)
Net profits tax payable 42,423
Less:
Tax reduction (100%, limited to HK$20,000) (20,000)
22,423

Explanations:

1. The withholding turnover tax is deductible as it was charged on gross earnings rather
than on profits. As the royalty income was taken to the income statement on a net
basis, no adjustment is required.

2. Legal fee on transfer of the company’s shares was capital in nature and not deductible
under s.17(1)(c).

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3. Regular contributions (mandatory, voluntary, or both) to an MPFS by an employer

are deductible under s.16(1). The allowable deduction is limited to 15% of the total
emoluments of the employee (s.17(1)(h)). Therefore, the amount added back is
HK$50,000 [(HK$100,000 +HK$250,000) − HK$2,000,000 × 15%].

4. Any tax payable under the IRO, except salaries tax paid on behalf of employees, is
disallowed under s.17(1)(g). However, BPL can claim to set off the property tax paid
against the profits tax payable under s.25.

5. The compensation payment to Mr. Chan was for prevention of future competition. It is
capital in nature and not deductible.

6. The loss on the staff loan was not a deductible expense under s.16(1). BPL was not
carrying on a moneylending business. The loan principal was not trading receipt
previously assessed. Hence, the loss on the loan principal is not deductible under
s.16(1)(d). Since the provision of credit was in Hong Kong, interest on the loan should
have been previously offered for tax. The writing off of the uncollected interest of
HK$2,000 is deductible under s.16(1)(d).

7. The penalty for late tax payment surcharge is not deductible as it was not incurred in
the production of chargeable profits.

QUESTION 2
(a)

Analysis for income Taxable (HK$) Non-taxable (HK$)

Compensation for early termination of
a contract with one supplier 200,000
Share of profits from a partnership 350,000
Exchange gain from bank deposit of
trade receipts 38,000
Interest income from a loan advanced
to a director 8,000
Interest income from a Hong Kong bank
deposit, not secured for any borrowing 5,000
Interest income from trade debts due
from overseas customers 8,000
General provision of uncollectible trade
debts written back 200,000
Deposit forfeited by customers 100,000
Total 308,000 601,000

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(b)

Analysis for expenses Deductible (HK$) Non-

deductible (HK$)
Interest expense on a trade debt 2,600
Interest expense on a bank loan from 88,000
Hang Seng Bank
Interest expense on a bank loan from 90,000
Standard Chartered Bank
Recognised occupational retirement 40,000 160,000
scheme special contribution
(HK$200,000 × 1/5 as deductible)
Recognised occupational retirement 600,000 200,000
scheme annual contribution
(HK$800,000 ÷ 20% × 15% as
deductible)
Refurbishment expense for the 300,000
director’s quarters (being a residential
property, expenses to be ranked for
commercial building allowance)
Refurbishment expense for a shop 200,000 800,000
(HK$1,000,000 × 1/5 as deductible)
Tax payment 150,000
Accounting depreciation 180,000
Total 1,080,600 1,730,000

(c) Depreciation allowances

20% pool 30% pool Total allowances

WDV b/f 90,000 120,000
Additions – office furniture/ 100,000 200,000
motor vehicle
Less: IA @ 60% (60,000) (120,000) 180,000
130,000 200,000
Less: AA (26,000) (60,000) 86,000
WDV c/f 104,000 140,000
266,000

There is no deduction for the manufacturing machine which was used by the
subcontractor in mainland China as it is a ‘leased’ asset and hence is excluded as
a prescribed fixed asset under s.16G. Also, there is no depreciation allowances for
the machine pursuant to s.39E as the machine was a ‘leased’ asset and used outside
Hong Kong.

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Commercial building allowances

Amount (HK$) Total allowances (HK$)

Qualifying expenditure b/f 400,000
Less: Disposal (400,000)
Add: Addition (refurbishment for residential 300,000
property-director’s quarters)
Qualifying expenditure c/f 300,000

WDV b/f 304,000

Less: balancing allowance for demolishment (304,000) 304,000
Add: Refurbishment of director’s quarters 300,000
Less: AA (12,000) 12,000
WDV c/f 288,000 316,000

(d) Ace Ltd

Profits tax computation for the year of assessment 2019/20

Basis period: year ended 30 June 2019

HK$
Profit before taxation 8,000,000
Add: Non-deductible expenses (per (b)) 1,730,000
9,730,000
Less: Non-taxable income (per (a)) (601,000)
9,129,000
Less: Allowances under Part 6 (per (c))
Depreciation allowances (266,000)
Commercial building allowance (316,000)

Assessable profits 8,547,000

Tax thereon [(2,000,000 × 8.25%) + ((8,547,000 − 2,000,000) × 16.5%)] 1,245,255
Less: Tax reduction (100%, limited to HK$20,000) (20,000)
Profits tax payable after tax reduction 1,225,255

QUESTION 3
(a) The new rule governing interest deduction on loan borrowed from a related party is
s.16(2)(g). S.16(2)(g) will be satisfied if the following conditions are satisfiedinsert a colon

• The lender was a non-Hong Kong associated corporation.

• Interest expenses were incurred by the Hong Kong borrower on intra-group

financing business

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• Interest received by or accrued to the non-Hong Kong associated corporation is

subject to tax in overseas at a rate not lower than Reference Rate (16.5% or 8.25% if
the Hong Kong company is a qualified corporate treasury centre)

• The associated corporation (lender) must be the beneficial owner (BO) of the
interest. That is the lender should have real control over the interest and does
not need to pass the interest to someone else. If the non-Hong Kong associated
corporation borrows money from another entity and on-lends the sum to the
Hong Kong associated corporation, then the non-Hong Kong associated corporation
may not be a BO.

(b) • In respect of s.16(2)(g), deduction will be restricted under s.16(2CA) if arrangements
are in place by which the relevant interest is payable to a related person, who is;

°° Neither subject to profits tax in Hong Kong nor subject to a similar tax outside
Hong Kong; or

°° Subject to profits tax in Hong Kong or a similar tax outside Hong Kong at a rate
less than the Reference Rate.

• The disallowed amount under s.16(2CB) =

°° Interest expense

× (no. of days during the basis period that the principle is outstanding and the
arrangement is in place)

÷ (no. of days the loan was borrowed for the basis period); and

• Also, there is ‘utilisation of tax loss’ restriction under s.16(2CC):

°° There would be no interest deduction if the main purpose or one of the main
purposes of the borrowing is to utilise a loss in order to avoid, postpone, or
reduce any liability, whether of the Hong Kong borrower or another person, to
profits tax in Hong Kong.

°° S.16(2CC) may be applicable if a non-Hong Kong associated corporation is

expected to sustain a loss, and a Hong Kong corporation borrows money from
such non-Hong Kong associated corporation, where the main purpose is to
utilise the loss of the non-Hong Kong associated corporation and to avoid tax
liability of the Hong Kong corporation.

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 4
Salaries Tax

CHAPTER TOPIC LIST

4.1 Salaries Tax Overview 4.4.8 Termination Payments

4.1.1 Scope of Charge 4.5 Benefits Specifically Excluded
4.1.2 Exemptions from Salaries Tax
4.1.3 Special Circumstances – Salaries 4.5.1 Payment or Refund of Rent
Tax or Profits Tax 4.5.2 Lump Sum Receipts from
4.2 Office, Employment and Pension Retirement Scheme
4.2.1 Office 4.6 Allowable Deductions
4.2.2 Employment 4.6.1 Outgoings and Expenses
4.2.3 Pension 4.6.2 Depreciation Allowances
4.3 Time Basis Assessment Overview 4.6.3 Loss Brought Forward
4.3.1 Time Apportionment 4.6.4 Excess of Allowable Deductions
of a Spouse Under Joint
4.4 Income Chargeable to
Assessment
Salaries Tax
4.6.5 Self-education Expenses
4.4.1 Income Specifically Chargeable
4.6.6 Concessionary Deductions
to Salaries Tax
4.4.2 Accommodation Benefits 4.7 Personal Allowances
4.4.3 Employee Share-based Benefits 4.7.1 Full Valuable Consideration
4.4.4 Education Benefits 4.7.2 Maintained or Treated as Being
4.4.5 Holiday Journey Benefits Maintained
4.4.6 Other Fringe Benefits 4.7.3 Ordinary Resident in Hong Kong
4.4.7 Retirement Benefits 4.7.4 Sole or Predominant Care

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4.7.5 Claims by More than 4.10.1 Separate Assessment

One Taxpayer 4.10.2 Joint Assessment
4.8 Joint Assessment of Spouses 4.10.3 Provisional Salaries Tax
4.8.1 Joint Assessment Election 4.11 Employees Tax Planning
4.8.2 Time and Manner a Joint 4.11.1 Structuring Employment
Election May be Made Arrangements
4.9 Ascertainment of Assessable 4.11.2 Structuring Remuneration
Income Packages
4.9.1 Income Accrued and Received
4.9.2 Lump Sum Payment on
Cessation of Employment or
Deferred Pay
4.10 Computation of Salaries Tax

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LEARNING OUTCOMES

PRINCIPAL LO2: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES FOR
PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT AND
STAMP DUTY IN HONG KONG
LO2.03: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Scope of salaries tax charge
2.03.01 Explain the scope of charge of salaries tax
2.03.02 Describe the circumstances under which income from employment would cover income
other than from employer
2.03.03 Explain when to apply salaries tax and when to apply profits tax in special circumstances
such as insurance agents
2.03.04 Explain and apply the various exemptions available under salaries tax
LO2.04: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Time basis assessment
2.04.01 Analyse circumstances to determine whether time apportionment is applicable
2.04.02 Apply DIPN No. 10
LO2.05: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Incomes
2.05.01 D
 escribe and apply the rules governing the source of income from office, employment
and pension
2.05.02 Apply DIPN No. 10
LO2.06: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Benefits in kind, housing benefits,
share-based benefits and holiday journey benefits
2.06.01 Analyse the taxation of benefits in kind, housing benefit and share-based benefits
2.06.02 Analyse the taxation of holiday journey benefits
2.06.03 Apply DIPN No. 16, 38 and 41
LO2.07: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Lump sum receipts
2.07.01 Analyse the taxation of lump sum receipts and retirement scheme benefits
2.07.02 Describe and apply the tax treatments of different termination payments under case law
2.07.03 Apply DIPN No. 23
LO2.08: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Expenses and deductions
2.08.01 Explain and apply the rules governing the deduction of expenses and depreciation
allowances available under salaries tax
2.08.02 Explain and apply the rules governing the deduction of concessionary deductions
2.08.03 Apply DIPN No. 9, 23, 35, 36 and 37

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LO2.09: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Losses
2.09.01 Describe the nature of losses
2.09.02 Explain the treatment of losses and apply loss relief
LO2.10: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Personal allowances
2.10.01 Explain and apply the rules governing the claims for various personal allowances
2.10.02 Apply DIPN No. 18
LO2.11: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Salaries tax: Separate taxation on spouses and
joint assessment
2.11.01 Explain the issues relating to the separate taxation and joint assessment of
a married taxpayer and his/her spouse
2.11.02 Apply DIPN No. 18
LO2.44: C
 alculate the following tax liabilities for transactions, individuals and entities: Salaries
tax: Ascertainment of salaries tax liability
2.44.01 Calculate the assessable income from an office, employment and pension, including using
time apportionment method
2.44.02 Calculate the allowable outgoings and expenses, depreciation allowances, losses brought
forward, concessionary deductions and personal allowances
2.44.03 Calculate the net assessable income
2.44.04 Calculate the net chargeable income
2.44.05 Calculate the salaries tax payable, including provisional salaries tax under separate taxation
or joint assessment
PRINCIPAL LO4: ADVISE ON HONG KONG TAX PLANNING IDEAS AND STRATEGIES TO ENHANCE
TAX EFFICIENCY
LO4.11: Advise on Hong Kong tax planning opportunities
4.11.01 Recommend tax-efficient ways to structure remuneration packages and employment
arrangements for employees

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OPENING CASE

GBANK – OPTIMISATION OF EMPLOYMENT
AND REMUNERATION STRUCTURE

G erman Bank AG (GBank) is one of the top banks in Germany and has branches all over the
world, including in Hong Kong. Over the past years, GBank has acquired and merged with
smaller banks in the region. As a result, the bank has inherited different compensation systems
for senior executives and assignees. These were not addressed during the integration due to
resource constraints as a result of an aggressive timeline.

Mr. Hans Weiss, the general manager of GBank Hong Kong is due for retirement after
30 years with the bank. The board of GBank in Germany is taking this opportunity to harmonise
the compensation of senior executives and global assignees in the region. The management
has assigned this task to Jane Sum, Human Resources Manager of GBank Hong Kong.

Jane is a human resource generalist. While she has experience in compensation and
benefits, she is not familiar with taxation. She is aware of employees with regional duties being
taxed in various countries and some senior executives resisting relocation due to tax impacts.
In view of this, she has agreed with her manager, Helmut, that the bank should seek expert
advice on tax-efficient employment arrangements and compensation packages in the region
prior to aligning the salary packages.

Jane contacted Jenny Yang, an experienced regional tax compensation and benefit
consultant at Yang Talent Consulting. Specifically, Jane has asked Jenny to assist in the
following:

• Structuring of employment arrangements for GBank employees with responsibilities

across multiple countries; and

• Recommend tax-efficient compensation packages to enable GBank to attract, retain

and reward key executives.

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OVERVIEW

The Hong Kong tax system is territorial in nature. Income from an employment, office or
pension arising in or derived from Hong Kong by an individual is subject to salaries tax. This
chapter discusses the scope of charge, derivation of office, employment and pension income,
the factors relevant to the determination of an employment location, various salaries tax
exemptions, deductions and allowances as well as how salaries tax liability is computed.

The chapter also deals with the 60-day exemption rule, time apportionment basis of
assessment, special rules that apply to aircraft crew and ship personnel as well as the
exemption for services rendered in a jurisdiction with which Hong Kong does not have a
comprehensive taxation agreement.

The chapter further addresses the definition of income from an office or an employment
under the Inland Revenue Ordinance (‘IRO’), the assessability of various fringe benefits,
how these benefits are taxed and the timing of taxation. It describes circumstances where
a contract for services is deemed to be a contract of services (an employment) and analyses
the tests applied to determine if an employment exists. Special focus is given to the taxation
of housing benefits, share-based compensations and benefits from recognised occupational
retirement schemes.

The chapter also looks at the criteria for the various deductions available under salaries tax
as well as the obligations imposed on the taxpayer with regards to such claims. It presents an
overview of personal allowances, identifies the taxpayers who are eligible, the circumstances of
claim as well as the restrictions imposed by the IRO.

Step-by-step guidance is provided on the computation of salaries tax payable under

separate and joint assessments, with and without time apportionment, as well as on provisional
salaries tax calculations. Tax planning opportunities through the structuring of an employment
contract and remuneration package are also discussed.

By the end of this chapter, you will be able to apply the relevant provisions of the IRO, the
Board of Inland Revenue’s (the Board) and Inland Revenue Department’s (IRD) interpretations
to determine the source of an employment, office or pension income, identify if employment
exists, distinguish the taxable and non-taxable receipts, assess if an item is deductible or
allowable, compute the assessable income and chargeable income of an individual and a
married couple, and prepare the salaries tax computations under different scenarios. In
addition, you will appreciate how employment and remuneration of an employee can be
structured to achieve tax efficiency.

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4 . 1
SALARIES TAX OVERVIEW

We have learned in Chapter 1 that the income of an individual is taxed under three different
taxing schedules depending on the type of income. Salaries tax, one of the taxing schedules,
is the tax on income from an employment or office and pensions. Parts 3 and 10A of the IRO
contain the salaries tax and provisional salaries tax provisions, respectively. The basic charging
section for salaries tax is s.8 of the IRO, which provides that salaries tax shall be charged on
every person in respect of his or her employment, office and pension income that are Hong
Kong sourced. The income of a person from the carrying on of a profession, that is, contract for
services, is chargeable to profits tax and not salaries tax (s.14(1)).

S.9 of the IRO enumerates various receipts that are to be considered income from any
office or employment. These statutory incomes are discussed in Section 4.4.1. In addition,
s.9A of the IRO deems certain income to be income from an employment, that is, service
company remuneration under what is commonly referred to as Type I service company
arrangement (Section 4.4.1.1). S.9A was introduced to counteract an attempt to avoid salaries
tax by interposing a service company between an individual and the ‘employer’. The tax effect
of this would be for the services income to fall within the profits tax regime where deductions
for employee benefits can be claimed and resulting in minimal tax liabilities.

Given that Hong Kong adopts a territorial basis of taxation, determination of the source of
income from an employment, office and pension is key. Only Hong Kong-sourced income from
employment, office and pension is subject to salaries tax. Income from an employment, office
and pension that are not derived from or arising in Hong Kong are not taxable in Hong Kong
(see Section 4.1.2).

To calculate the salaries tax liability of an individual, the following are deducted from total
income from employment, office and pension arising in or derived from Hong Kong to arrive at
the individual’s net chargeable income:

• Income that is specifically exempt under the IRO (Section 4.1.2);

• Deductions allowable under s.12 (Section 4.6);

• Losses under s.12A (Section 4.6.3);

• Concessionary deductions under Part 4A (Section 4.6.6); and

• Personal allowances under Part 5 (Section 4.7).

Salaries tax is charged at the lower of the progressive tax rates on the net chargeable
income or the standard rate (currently 15%) on the net income (being net assessable income
as reduced by allowable concessionary deductions under Part 4A) of an individual. The
progressive tax rates and standard tax rate are prescribed in Schedules 2 and 1 of the IRO,
respectively.

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Note that a married taxpayer is taxed separately from his or her spouse under salaries
tax unless an election is made for a joint assessment (s.10(1)). A joint assessment election is
allowed if the total tax payable by the married couple living together is lower when assessed
jointly as compared to separately assessed (s.10(2)). Section 4.8 of this chapter covers joint
assessment.

The term marriage, as defined in s.2 of the IRO, has been reinterpreted to include a same-
sex marriage following a recent Hong Kong Court of Final Appeal case, Leung Chun Kwong v
Secretary for the Civil Service (2019) 22 HKCFAR 127. In this case, the taxpayer, a civil servant, is
legally married in New Zealand with the taxpayer’s same sex spouse. The Court of Final Appeal
ruled in favour of the taxpayer, recognising his rights to enjoy the same civil servant spousal
benefits as his heterosexual counterparts and to elect for salaries tax joint assessment. The
court ruled that:

• the term marriage shall mean any marriage, whether or not so recognised, entered
into outside Hong Kong according to the law of the place where it was entered into and
between persons having the capacity to do so, provided where the persons are of the
same sex and such a marriage between them would have been a marriage under this
Ordinance but for the fact only that they are persons of the same sex, they shall be
deemed for the purposes of such a marriage to have the capacity to do so; and

• for the purposes of the IRO, references to:

°° “husband and wife” shall be read as “a married person and his/her spouse”;

°° “not being a wife living apart from her husband” shall be read as “not being a
spouse living apart from the married person”; and

°° “either the husband or wife” shall be read as “either the married person or his or
her spouse”.

A same-sex marriage is therefore a valid marriage for the purposes of the IRO and a
same-sex married taxpayer is treated the same as a heterosexual married taxpayer. A same-
sex married taxpayer and his/her spouse may elect for a joint assessment or a personal
assessment joint filing. He/she is also entitled to claim the deductions or allowances available
to a married taxpayer and his/her spouse under the IRO.

A taxpayer who is liable to salaries tax would also be liable to pay provisional salaries tax in
respect of the year of assessment (s.63B(1)). Generally, provisional salaries tax is calculated by
applying the prescribed tax rate/(s) on the individual’s net income or net chargeable income for
the preceding year of assessment.

4.1.1 Scope of Charge

Under s.8(1), salaries tax is charged on income arising in or derived from Hong Kong from
an employment, office or pension during the year of assessment. This means that the
employment income of an individual with a Hong Kong employment will be subject to
salaries tax irrespective of the place where the services are performed. However, income

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arising in or derived from Hong Kong from any employment excludes income derived by an
individual where:

• the individual is not employed by the Hong Kong Government or is not a crew member
of a ship or an aircraft, and he/she renders all services outside of Hong Kong (s.8(1A)
(b)) – see Section 4.1.2.2 on the 60-day exemption rule; or

• the income for services rendered outside Hong Kong (in a non-tax treaty country) has
been subject to similar foreign income taxes and such taxes have been paid (s.8(1A)
(c)) – Section 4.1.2.3.

Specific tax exemption is provided under s.8(2)(j) of the IRO in respect of the income of
aircraft or ship personnel (see Section 4.1.2.1). Note that under s.8(1AB), s.8(1A)(b) would not
apply to the income of a visiting teacher or researcher who was a Hong Kong tax resident
immediately prior to the foreign posting, if such income was exempted from tax in the foreign
country of posting pursuant to the double taxation agreement (DTA) Hong Kong has concluded
with that country.

In addition to s.8(1), s.8(1A)(a) provides that employment income arising in or derived from
Hong Kong includes all income derived from services rendered in Hong Kong including leave
pay attributable to such services. This means that the income of an employee with a non-Hong
Kong employment will be chargeable to salaries tax to the extent of services rendered in Hong
Kong and his or her visits to Hong Kong exceed a total of 60 days in the year of assessment
(s.8(1B)). Such an employee will be subject to salaries tax on the income derived from the
days they render services in Hong Kong under the time apportionment basis of assessment
(see Section 4.3).

Exhibit 4.1(a) and (b) show the decision flowcharts on the chargeability of salaries tax on
employment.

In the case of income from an office (e.g. director’s fees), the income is Hong Kong
sourced if the company paying the fees is centrally managed and controlled in Hong Kong
(see Section 4.2.1).

Pensions are generally considered Hong Kong sourced income if the funds from
which the pensions are paid are controlled and managed in Hong Kong and the pensions
(except government pensions) are attributable to services rendered in Hong Kong
(see Section 4.2.3).

Note that neither the extension to the basic charge under s.8(1A)(a) nor the exclusion under
s.8(1A)(b) or (c) apply to income from an office or pensions.

4.1.2 Exemptions
S.8(2) sets out a list of incomes which are exempted from salaries tax. These exemptions
include official emoluments of staff of consulate, commutation of certain recognised
retirement schemes (Section 4.5.2), most payouts from employers’ mandatory contributions
to mandatory provident fund schemes (Section 4.4.7), certain scholarships, periodic alimony
received from a taxpayer’s former spouse, non-deductible remuneration paid to the spouse
of a sole proprietor, or a partner or a spouse of a partner of a partnership under s.17(2) for
profits tax (s.8(2)(k)), etc.

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(a) Yes
Services
rendered
outside HK? ALL services Yes
rendered outside
No HK?

No
Fully taxable
in HK
s.8(1)(a)
Visits to HK ≤ 60
days in the year of Yes
assessment?
s.8(1B)

No
Tax exempt
s.8(1A)(b)3
Foreign income
No taxes1 paid in
respect of income
from foreign
services?

Yes

Yes (but with tax

credit under
s.8(1C) and s.50) Services rendered in
DTA countries?2

No
1Substantially same nature as
salaries tax.
2Countries with double taxation
agreements with Hong Kong. Income from foreign
3Not applicable to HK government services is tax
employees and air/sea crew members, exempt
and visiting teachers/researchers s.8(1A)(c)
under conditions in s.8(1AB).

EXHIBIT 4.1 (a) Chargeability to salaries tax – Hong Kong

employment

(b)
Visits to HK ≤ 60
ALL services No No
days in the year of
rendered
assessment?
outside HK?
s.8(1B)

Yes Yes

Not taxable
(outside HK Salaries tax charged
salaries tax net) on time
apportionment
basis (s.8(1A)(a))

EXHIBIT 4.1 (b) Chargeability to salaries tax – Non-Hong Kong

employment

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4.1.2.1 Income of Ship or Aircraft Crew – s.8(2)(j) Exemption

Income derived by a person from services rendered as master, commander or member
of a crew of a ship or an aircraft is exempt from salaries tax if the person is present in
Hong Kong for:

• Not more than a total of sixty (60) days in a year of assessment; and

• Not more than a total of one hundred and twenty (120) days in two consecutive years of
assessment, one of which relate to the year of assessment concerned (s.8(2)(j)).

In computing the days under s.8(2)(j), transit days are considered days present in Hong
Kong. This position is confirmed in Inland Revenue Board of Review Decision (IRBRD) D11/13.
In this case, the taxpayer was a member of an aircraft crew and spent his transit time in the
airport area after landing and before taking off. The Board held that for the purpose of s.8(2)(j),
it did not matter that the taxpayer did not pass airport control. The ordinary meaning of
‘present’ was ‘being here’. The fact was that the taxpayer spent his time in a Hong Kong airport,
and therefore was present in Hong Kong.

Illustrative Example 1 – Income of an Aircraft Crew Member

s.8(2)(j) Exemption
Scott is a trained A350 pilot and he joined a Hong Kong airline company (HKAC) in
January 2019. His contract of employment was negotiated and concluded in Hong Kong,
and HKAC is a tax resident in Hong Kong. Scott flew international long-haul sectors. For
the year of assessment 2019/20, he was in Hong Kong for 29 days. In the same year of
assessment, he transited at the Hong Kong airport for 32 occasions on 32 different dates.

 cott was present in Hong Kong for a total of 61 days. Even though he did not enter
S
Hong Kong on the transit days, Scott was present in Hong Kong on those dates for
the purpose of s.8(2)(j). Thus, his entire income from HKAC is chargeable to salaries
tax under s.8(1)(a).
In the case where a crew member of an aircraft or ship has a non-Hong
Kong employment, his or her income will be subject to salaries tax on a time
apportionment basis if he or she does not qualify for an exemption under s.8(2)(j).

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Exhibit 4.2 provides a decision flowchart on the exemption under s.8(2)(j).

Present in HK ≤ 120
days over 2
Present in HK ≤ 60 Yes consecutive years of
days in a year of
assessment, one of
assessment (YA)?
which is the YA
concerned?
No
Yes

Not HK
HK employment: employment: Time Tax exempt in HK
Fully taxable apportionment s.8(2)(j)
s.8(1)(a) basis of assessment
s.8(1A)(a)

EXHIBIT 4.2 Exemption under Hong Kong salaries

tax – aircraft/ship crew

4.1.2.2 60-Day Exemption Rule – s.8(1B)

The income derived from services rendered by a person, not being a government employee
or a ship or air crew member, is exempt from salaries tax if all services in respect of the
employment are performed outside Hong Kong (s.8(1A)(b)). For the purpose of determining
if all services were performed outside Hong Kong, services rendered in Hong Kong during
visits not exceeding a total of 60 days in the year of assessment are disregarded (s.8(1B)). This
is commonly known as the 60-day exemption rule. The IRD states on page 3 of its pamphlet,
‘A Guide to Salaries Tax for People Coming to Work in Hong Kong’, that a person who makes a
trip to Hong Kong for the purpose of training, attending conference or reporting work progress
is regarded as rendering service in Hong Kong.

Meaning of ‘Visit’
The IRO does not define the term ‘visit’. ‘Visit’ is defined in the Oxford Dictionary to mean a
temporary stay at a place, thus ‘visits’ means multiple temporary stays at a places. The word
‘visit’ was also considered in various Board’s cases. In IRBRD D29/89, the Board held that the
taxpayer could not have ‘visited’ Hong Kong as his home and normal place of residence was in
Hong Kong. However, in a later case, IRBRD D11/97, the Board questioned the view adopted in
IRBRD D29/89 and stated: ‘The meaning of the word must of course be construed in its context.
The context of s.8(1B) is that the person is ex hypothesi outside the jurisdiction for most of the
year and the word ‘visit’ may not be inapposite to describe a period of a short stay. It seems to
us somewhat precarious to hang on that single word an intention, not otherwise expressed, on
the part of the legislature to exclude from the beneficial application of s.8(1B) all persons who
have their home in Hong Kong’.

The Board supported the approach in IRBRD D27/03 and stated that the Board would not
deprive a taxpayer of s.8(1B) exemption purely because the taxpayer is a Hong Kong resident
or has a home in Hong Kong. Instead, the Board will take into account the 60-day exemption
rule in s.8(1B) when assessing if the taxpayer has rendered all services outside Hong Kong.

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Similarly, in IRBRD D79/05, the taxpayer who was employed as a project manager to
supervise two projects in China returned to Hong Kong during weekends. Thus, his visits
to Hong Kong totalled more than 60 days. The taxpayer and his manager gave evidence
that he did not render any services in Hong Kong during his visits and the Board held
that the taxpayer had rendered all services outside of Hong Kong and set aside the
assessment issued.

The IRD has indicated that whether the nature of a trip to Hong Kong is a visit depends
on the circumstances of each case and, generally, occasional return to Hong Kong by a
Hong Kong resident who is a permanent employee of a foreign work base will be considered
as a ‘visit’ (see IRD website: https://www.gov.hk/en/residents/taxes/salaries/salariestax/
exemption/employee.htm#exempt). In the case of a foreign employee on short-term
assignment to Hong Kong, the IRD has indicated that the type of visa held by the employee
alone is not the decisive factor in determining if the assignee meets the criterion of ‘visits’ for
the purposes of s.8(1B).

The Board has focused on if all services were rendered outside of Hong Kong in taking
into account the 60-day exemption rule. If a taxpayer’s total days in Hong Kong in a year
of assessment exceed 60 days, the onus of proof will fall on the taxpayer to prove that
he did not perform any services during these days in Hong Kong – see IRBRD D90/03 and
IRBRD D19/16.

Another issue concerning the word ‘visits’ in s.8(1B) was analysed by the High Court in CIR v
So Chak Kwong, Jack (1986) 2 HKTC 174. The court ruled that the 60 days in s.8(1B) referred to
‘visits’ and not ‘services rendered’. Thus, if a taxpayer worked in Hong Kong, albeit minimally,
that is, less than 60 workdays, he or she must not visit Hong Kong for a total of more than 60
days in the relevant period in order for his or her employment income to be exempted from
salaries tax. By the same token, a taxpayer must not render any services if his or her visits
exceed 60 days in the assessment year.

In IRBRD D2/06, the taxpayer was employed in Hong Kong to work in the office of the
employer in China. The taxpayer spent her weekends with her family in Hong Kong, resulting in
visits of more than 60 days during the year of assessment. In addition, she attended a meeting
in Hong Kong as the representative of the Chinese entity. She was registered as a ‘visitor’ at the
Hong Kong company’s reception. The Board acknowledged from the facts that the taxpayer had
provided all services outside of Hong Kong except for the one-day meeting in Hong Kong and
dismissed the case given that her visits exceeded 60 days in total.

Meaning of ‘Days’
Absence of a definition of ‘days’ in the IRO, the Board has adopted its ordinary meaning.
In IRBRD D20/00, the Board held that ‘When a person arrives today and leaves tomorrow even
if the duration of his visit is less than 48 hours, one would treat his visit as two days’.

Similarly, in IRBRD D40/07, the Board adopted the view in IRBRD D20/00 and held that part
of a day should be counted as one day. Consistent with the Board’s interpretation, the IRD has
on page 3 of its pamphlet ‘A Guide to Salaries Tax for People Coming to Work in Hong Kong’
indicated that in counting the days for the 60-day exemption rule, both the arrival and
departure days are to be included, that is, arrival at 11:59 p.m. on 30 March and departure at
11:00 a.m. on 31 March will be counted as a visit of two days.

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In general, a point of contention is whether ‘days’ refers to days actually spent rendering
services or ‘days’ of stay generally. The IRD typically assumes the latter and will typically assess
on the basis that a day spent in Hong Kong is, subject to compelling evidence to the contrary,
a day spent rendering services in Hong Kong. The technical soundness of that approach may
be questionable, but because the burden of proof is on the taxpayer to show an assessment to
be excessive, it is difficult to prove that one did not render any services in employment while
staying in Hong Kong.

Illustrative Example 2 – S.8(1B) 60-Day Exemption Rule

Stephanie is employed by a Hong Kong consulting firm to work in China. In her position,
Stephanie is required to attend quarterly meetings in Hong Kong. Stephanie’s visits to
Hong Kong for the year of assessment 2018/19 are summarised below:

Purpose of visit Arrival Departure Days

Time Date Time Date
Meetings (25–29/6/2018) 10:30 p.m. 21/6/2018 1:50 a.m. a
3/7/2018 12
Travelling from Hong Kong 10:00 a.m. 10/8/2018 0:30 a.m. 12/8/2018 3
to London (return)
7:45 p.m. 18/8/2018 6:30 a.m. 20/8/2018 3
Meetings (24–28/9/2018) 9:00 p.m. 22/9/2018 6:30 a.m. 1/10/2018 10
Meetings (17–21/12/2018) 10:30 p.m. 14/12/2018 7:25 a.m. 5/1/2019 23
and annual leave
Meetings (25–29/3/2019) 7:30 p.m. 22/3/2019 7:00 p.m. 31/3/2019 10
61
a
 ather than flying back to China in the evening of 2 July 2018, it was more efficient for Stephanie to take a flight
R
direct from Hong Kong to Osaka for her next meetings in Osaka.

For the purpose of computing the days in Hong Kong under s.8(1B), part of a day is
considered as one day. Thus, Stephanie’s early morning departures from Hong Kong for
Osaka and London have resulted in additional two days in Hong Kong (one day for each
departure). As a result, she would not meet the 60-day exemption and her employment
income would be subject to salaries tax under s.8(1).

4.1.2.3 Services Rendered and Tax Paid in Non-double Taxation Agreement

Jurisdiction – s.8(1A)(c)
S.8(1A)(c) is intended to prevent the employment income of a person from being taxed twice,
that is, once in the country where the services were rendered and a second time in Hong Kong
under s.8(1), being a Hong Kong employment. To qualify for an exemption under s.8(1A)(c), the
following three criteria must be satisfied:

1. The income must be derived from services rendered outside Hong Kong;

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2. The income must be chargeable to tax of substantially the same nature as salaries tax
in the jurisdiction where the services were rendered; and

3. The commissioner is satisfied that that person has, by deduction or otherwise, paid the
foreign tax.

For the purpose of criteria (2), the IRD expresses in DIPN No. 10 (Revised), paragraph 37,
that the IRD will generally accept as sufficiently similar any tax charged by reference to the
amount of employment income derived. The tax rate and assessment method are irrelevant.
To qualify for s.8(1A)(c) exemption, chargeability and actual payment of foreign tax are crucial.
The amount of foreign tax paid is irrelevant. As long as some foreign tax is paid, the taxpayer is
eligible for the s.8(1A)(c) exemption, that is, the entire income derived from services rendered
outside Hong Kong, on which the foreign tax has been paid, is exempt from salaries tax. If, for
any reason, no foreign tax was paid, the exemption would not apply and the relevant income
would be chargeable to salaries tax.

Given the tax year in the foreign jurisdiction may not coincide with Hong Kong’s, and
foreign tax may not have been paid at the time of tax assessment, the taxpayer must lodge
an objection to the assessment issued on the basis that foreign tax will be paid in due course
(see Chapter 2, Section 2.4, on objection). Upon payment of the foreign tax and submission
of documentary evidence, the IRD will amend the assessment to exempt the relevant income
accordingly.
S.8(1A)(c) only exempts from salaries tax income attributable to services rendered in
another jurisdiction. For example, if an employee with a Hong Kong employment is tax resident
in Sweden and renders services for 165 days in Hong Kong and for 200 days in Sweden, he
will be exempt from salaries tax on his income from employment attributable to the 200 days
in Sweden to the extent that he pays Swedish tax thereon. However, if Sweden taxed him on
his worldwide income, he would be double taxed on the income attributable to his services
rendered in Hong Kong (i.e. once to salaries tax and then again to Swedish tax on worldwide
income), subject to any Swedish unilateral tax credit.

With effect from the year of assessment 2018/19, s.8(1A)(c) exclusion only applies to foreign
taxes paid in a country with which Hong Kong does not have a double taxation agreement
(DTA). A taxpayer who is subject to foreign tax for services rendered in a country with which
Hong Kong has a DTA, for example, China, will only be able to claim a foreign tax credit (FTC)
under s.50 if he is a Hong Kong tax resident on the terms of the ‘Residence’ article of the DTA
in question (s.8(1C)). This means that a person with a Hong Kong employment, who is not a
Hong Kong resident and does not ordinarily reside in Hong Kong, will not be eligible for FTC
under the DTA between Hong Kong and the Mainland China if he or she spent, say, more than
183 days working in China and is subject to individual income tax in China. See Chapter 10 on
calculation of tax credits under DTA.

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Note that under s.50AA(2), a taxpayer is required to take steps to minimise the amount of
foreign taxes paid as a condition for claiming an FTC. The FTC must not exceed the amount of
relief that would have been granted had all foreign tax minimisation steps been taken. The IRD
has to date not released any published guidance on the application of foreign tax credit.

Illustrative Example 3 – Chargeability and Payment of Foreign Tax

s.8(1A)(c)
Mrs. Leung was employed by GBank Hong Kong since January 2013. In 2017, GBank
Hong Kong assigned her to GBank Singapore. Mrs. Leung was based in Singapore from
1 April 2017 to 31 December 2017. Mrs. Leung is a Singapore citizen. Upon completion of
the project at GBank Singapore in January 2018, Mrs. Leung returned to Hong Kong.

Mrs. Leung’s employment income derived from services rendered in Singapore for
the calendar year ended 31 December 2017 was chargeable to Singapore tax. However,
after deductions and reliefs (including the working mother child relief available to a
Singaporean), Mrs. Leung’s Singapore tax liability for the year of assessment 2018 (covering
the preceding calendar year 2017) was nil. Would Mrs. Leung be chargeable to salaries tax
on the employment income derived during her assignment in Singapore?

Let’s analyse this by applying the flowchart in Exhibit 4.2:

• Mrs. Leung has a Hong Kong employment.

• For the period 1 April 2017 to 31 December 2017, she rendered all services in
Singapore.

• She returned to Hong Kong 1 January 2018 and worked in GBank Hong Kong
from 1 January 2018 to 31 March 2018. Therefore, she did render services
in Hong Kong and the 60 days exemption rule would not apply. Note that
the exemption under s.8(1B) is with reference to a year of assessment
and not for each separate employment – see IRBRD D29/95, D30/03 and
IRBRD D53/12.

• Even though her employment income during the period in Singapore

was chargeable to Singapore tax, her Singapore tax liability was nil due to
deductions and reliefs available to her. Thus, Mrs. Leung did not meet criteria
three of s.8(1A)(c)(ii) and the exemption would not apply here.

• Her employment income derived for the whole year (1 April 2017 to 31 March
2018), that is, including the period she worked in Singapore would be chargeable
to Hong Kong salaries tax in the year of assessment 2017/18 under s.8.(1)(a).

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Apply and Analyse 1
The job scope of Hong Kong employees often spans beyond Hong Kong to include
neighbouring Asian countries. Mrs. Leung of Illustrative Example 3 was promoted to
senior manager for North Asia at GBank Hong Kong when she returned on 1 January 2018.
Her new position required her to travel and work on projects across Asia. Mrs. Leung was
assigned to Brunei from 1 April 2018 to 31 March 2019. During the assignment, she took
one week annual leave and returned to Hong Kong. She arrived in Hong Kong at 11:45 p.m.
on 22 December 2018. She departed for Brunei at 12:30 p.m. on 3 January 2019, after
attending a two-hour meeting at GBank Hong Kong. She did not pay any personal tax on
her income during this period as Brunei has no personal income taxes.

Upon completion of her Brunei project, Mrs. Leung was seconded to GBank Taiwan to
roll out a similar project. She worked from the client’s Taipei office effective 1 April 2019.
In order to meet the project timeline, Mrs. Leung and her team worked over weekends.
She only returned to Hong Kong during the Christmas holiday period for 5 days from 23 to
27 December 2019. The project was completed, and Mrs. Leung returned to Hong Kong on
31 January 2020. Mrs. Leung paid individual income tax in Taiwan during the period of her
secondment.

Mrs. Leung has a Hong Kong employment. Advise Mrs. Leung on her liability to salaries
tax for the years of assessment 2017/18, 2018/19 and 2019/20.

Analysis

First, let us summarise Mrs. Leung’s itineraries for the relevant years of assessment:

Year of Period Employment

assessment base
2017/18 1/4/2017–31/12/2017 Singapore Taxable in Singapore but no tax
liability paid
1/1/18–31/3/2018 HK
2018/19 1/4/18–22/12/2018 Brunei No individual income
tax in Brunei
22/12/18–3/1/2019 HK Annual leave and a two-
hour meeting on 3/1/2018
(13 daysa in HK)
3/1/19–31/3/2019 Brunei No individual income
tax in Brunei
2019/20 1/4/19–23/12/2019 Taiwan Taiwan personal income tax paid
23/12/19–27/12/2019 HK Annual leave (five daysa in HK)
27/12/19–30/1/2020 Taiwan Taiwan personal income tax paid
31/1/20–31/3/2020 HK
a
Any part of a day is counted as one day (60-day exemption rule).

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Apply and Analyse 1 (continued)

 rs. Leung has a Hong Kong employment and her employment income is subject to
M
salaries tax under s.8(1)(a) unless relief is available under ss.8(1A)(b)(ii), 8(1B) or
s.8(1A)(c).

Year of assessment 2017/18:

Mrs. Leung worked in Hong Kong from 1 January to 31 March 2018, thus she did not
render all services outside of Hong Kong for the purpose of s.8(1A)(b)(ii). Further, she
did not pay any taxes in Singapore and s.8(1A)(c) is not applicable. Mrs. Leung’s income
from the entire year of assessment 2017/18 is therefore chargeable to salaries tax.

Year of assessment 2018/19:

Mrs. Leung’s income from the Brunei assignment would be exempt from Hong Kong
salaries tax under ss.8(1A)(b)(ii) and 8(1B) as she has rendered all services outside
Hong Kong given that her visits to Hong Kong were 13 days in total, that is, not more
than 60 days.

Year of assessment 2019/20:

Mrs. Leung did not render all services outside Hong Kong in this year of assessment.
However, she paid individual income tax in Taiwan for income relating to services
rendered in Taiwan. As Taiwan individual tax is levied based on the amount of
employment income, they would satisfy the ‘substantially of the same nature
as salaries tax’ requirement under s.8(1A)(c)(i). Taiwan does not have a double
taxation agreement with Hong Kong, thus Mrs. Leung can apply for an exemption
from salaries tax in respect of the income relating to services rendered in Taiwan
by completing the relevant sections of her tax return (ss.8(1A)(c), 8(1C)). To prove
payment of Taiwan tax, a copy of the tax receipt must be submitted.

4.1.3 Special Circumstances – Salaries Tax or Profits Tax

Unlike an employee whose income is charged to salaries tax, the income of a self-employed
person is chargeable to profits tax (Chapter 3). Common examples of self-employed persons
are insurance agents, independent professionals and contractors.

A person who registers an insurance agency business (business owner) provides his or her
own tools and equipment and pays all the expenses. An independent insurance agent business
owner may be a captive agent or may offer different insurance companies’ products and services.
The business owner keeps his or her own records and determines how and when the work is to be
done, including outsourcing/delegating certain activities to others. The business earns its income
based on the results produced, that is, commissions/fees are paid on the policies the insurance
agent business owner sells. The profit under such a situation is subject to profits tax.

Alternatively, insurance agents may be employees of insurance companies. An insurance

agent is an employee if there is a master–servant relationship with the company that employs
the agent to negotiate and sell insurance policies for the company. Typically, the insurance
company has control over how the agent performs the work. The company provides training,
guidelines, or other supervision over the insurance products. An insurance agent employee
often works at the employer’s place of business. See also Section 4.2.2.1 on how to determine if
an employment exists.

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The Hong Kong income of an insurance agent who is an employee or deemed an employee
is chargeable to salaries tax. DIPN No. 33 (Revised) provides the IRD’s view with regards to
the taxation of any upfront payment received by such an insurance agent (paras 28–33).
The IRD adopts the decision of the Board of Review that upfront payments are income from
employment under s.9 of the IRO.

Key Learning Point

Salaries tax is charged on any income arising in or derived from Hong Kong from an
employment or office and pensions except income which are specifically exempt under the
provisions of the IRO.

Knowledge Check Questions

Question 1
Identify which of the following taxpayer will be charged salaries tax.
(I) Mr. Yun’s income from his telco employer during his assignment to the office in
Beijing from 1 April 2019 to 31 March 2020. During this period, he visited Hong Kong
every month and each visit was for four to five days. In addition to these private visits,
he attended two weeks of training and meetings at the company’s Hong Kong head
office from 11 to 23 September and two days staff excursion to Lantau Island over the
Christmas holiday period.

(II) Janet’s employment income. She is an accountant and works for a Chinese company
in Shenzhen. She lives with her parents in San Tin and commutes to work. For
the year 1 April 2019 to 31 March 2020, Janet attended five days training courses
conducted by the Hong Kong Institute of Certified Public Accountants (HKICPA)
in Hong Kong. She also spent four days of annual leave in Hong Kong to help her
parents with some private matters.

(III) John Chan’s income from a Singapore airline company where he worked as chief
steward. He visited Hong Kong 43 days in 2019/20. On top of this, he transited Hong
Kong 18 times when he was flying from Singapore to San Francisco.

(IV) S.N. Singh, an Indian’s national income from the Consulate General of India in
Hong Kong.

(V) Mrs. Wong’s salary from working at her husband’s sole proprietor dental clinic
in Wan Chai.

A I, II and III
B I, III and IV
C I and III
D II, IV and V

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Knowledge Check Questions (continued)

Question 2
Miss Chen is an air stewardess with a Hong Kong airline company. The following are the
days she spent in Hong Kong for the past four years of assessment:

Year of assessment Days in Hong Kong Annual income

including transit (HK$)
2016/17 79 400,000
2017/18 50 420,000
2018/19 58 450,000
2019/20 61 490,000

Analyse which of the following correctly reflects Miss Chen’s income chargeable to
salaries tax.

2016/17 2017/18 2018/19 2019/20

HK$ HK$ HK$ HK$
A 400,000 420,000 – 490,000
B 400,000 – – 490,000
C 86,575 – 71,507 92,630
D 86,575 57,534 – 92,630

4 . 2
OFFICE, EMPLOYMENT AND PENSION

S.8(1) is the primary charging provision for salaries tax. Under s.8(1), salaries tax is charged
on income arising in or derived from Hong Kong from an office or employment and pension.
We consider the applicability of s.8(1) in the context of these income categories in the
following sections.

4.2.1 Office
Income received by a person from holding an office as a company director or a company
secretary is subject to salaries tax if the fee is Hong Kong sourced.

‘Office’ is not defined in the IRO. The definition of an office was given in the English case
Great Western Railway v Bater (1922) 8 TC 231 as ‘a subsisting permanent substantive position
which had an existence independent of the person who filled it, which went on and was filled in
succession by successive holders’.

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The meaning of ‘office’ was also considered by the Court of Appeal in Edwards v Clinch
(1980) STC 438 and by the House of Lords in Edwards v Clinch (1981) STC 617. In Edwards
v Clinch, an engineer who acted from time to time as an inspector for the Department of
Environment (Department) belonged to a panel of inspectors that the Department engaged
for local public inquiries. The Department paid him a daily fee for the engagement. Lord
Wilberforce stated that the word ‘office’ ‘must involve a degree of continuance (not necessarily
continuity) and of independent existence; it must connote a post to which a person can be
appointed, which he can vacate and to which a successor can be appointed. It was held that
he was acting in a personal capacity to carry out a specified task and was not the holder of
an office.

4.2.1.1 Source of Income from an Office

Generally, the source of income from an office is where the office is located. Thus, the source
of a director’s fee is determined by the location where the company making the payment is
resident. ‘Resident’ as regards a company is not defined in the IRO specifically in the salaries
tax context (though it is defined elsewhere in the IRO in other contexts). Case law provides that
a company is resident in the jurisdiction where its central management and control actually
abide. This test emerged from De Beers Consolidated Mines Ltd v Howe (1906) 5 TC 198. (This
means central management and control at the board level, that is, where the substantive
business decisions are actually taken.) In McMillan v Guest (1942) 24 TC 190, it was held that the
office of a director is located where the company has its central management and control. The
Board and IRD adopt this position and this is reflected in various Board decisions and in DIPN
No. 10 (Revised), paragraph 34, respectively.

On the assumption that the real business of a company is carried on at the board
of directors meeting, the place where such meetings are held is an important factor in
determining the location of the company’s central management and control. However, in
today’s electronic world, directors are highly mobile and it is common for directors to be
located in different places while board meetings are often conducted via video conferencing.
Thus, the location of the board meetings has become less relevant in deciding where central
management and control is exercised.

In IRBRD D21/13, the Board held that, while the place where the board meetings are
held is a factor, it is irrelevant in determining the central management and control of the
company. There is no one single factor that determines the residence of a company, but all
facts and circumstances must be taken into account. In this case, considerations were given
to the company’s main activities, principal place of business and place of incorporation and
registration, where the company held its annual general meetings, employed staff, conducted
its business as well as maintained its books and bank accounts. The company was held to be a
Hong Kong resident and the director’s fees were arising in or derived from Hong Kong.

In a recent Australian High Court case Bywater Investments Ltd v Commissioner of Taxation,
Hua Wang Bank Berhad v Commissioner of Taxation (2016) HCA 45, the court identified the
place where central management and control was exercised by looking beyond the structures
formally established and examined the reality of what transpired: The place where the board
formally meets is not the place where the company is centrally managed and controlled, if the
substantive decisions are in reality taken elsewhere (see also Wood v Holden (Inspector of Taxes)
(2006) EWCA Civ 26).

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Illustrative Example 4 – Source of Income from an Office

Mr. and Mrs. Li live in Taipei and are the sole shareholders of a property investment and
management company incorporated in Hong Kong. Both are directors of the Hong Kong
company. The company owns and manages several commercial properties in Hong Kong.
It has an office in Wan Chai and employs eight staff. The Hong Kong staff attends to the
day-to-day business of the company with no management directing authority. Mr. Li
travelled to Hong Kong monthly for business to meet with staff and customers. Mrs. Li
only visited Hong Kong once in the year of assessment 2019/20 to attend the company’s
annual dinner with the staff. All directors’ meetings were held outside Hong Kong;
however, such meetings did nothing more than endorse decisions in substance already
taken in Hong Kong.

For the year ended 31 March 2020, the Hong Kong company paid Mr. and Mrs. Li each
a director’s fee of HK$150,000 and HK$100,000, respectively. Are Mr. and Mrs. Li liable for
salaries tax in Hong Kong?

Only income arising in or derived from Hong Kong from an office is chargeable to
salaries tax. Applying the Board’s decisions in IRBRD D21/13, the company is likely a
Hong Kong resident as its central management and control is exercised in Hong Kong.
Thus, although meetings were held outside of Hong Kong, these did little more than
‘rubber stamp’ decisions previously made in Hong Kong. The directors’ fees are therefore
Hong Kong sourced and are chargeable to salaries tax.

4.2.2 Employment
Employment income is income received by a person in consideration for his or her services
under a contract of employment. On the contrary, Hong Kong sourced income received by a
person under a contract for services are subject to profits tax.

By now, we know that Hong Kong sourced employment income is subject to salaries tax.
Briefly, salaries tax is charged on two categories of employment income, that is,

1. Income from an employment located in Hong Kong under s.8(1)(a), except where the
services are:

a. Fully rendered outside Hong Kong (s.8(1A)(b)(ii)); or

b. Rendered in Hong Kong during visits not exceeding 60 days (s.8(1B)); or

c. Rendered in a territory outside Hong Kong and tax of substantially the same
nature as salaries tax has been paid on the income under the laws of the territory
(s.8(1A)(c)).

2. Non-Hong Kong employment income derived from services rendered in Hong Kong
if the individual’s visits to Hong Kong exceeded a total of 60 days in the year of
assessment (s.8(1A)(a)).

4.2.2.1 What Is an Employment?
Whether a person is rendering services as an employee or otherwise is a mixed question
of fact and law. Several tests were developed by case law to examine if there existed an

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employer–employee relationship. We shall look at these tests and how they are applied by the
IRD and various Board of Review cases.

Control Test
The traditional control test under a master–servant relationship is whether the servant
(employee) is ‘a person subject to the command of his master as to the manner in which he
shall do his work’. It was established in Yewens v Noakes (1880) 6 QBD 530. The element of
control would be exercised in the nature of the work to be performed. Control or direction
on how a task is to be done may not be appropriate in the case of an employee hired with
specialised skills, knowledge and expertise as the employee is likely to exercise his or her
judgement in performing the specialised duties assigned. This does not mean that the person
is not an employee. The control the employer has over the employee in such a situation may
relate to the duties to be assigned rather than how the assigned duties were to be done.

Integration Test
Under this test, the issues to be considered are whether and how the person participated in
the business that engaged them, for example, if the person held a position and reported to a
manager in the organisation, how the person represented him or herself to outsiders, and if
the person was part of the organisation (see Bank voor Handel en Scheepvaart NV v Administrator
of Hungarian Property (1954) 35 TC 311). In DIPN No. 25 (Revised), paragraph 41, the IRD
acknowledges the adoption of the integration test in examining the employer–employee
relationship if the control test is inadequate.

Economic Reality Test

The economic reality test was laid down in Market Investigations Ltd v Minister of Social Security
(1969) 2 Q.B. 173 and in Fall v Hitchen (1972) 49 TC 433. In Market Investigations Ltd v Minister of
Social Security (1969) 2 Q.B. 173, 184–185, Judge Cooke summarised as follows:

The fundamental test to be applied is this: ‘Is the person who has engaged himself to perform
these services performing them as a person in business on his own account?’ If the answer to that
question is ‘yes’, then the contract is a contract for services. If the answer is ‘no’, then the contract is
a contract of service. No exhaustive list has been compiled and perhaps no exhaustive list can be
compiled of the considerations which are relevant in determining that question, nor can strict rules
be laid down as to the relative weight which the various considerations should carry in particular
cases. The most that can be said is that control will no doubt always have to be considered,
although it can no longer be regarded as the sole determining factor; and that factors which may
be of importance are such matters as whether the man performing the services provides his own
equipment, whether he hires his own helpers, what degree of financial risk he takes, what degree
of responsibility for investment and management he has, and whether and how far he has an
opportunity of profiting from sound management in the performance of his task.

Thus, the facts supporting a contract for services are among others: business registration,
risk borne by the person, assets deployed in the business and expenses incurred by them in
generating the service income.

Mutuality of Obligation Test

Under this test, we examine whether there is an obligation on the person to work and on
the business engaging the person to pay him or her and provide work during the time of
the contract.

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In a recent case, Hafal v Lane-Angell (2018) EAT 0107/17, Hafal, a charity, appointed Miss
Lane-Angell and put her on its on-call shift rota. If work was available, Hafal would call on
its rota who could accept or reject the work. Hafal implemented a ‘three strikes’ rule to
resolve operational difficulties. Miss Lane-Angell was removed from the rota under this
policy and claimed unfair dismissal. The Employment Appeal Tribunal found that the working
arrangement demonstrated no obligation to provide or accept work and there was no
overarching contract of employment. Judge Choudry stated: ‘It is a trite observation that an
expectation that the Claimant would provide work is not the same as an obligation to do so’.

Summary – Totality of Facts
Contemporary practice is not to rely on the application of any given test or a combination of
them in a ‘check-list’ format, but to look holistically at the relationship between the putative
employer and employee. The IRD applies the previous four tests in DIPN No. 25 (Revised),
appendix B. Appendix B sets out a list of questions which are to be answered by the taxpayer
when they request for an advance ruling on whether an employer–employee relationship exists.
The answers to these questions would enable the IRD to analyse all facts in totality in making the
determination.

This totality of facts approach was applied in a recent Court of First Instance case CIR v Pang
Fai (2017) HCIA2/2016. In this case, a certified public accountant received honorarium from
the HKICPA for his services as a workshop facilitator and an exam marker. The IRD relied on
the facts that HKICPA controlled the work assignments, for example, workshop structure and
material, date, time and venue of the workshop, and so on, plus the fact that the taxpayer did
not have any financial risk and concluded the existence of an employer–employee relationship
between the taxpayer and the HKICPA. Salaries tax was assessed in respect of the honorarium.

On appeal, both the Board and court looked at all the facts and circumstances and
concluded that it would not be appropriate to apply the control and economic reality tests here.
The Board and court considered the following:

• The taxpayer did not take up the roles for gainful employment or monetary gain but to
assist the profession in maintaining a proper education and qualification programme.
Thus, the economic reality test would not be suitable here.

• The taxpayer was engaged as a practitioner to contribute his skills, expertise and
guidance and it would be ‘totally inapt to adopt the ‘control test’, the object of which
was the identification of a superior–subordinate dominant–subservient relationship’.

• The reward was inconsistent with an employer–employee relationship.

• Both parties could rescind the arrangement at any time without any adverse
consequence.

• HKICPA did not regard the workshop facilitators or exam markers as an integral part of
its organisation.

• The taxpayer was providing professional services as the workshop facilitator and exam
marker and the honorarium for such services should be assessed under profits tax. An
employer–employee relationship did not exist.

It is important to note that while each test is relevant, the extent of the relevance must be
considered alongside the circumstances of the case. All facts should be examined in totality in
deciding if there was an employer–employee relationship.

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4.2.2.2 Source of Employment Income

We have learned that the income arising in or derived from an employment in Hong Kong is
subject to salaries tax (s.8(1)(a)). The IRO does not define what constitutes income arising in or
derived from Hong Kong from an employment. However, this matter has been considered at
Hong Kong case law. Of significance is CIR v George Andrew Goepfert (1987), 2 HKTC 210, also
known as the Goepfert case.

Goepfert Case
Goepfert was employed by a company in the United States and was seconded to work for
a company in the group in Hong Kong. His services were for the benefits of other affiliated
companies in the region. The master–servant relationship was between the taxpayer and the
US company. At all times, Goepfert was paid by the US company and costs of his housing was
partly borne by him and partly by the affiliates outside of Hong Kong. He reported back to the
United States. The Hong Kong company was merely hosting him administratively. The court
ruled that the source of income was the United States’ and not Hong Kong’s. The following
summarises the court’s interpretation of the relevant charging provisions in the Goepfert case:

• For the purpose of s.8(1), the proper consideration is not the place where the employee
performed his or her duties but the location of the employment.

• Three factors are relevant in deciding the location of the employment:

°° The place where the contract was negotiated and concluded;

°° The residence of the employer; and

°° The place where the employee was paid.

• The place where the services were performed is irrelevant in making this determination.

The commissioner may need to examine beyond the employment contract and look at
other factors that point to the real locus of the source of income under the totality of facts
test. All facts (except place of work) must be considered in each case. If evidence showed that
a taxpayer was employed by a Hong Kong company, the fact that his remuneration was paid
outside of Hong Kong would not exempt them from salaries tax.

• If a person’s income falls within the standard charge to salaries tax under s.8(1) during
a year of assessment (i.e. location of his or her employment is in Hong Kong), his or her
entire employment income will be subject to salaries tax irrespective of the place the
services are performed unless all the services are rendered outside Hong Kong (s.8(1A)
(b)(ii)). Thus, once income is caught by s.8(1) there is no provision for apportionment.
Note that services rendered in Hong Kong during visits not exceeding 60 days in a year
of assessment are deemed services rendered outside Hong Kong (s.8(1B)). Further,
s.8(1A)(c) provides for employment income from services rendered outside Hong Kong
(beyond the 60-day exemption threshold) to be excluded from salaries tax if foreign
taxes similar to salaries tax are charged and paid.

• If s.8(1) is not applicable, a person may still be subject to salaries tax if he or she derived
income from an employment in respect of which he or she rendered services in Hong
Kong under s.8(1A)(a), that is, the extended charge. In this case, the person will only
be liable to salaries tax on the portion of the income that relates to the days he or she
rendered services in Hong Kong, subject to the 60-day exemption rule (s.8(1B)).

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See Exhibit 4.1(a) and (b) which provide the decision flowcharts on the chargeability of
employment income to salaries tax.

DIPN No. 10 (Revised) incorporated the Goepfert case into the IRD’s approach to
determining the source of employment income. The IRD acknowledges that while the
employment contract is a key factor, the IRD will review each case based on all relevant facts
and apply the substance over form principle.

Contract of Employment
As we have seen in the Goepfert case, where the employment contract is negotiated, executed
and enforceable plays an important role in deciding if the income from an employment is Hong
Kong sourced. If an employment is located in Hong Kong, any income from the employment
will be Hong Kong sourced and subject to salaries tax.

With regards to the employment contract determination, the IRD expects from the taxpayer
a copy of the written contract and in the absence of a written contract, documentary proof
of the employment with terms, start date, and so on, signed by both the employer and the
employee (DIPN No. 10 (Revised), para. 8).

The Board and Hong Kong court have applied the Goepfert case to disputes raised with
them on the determination of an employment. Some of these are:

Lee Hung Kwong v CIR (2005) 4 HKLRD 80: In this case, both the court and Board considered
all the facts gathered and concluded that the taxpayer worked under the direction of his
Hong Kong employer and was sent to China to discharge the employer’s obligations under
a cooperation agreement with a Chinese company. Thus, the remuneration paid to him in
China stemmed from his employment contract, which was entered into, and enforceable, in
Hong Kong. His employer was resident in Hong Kong. All these facts outweigh the fact that the
taxpayer was paid in China. The remuneration was held to be Hong Kong sourced.

Similarly, in Ahn Sang Gyun v CIR (2009), HCIA 4/2008, the Board applied the totality of facts
test in the Goepfert case and held that Mr. Ahn’s employment with Goldman Sachs (Asia) LLC
(GSALLC) was Hong Kong sourced on the basis that:

• Mr. Ahn’s contract of employment was most closely connected with Hong Kong. He was
interviewed by GSALLC Hong Kong’s key personnel, was recruited for and belonged to
part of a team in Hong Kong. He also reported to various supervisors in Hong Kong.

• GSALLC was resident in Hong Kong given GSALLC had in regulatory filings made
representations that it was controlled by its directors, a majority of whom were Hong
Kong based. Thus, the central management and control of GSALLC was in Hong Kong.

Note this case was dismissed by consent as the taxpayer withdrew his appeal.

Residence of the Employer/Company
In DIPN No. 10 (Revised), paragraph 12, the IRD opines that it would be unlikely for the IRD to
accept a claim for a non-Hong Kong employment if the employer was resident in Hong Kong.
This position is taken even if the contract was negotiated and executed outside of Hong Kong.
The IRD referred to IRBRD D8/92 where the Board concluded that the master–servant
relationship was between the taxpayer and a Hong Kong company. The fact that the contract
was negotiated, received and concluded when he was physically in the United States is
not material.

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In deciding the residence of the employer, the IRD relied on the common law principle.
Under common law rule, a company is resident where its real business is carried on and its
real business is carried on where its central management and control actually abides (see
Section 4.2.1.1).

The IRD acknowledges in DIPN No. 10 (Revised) that the IRD will follow the three key guiding
principles in Re Little Olympian Each Ways Ltd (1995) 1 WLR 560 in deciding the residence of
limited company. These are:

• The mere assertion of where the company’s central management and control is not
sufficient. The primary facts must support such an assertion.

• All the circumstances in which the company carries on its business should be taken into
account, though the weight to be applied to each factor may differ from case to case.
These factors include the provisions of the company’s objects clause, and the place:

°° Of incorporation;

°° Where the company’s real trade and business is carried on;

°° Where the company’s books are kept;

°° Where the company’s administration is carried out;

°° Where the directors with power to disapprove of local steps or to require different
ones to be taken themselves meet or are resident;

°° Where its chief officer or the company secretary is to be found; and

°° Where the most significant assets are.

• In applying the test to a non-trading company, it may be more important than would
otherwise be the case to have regard to the nature of the company’s corporate activities
(DIPN No. 10 (Revised), para. 17).

• The issue of whether a company was centrally managed and controlled outside Hong
Kong or in Hong Kong was critically examined in Board of Review Decision Case No.
D123/02, 18 IRBRD 150. The IRD will follow the above guiding principles in ascertaining
where a limited company resides. In general, importance is attached to the place
where the directors hold board meetings. In many cases, the directors meet in the
country where the business operations take place, and central management and
control is clearly located in that place. In other cases, the directors may exercise central
management and control in one jurisdiction, while the actual business operations may
take place in another. The place of board meetings, however, is significant only in so
far as those meetings constitute the medium through which central management and
control is exercised. The location where central management and control is exercised
is a question of fact and each case must be decided on its own facts. When reaching a
conclusion in accordance with case law principles, only factors which exist for genuine
commercial reasons will be accepted.

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In the case of a parent–subsidiary situation, control by a parent company is not sufficient

per se to constitute central management and control. The IRD would normally regard the
subsidiary and its parent as separate legal entities, each being managed and controlled by
its own board of directors. While it is normal for a parent company to exert influence and
exercise power over the subsidiary company, it is not always the case that the subsidiary is
resident in the same territory as the parent. Regard will be given to the degree of autonomy
with which the board of directors in the subsidiary deals with such matters as to investment,
production, marketing and procurement without reference to the parent. If the subsidiary’s
board of directors merely executes the decisions made by the parent company and there was
no strategic autonomy then the central management and control would be found to be with
the parent company.

The IRD would require the taxpayer to provide the following details of individuals who are
responsible for the central management and control of the company if the taxpayer claimed
that such central management and control is exercised outside Hong Kong (DIPN No. 10
(Revised), para. 20):

• Names;

• Capacities in the employer’s organisation;

• Specific tasks undertaken; and

• Where they are located while exercising management and control.

Documentary proof may be required. The IRD will generally accept certified copies of
directors’ reports and minutes of meetings for this purpose.

Location of Remuneration Payment

While the place of payment may infer the location of an employment, we have seen from the
preceding text that it may not carry the same weight as the other two factors discussed. A party
may make payment for and on behalf of another; thus, the place where payments are made
alone would not prima facie infer the location of the employment.

We have seen in Lee Hung Kwong v CIR (2005) 4 HKLRD 80 that the place where an employee
is paid is not a deciding factor in determining the source of employment income. The IRD
acknowledges in DIPN No. 10 (Revised) that the place of remuneration payment on its own
should not be the decisive factor. See also IRBRD D20/97 where the Board remarked that source
of employment income should not depend on the place where an employee was actually paid.

Summary
Following the High Court decision in the Goepfert case, the IRD adopts the ‘totality of facts’ test
and looks at all the facts and circumstances in determining the locality of an employment.
Considerations are given to the previous three factors. If situations call for a closer review,
the IRD would scrutinise and look beyond the form and look at other factors that point to the
source of the employment income. Case law would suggest that the most relevant factors
are the locality of the effectuation of the employment contract and the jurisdiction of fiscal
residence of the employer.

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Illustrative Example 5 – Source of Income from an Employment I

Wolfgang works for GBank Germany as an architect since 2008. On 2 January 2019, he
was seconded to the bank’s branch in Hong Kong to oversee the bank’s building projects
in the Asia Pacific countries. Although Wolfgang is based in Hong Kong, he reports to a
manager in Germany and he travels extensively in the region. Gbank continues to pay his
remuneration into his German bank account in Frankfurt. He also continues to contribute
to the German pension and social security schemes. GBank Hong Kong provides
Wolfgang with an apartment in Mid-Levels and GBank reimburses the rents paid by
GBank Hong Kong in addition to all other travel costs incurred locally by Wolfgang. What
is Wolfgang’s salaries tax liability, if any?

Income from an employment is chargeable to salaries tax if:

1. The employment is Hong Kong sourced (s.8(1)(a)). Following the principles

established under the Goepfert case, Wolfgang does not have a Hong Kong
employment because:

• Wolfgang was employed by GBank in Germany. His master–servant

relationship is with GBank who pays for his services. He has a secondment
letter with GBank in Germany and he continues to report to a manager in
Frankfurt during the assignment. Thus, his contract and the assignment letter
were negotiated and concluded is Germany.

• Gbank is a not a Hong Kong resident.

• Though of lesser weight, his remuneration continues to be paid by GBank.

2. Wolfgang travels extensively. However, if he were to render services in Hong

Kong, salaries tax would be chargeable on the income relating to those services
rendered in Hong Kong under s.8(1A)(a) unless his stay in Hong Kong was for a
period of 60 days or less in a year of assessment.

If his stay was for a period of more than 60 days, the IRD would apply the time
apportionment basis to compute the income which was attributable to services
rendered in Hong Kong, unless this basis was proven to be not appropriate, for
example, where the contract provided specifically the remuneration applicable to
each service – see DIPN No. 10 (Revised), paras 29 and 30.

If Wolfgang’s stay in Hong Kong during a year of assessment did not exceed 60 days, he
would not have a salaries tax liability with regards to that year of assessment.

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Illustrative Example 6 – Source of Income from an Employment II

Dan was born in Hong Kong and his family emigrated to Vancouver when he was five.
Dan is an intellectual property (IP) lawyer at an international law firm in Vancouver. On 1
April 2019, he was seconded to his firm’s Hong Kong branch to set up the IP practice. Dan
reports to the Hong Kong’s managing partner. The Hong Kong branch pays Dan his salary
and provides Dan with a two-bedroom serviced apartment and the use of a company car.
His salary is paid locally into his Hong Kong bank account.

Dan travelled in the region to attend the Hong Kong practice’s client meetings as well
as interview candidates for the newly set-up IP practice. He was in Hong Kong for a total of
140 days in the year of assessment 2019/20. Advise Dan if and how he would be taxed in
Hong Kong.

Although Dan was seconded from the Vancouver law firm to its Hong Kong branch,
Dan’s employment is a Hong Kong employment under the totality of facts test as:

1. His secondment was closely connected with Hong Kong. His main task was to set
up the IP practice for the branch in Hong Kong. His meetings and interviews were
for the Hong Kong branch. The candidates recruited were part of the Hong Kong
practice (see Ahn Sang Gyun v CIR (2009), HCIA 4/2008).

2. His employer is the Hong Kong branch. The master–servant relationship is with
the Hong Kong Branch who pays for his services.

3. His employer, the Hong Kong branch is a Hong Kong resident as its real business
is carried on in Hong Kong (Re Little Olympian Each Ways Ltd (1995) 1 WLR 560).

Given that Dan’s secondment is a Hong Kong employment, his remuneration is

chargeable to salaries tax under s.8(1)(a). He did not render his services outside Hong Kong
and the relevant exemptions would not apply.

Illustrative Example 7 – Source of Income from an Office and an

Employment III
Bernard Ho is one of the directors of Ho Ho Ho PLC, a company incorporated in Hong
Kong. Ho Ho Ho PLC has its principal place of business and is centrally managed and
controlled in Hong Kong. The board of directors comprised Hong Kong residents and
all board meetings are held in the company head office in Wan Chai. On 1 April 2019,
Bernard was seconded to Singapore to assume the product development director role
with Ho Ho Ho Pte Ltd. Ho Ho Ho Pte Ltd is a newly incorporated Singapore private

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Illustrative Example 7 (continued)

limited company in Singapore and is 70% held by Ho Ho Ho PLC. He was contracted
by the Singapore company for a period of two years. Bernard reports to the managing
director of Ho Ho Ho Pte Ltd in his product development position and the Singapore
company pays him an annual salary of S$250,000.

As the head of product development, he is required to travel to Hong Kong and other
South East Asian countries for the Singapore company. During the year 2019/20, his visits
to Hong Kong totalled 22 days. He had combined two of his business trips to Hong Kong
with Ho Ho Ho PLC board of directors meetings.

For the year ended 31 March 2020, Bernard also received a director’s fee of HK$80,000
from Ho Ho Ho PLC. Is his salary and director’s fee subject to Hong Kong salaries tax for
the year 2019/20?

Bernard’s contract of employment as the product development director is a

Singapore employment and not a Hong Kong employment because:

1. His contract of employment is with a Singapore company;

2. His remuneration is paid by a Singapore company; and

3. He reports to the managing director of the Singapore company.

Bernard’s visits to Hong Kong during the tax year 2019/20 did not exceed 60 days. In
view of this, his salary from Ho Ho Ho Pte Ltd of S$250,000 would not be subject to salaries
tax in Hong Kong (s.8(1B)).

Regarding Bernard’s director’s fee, the income is Hong Kong sourced as it is paid by Ho
Ho Ho PLC. Ho Ho Ho PLC:

1. Is a Hong Kong resident company;

2. Has its central management and control exercised in Hong Kong; and

3. Has its board of directors’ meetings held in Hong Kong.

The director’s fee of HK$80,000 is subject to Hong Kong salaries tax in the year of
assessment 2019/20.

4.2.3 Pension
Under s.8(1)(b), income arising in or derived from Hong Kong from any pension falls within
the salaries tax net. As the IRO does not define pension, the ordinary meaning of pension
is adopted, that is, a periodic payment made to a person upon retirement or cessation of
an employment. S.9(3) provides that a pension includes one that is voluntary or is capable
of being discontinued. This provision was introduced after the decision in Stedeford v Beloe
(1929–1932) 16 TC 505, where it was held that voluntary payment was not pension but a mere
gift or donation.

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4.2.3.1 Source of Pension
From case law, the source of pension is dependent on the location of the pension fund.
The pension fund, in turn, is located in the place where it is managed and controlled.
Thus, pension paid from a fund managed and controlled in Hong Kong is Hong Kong sourced
and subject to salaries tax. Pension paid from a non-Hong Kong managed and controlled fund
is not taxable in Hong Kong under the territorial basis of taxation. Further, pension attributable
to non-government services rendered outside Hong Kong is exempt from salaries tax under
s.8(2)(ca).

Government pensions are fully assessable to salaries tax irrespective of whether the
services were rendered in or outside Hong Kong.

Exhibit 4.3 summarises taxation of pension in Hong Kong.

Pension from fund

Yes Goverment No managed and No
pension? controlled in
Hong Kong?

Yes

No Attributable to
services rendered
outside Hong Kong?

Yes

Fully taxable in HK Not taxable in HK

s.8(1)(b) s.8(2)(ca)

EXHIBIT 4.3 Pension chargeable to Hong Kong

salaries tax

Key Learning Point

Income from a Hong Kong employment is chargeable to salaries tax (s.8(1)(a)) unless
all services are rendered outside Hong Kong save for 60 days (ss .8(1A)(b)(ii) and (1B))
or equivalent foreign taxes are paid where the services are performed (s.8(1A)(c));
whereas income from a non-Hong Kong employment is chargeable to salaries tax only
if the services are rendered in Hong Kong during visits exceeding 60 days in the year of
assessment (ss.8(1A)(a) and (1B)).

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Knowledge Check Questions

Question 3
Identify who of the following taxpayer(s) has a Hong Kong employment.
(I) Stefan is a freelance IT specialist. He rendered services to a Hong Kong company
on an ad hoc basis and was paid based on the hours he worked. Stefan works
independently and usually from his home. He only goes into the Hong Kong
company’s office to update Mr. Wong, who is the IT manager of company.

(II) Miss Tam was interviewed by a UK company in London upon completion of her
doctorate. She signed her contract of employment with the UK company for a
position with the company’s subsidiary in Hong Kong. Her manager and team are
based in Hong Kong and she is paid by the Hong Kong company.

(III) James was assigned to Hong Kong on a two-year contract. He met a local girl and
decided to stay in Hong Kong after his assignment period expired in 2018. His US
employer organised for James to be transferred to Hong Kong on a local contract.

(IV) Pierre is a comedian. Pierre signed an exclusive contract with a private radio studio in
Hong Kong to perform every Monday to Friday night at the studio. Pierre has a room
reserved for him in the studio and his schedules are fixed by the studio although
he can decide on the content of the show to the extent that they are not politically
controversial.

A I and II
B II, III and IV
C I, II and IV
D III and IV

Question 4
Identify which of the following income is chargeable to salaries tax.
(I) The pensions received by a person who worked at the Hong Kong Economic and
Trade Office in Tokyo.

(II) Peyton Cheong’s salary. He is contracted with a Hong Kong company to work in
its factory in Shenzhen. Peyton commutes each Monday morning to Shenzhen
and Friday night back to his parents at Taikoo Shing. Sometimes Peyton worked
from home.

(III) Mr. Tze is one of the four directors of a Chinese company based in Guangzhou.
The three directors are brothers living in Guangzhou and all board meetings are held
there. In June 2019, Mr. Tze was paid a director’s fee of RMB50,000.

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Knowledge Check Questions (continued)

(IV) Mr. Tze also sits on the board of a Hong Kong manufacturing and sales company with
four other directors. All directors, including the chief executive officer (also the main
shareholder), are Hong Kong residents except the chief financial officer, who is based
in the company’s production site in Beijing. The board held four meetings during the
year and three were conducted via video conference and one physical meeting in
Beijing. The company’s sales team is based in its main office in Wan Chai.

A I, II and IV
B I, III and IV
C II and IV
D III and IV

4 . 3
TIME BASIS ASSESSMENT OVERVIEW

We have learned that the income from a non-Hong Kong employment is only chargeable
to Hong Kong salaries tax if the employee renders the services in Hong Kong and his or her
stay in, or visits to, Hong Kong exceeds 60 days in the year of assessment. Under such a
scenario, the income chargeable to salaries tax is that part that relates to services rendered in
Hong Kong, including leave pay attributable to such services. Income attributable to services
rendered outside Hong Kong is out of the salaries tax scope.

Unless the amount of income that relates to services rendered in Hong Kong is clearly
identifiable, for example, the services can be identified to specific rate under the contract of
employment, the IRD uses the time apportionment basis or ‘time-in-time-out basis’ with
reference to the days in Hong Kong to calculate the income attributable to services rendered in
Hong Kong.

4.3.1 Time Apportionment

Under the time apportionment basis, the income attributable to services rendered in
Hong Kong is computed by allocating the remuneration of the employee (including leave pay)
based on the days the employee spent in Hong Kong:

Income attributable to services

Days in Hong Kong during the YA 1
rendered in Hong Kong in thhe Annual income
year of assessment ( YA ) Total number of days in the YA

 Including leave days attributable to services rendered in Hong Kong computed as follows:
1

Bu sin ess days in Hong Kong during the YA

Leave days,
Total bu sin ess days in the YA

 here the sum of business days in Hong Kong, business days outside Hong Kong and leave days is 365 or 366, as the
w
case may be.

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On page 6 of the IRD pamphlet ‘A Guide to Salaries Tax for People Coming to Work in
Hong Kong, HK or non-HK office, HK or non-HK Employment, the Days-in-days-out Basis of
Assessment’, the IRD indicates that the day of arrival and the day of departure would be
counted as one day (known as the ‘midnight rule’) for the purpose of computing the days in
Hong Kong during a year of assessment. If the date of arrival is the same date of departure,
only a half day would be counted. This is unlike the calculation of days under the 60-day
exemption rule where part of a day is counted as one day (see Appendix 4.A that sets out the
two bases of counting the days in Hong Kong).

The IRD indicates in DIPN No. 10 (Revised), paragraph 29, that it would apply a different
approach if the time apportionment basis proved to be inappropriate. Note that the IRD refers
to ‘exceptional circumstances’ and a circumstance where the employee ‘can establish’ that the
rate of remuneration for the services rendered outside Hong Kong is substantially greater than
the rate he receives in Hong Kong. The onus of proof lies with the taxpayer and in the absence
of documentary evidence supporting a different basis of allocation, the IRD will apply the
‘time-in-time-out’ basis of apportionment.

When the income derived from Hong Kong services is clearly identifiable (e.g. clearly
specified in the contract of employment), the time apportionment basis rule will not apply. The
Board supports this view in IRBRD D106/89. Here, the Board has held that the time-in-time-
out apportionment basis is a rough and ready method of assessing income chargeable to tax
where payment for services rendered in Hong Kong cannot be readily ascertained. When the
derivation of an item of income is clearly identifiable, there is no room for the application of the
time-in-time-out formula.

Illustrative Example 8 – Days-in-days-out Income Apportionment

Wol6gang’s .(Illustrative Example 5) annual remuneration for the year of assessment
2019/20 was HK$1.55 million based on the buying exchange rates published by the IRD.
In August 2019, he was working on a project in Hong Kong. Prior to this, he took his
30 days leave entitlement. For management purposes, Wolfgang’s remuneration was
allocated to GBank’s branches in the region based on the total revenue of each branch.
Compute his taxable salary.

The following are his travel schedules for the year of assessment 2019/20.

Arrival date Departure date Days in HK

1/4/2019 3/4/2019 2
6/5/2019 14/5/2019 8
7/6/2019 16/6/2019 9

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Illustrative Example 8 (continued)

Arrival date Departure date Days in HK

3/8/2019 22/8/2019 19
28/8/2019 27/9/2019 30
30/9/2019 15/10/2019 15
1/11/2019 17/11/2019 16
12/12/2019 20/12/2019 8
28/12/2019 24/1/2020 27
134
Leave days attributable to HK a
12
Days chargeable to salaries tax 146

a
Leave days attributable to Hong Kong:

Business days in HK (134 )

Leave days (30) 12 days.
Total business days (336)

 hile the remuneration allocation used by management may be considered a fair

W
allocation among branches having the benefit of Wolfgang’s services, it has no
relation with the services actually rendered by him in Hong Kong and would not be
acceptable by the IRD (see IRBRD D49/94.).

 olfgang’s income attributable to Hong Kong under the time-in-time-out basis for
W
salaries tax purposes is computed as follows:

Days in Hong Kong (146)

Annual income (HK$1, 550, 000) HK$618,306.
Total number of days in the YA (366)

Key Learning Point

Time basis assessment applies only in the case of a non-Hong Kong employment to
attribute the employment income of an employee to services rendered in Hong Kong when
the payment for services cannot be readily ascertained.

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Knowledge Check Question

Question 5
Identify which of the following are subject to the time-in-time-out basis of apportionment
for ascertaining the salaries tax liability in Hong Kong.
(I) Gary Fisher is an Argyle diamond specialist. He has a contract of employment with a
UK company as Senior Fancy Diamond Adviser. In addition, Gary travels to Hong Kong
every month for a week (seven days) to provide services to the Hong Kong office of
the UK company.

(II) Sally works as an accountant for an IT company in Hong Kong. Every month, she
travels to China, Macau and Taiwan for work.

(III) Mr. Wong is employed by the Hong Kong subsidiary of a US multinational company as
Tax Director, North Asia. He is also required to support South Asia and Oceania and
has a separate contract of employment with the Singapore subsidiary of the same US
multinational company.

(IV) Billy is an IT specialist consultant with a US multinational corporation. He was

seconded to its Hong Kong subsidiary in April 2019 to roll out the system for the
company’s subsidiaries in the Asia Pacific region. Billy travels extensively and he was
in Hong Kong for just 70 days in the year of assessment 2019/20.

A I and II
B II and III
C I and IV
D III and IV

4 . 4
INCOME CHARGEABLE TO SALARIES TAX

The IRO does not define the term ‘income’ exhaustively, thus, guidance is sought under
common law principles. Case law has established a set of principles which provides constructive
guidance in determining if an item constitutes income under the ordinary concepts. Income
according to ordinary concepts clearly includes remuneration from an employment.
Receipts from winning a lottery or undertaking a hobby are ordinarily not income. Similarly,
reimbursement of a business expense incurred by the employee on behalf of the employer is
not income. Further, some receipts are not income because they are capital in nature.

Under common law principles, income under ordinary concepts must be:

• Beneficially derived by the recipient, that is, there must be an inflow of money to the
taxpayer’s own benefit. See Federal Commissioner of Taxation (FCT) v Cooke and Sherden
(1980) 80 ATC 4140, where the receipt of an item that saved a taxpayer from incurring
expenditure was held not to be income.

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• A real gain – see Hochstrasser v Mayes (1960) AC 376 (compensation for work-related

expenses was held not to be income as it was not a real gain).

• Convertible into money or money’s worth (this is one of the key factors used in deciding
if a benefit provided to an employee is chargeable to salaries tax). A benefit that cannot
be converted into money is not income to the taxpayer – see FCT v Cooke and Sherden
(1980) 80 ATC 4140. Frequent-flyer points earned from work travels were held not to
be income on the basis that the flight rewards from frequent flyer programmes arose
as a result of a personal contractual relationship between the individual and the airline
company and the points were not convertible to cash (Payne v FCT (1996) 66 FCR 299).

• A reward for services rendered. An amount being a payment for personal exertion or
a reward which can be related to some services provided by the recipient constitutes
ordinary income; for example, tips paid for good services (Calvert v Wainwright (1947)
27 TC 475).

• Periodic, recurrent and regular.

The preceding information are the broad characteristics of income under common law.
Let us now look at the income specifically chargeable to salaries tax under the provisions
of the IRO.

4.4.1 Income Specifically Chargeable to Salaries Tax

S.9(1) of the IRO defines a set of receipts that qualify as income from any office or employment
for salaries tax purposes. Generally, most income from an employer to an employee is subject
to salaries tax whether the payments are made pursuant to the employment contract or
otherwise.

Under s.9(1)(a), income derived from any office or employment irrespective of whether
they are from the taxpayer’s employer or another party includes: wages, salary, leave pay,
fee, commission, bonus, gratuity, perquisite (see Section 4.4.6 ) and allowances. This includes
payments or perquisite an employee receives from parties related to his or her employer, for
example, shareholders, directors and so on. It was held in D21/16 that the dividends received
by a taxpayer from certain restricted stock awards from his employer are perquisite from
his employment subject to salaries tax. Here, the taxpayer was granted a certain restricted
stock award that he could not deal in until the expiry of the restriction period. In the interim,
the shares were held in trust and the taxpayer received cash dividends. When assessed on
the dividends, the taxpayer appealed, and the Board concluded that the ‘dividends’ had the
character of a perquisite akin to an extra bonus to the taxpayer. The Board cited PA Holdings
Ltd v Revenue and Customs Commissioners (2012) STC 582 – ‘the correct approach is to consider
all the facts to the receipt of the income. This requires the court not to be restricted to the legal
form of the source of the payment but to focus on the character of the receipt in the hands of
the recipient’.

Exhibit 4.4 shows what is specifically classified as income under s.9(1).

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Income under s.9(1) Relevant IRO Chapter

provision reference
Receipts from a pension or provident fund, occupational retirement
Section 4.4.7
scheme or society being:
• Amounts representing the employer’s contributions to a s.9(1)(aa)
non-recognised retirement fund or scheme or non-approved
retirement scheme in Hong Kong
• Amounts (other than a pension) representing the employer’s s.9(1)(ab)(i)
contributions to a recognised occupational retirement scheme
other than on termination of service, death, incapacity, terminal
illness or retirement
• Any amount (other than a pension) paid on termination of service s.9(1)(ab)(ii)
that is attributable to the employer’s contributions to a recognised
occupational retirement scheme that exceeds the proportionate
benefit calculated in accordance with s.8(5)
• Any payment received pursuant to a judgement given under s.57(3) s.9(1)(ac)
(b) of the Occupational Retirement Schemes Ordinance (ORSO)
(Cap.426) that is attributable to the employer’s contributions
to the occupational retirement scheme in respect of which the
judgement was given
• So much of the accrued benefit that an employee has received, or s.9(1)(ad)
is taken to have received, from a mandatory provident fund (MPF)
scheme representing the employer’s contributions other than
on retirement, death, incapacity, terminal illness or termination
of service
• So much of the accrued benefit that an employee has received, s.9(1)(ae)
or is taken to have received, from a MPF scheme representing
the voluntary contributions paid to the scheme by the employer
that exceeds the proportionate benefit calculated in accordance
with s.8(5)
The rental value of any place of residence provided rent-free by the s.9(1)(b)
employer or an associated corporation
The excess of the rental value over rent where an employer or an s.9(1)(c) Section 4.4.2
associated corporation provides a place of residence at a rent less
than the rental value
Any gain realised by the exercise of, or by the assignment or release s.9(1)(d) Section 4.4.3
of, a right to acquire shares in a corporation obtained by a person
as the holder of an office in or an employee of that or any other
corporation

EXHIBIT 4.4 Classification of income under s.9(1)

Note that s.9(6) defines ‘employee’ to include a holder of an office, such that all categories
of income are chargeable not only in the hands of an employee, but also in the case of an
office holder.

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While some items specified in s.9(1)(a) like salary, wages, bonus, allowances and so on are
straightforward income categories, the term perquisite’ and what constitutes taxable perquisite
was considered under various case law in Hong Kong. Prior to David Hardy Glynn v CIR (1990)
3 HKTC 245 (also known as ‘Glynn Case’), the IRD generally took the position that fringe benefits
in the form other than money, would only be chargeable unless specifically covered under a
specific provision in the IRO, if:

• It was capable of being converted into money by the recipient; or

• Involved the discharge of a personal liability of the employee.

In the Glynn Case, the term ‘perquisite’ was held to include money that is paid in discharge
of a debt of an employee. The taxpayer, David Hardy Glynn was assessed to salaries tax in
respect of school fees paid directly by his employer to his child’s school, for which his employer
was liable under his employment contract. The court held that all sums paid by the employer
for the benefit of the employee are taxable as perquisite. This deviates from the convertibility
into money principle under common law (see Section 4.4.6), which was the position adopted by
the IRD. In view of the Glynn Case, the IRO was amended to include the ‘liability test’ provision,
that is, s.9(1)(a)(iv).

Under s.9(1)(a)(iv), an amount paid by an employer to, or for the credit of, a person
other than the employee in discharge of a sole and primary liability of the employer to that
person, not being a liability for which any person was surety is not chargeable to salaries tax.
This means that as long as an employer is paying under its own obligations to a third party, the
payment does not constitute income from an employment or office. However, there are three
exceptions to this general rule pursuant to s.9(2A). The exceptions are any payment:

• In relation to a benefit provided by an employer not in connection with a holiday

journey and is capable of being converted into money by the recipient – s.9(2A)(a)
(Section 4.4.6);

• In connection with the education of a child of an employee – s.9(2A)(b) (see

Section 4.4.4); and

• In connection with a holiday journey – s.9(2A)(c) (Section 4.4.5).

The above exceptions are benefits that are specifically chargeable to salaries tax.

Illustrative Example 9 – S.9(1)(a)(iv) Liability Test

GBank Hong Kong pays for the utility bills of its senior executives who are seconded
from GBank Germany. The utilities service contracts are executed between the utilities
company and GBank Hong Kong.

Are the utilities payments made by GBank Hong Kong benefits chargeable to salaries
tax in the hand of the executives?

 nder s.9(1)(a)(iv), the utilities paid by GBank Hong Kong to the utilities company
U
in discharge of the bank’s primary liability are not chargeable to salaries tax as the
payments are not convertible to cash to the executives.

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DIPN No. 16 (Revised) provides guidance on the IRD’s position with regards to the
chargeability of non-cash fringe benefits derived by an employee or an office holder. In
paragraph 18 of this DIPN, the IRD has cautioned where a transaction was fictitious or
structured for the dominant purpose of obtaining a tax benefit, the IRD would disregard such
transaction or take the necessary action to counter the tax benefit (see also IRBRD D20/09
and IRBRD D34/13 in Section 4.4.2.1).

4.4.1.1 Deemed Income from Employment

Other than defining specifically a list of items which are treated as income, the IRO also
contains a provision on deemed employment income (s.9A).

Given that very few expenses are deductible under salaries tax assessment when compared
to those available under profits tax, it is not surprising that taxpayers providing services to a
business prefer to be assessed under profits tax. In view of this, some taxpayers use service
companies to disguise the employer–employee relationships in order to access the deductions
under profits tax, including the provisions of ‘tax friendly’ benefits to the individual, the
‘employee’ of the service company. In response to this, the IRO has been amended to include
s.9(A) and the IRD has issued DIPN No. 25 (Revised), which addresses these service companies
(known as Type I) with detailed coverage on the four tests in deciding if an employer–employee
relationship existed (see Section 4.2.2.1).

S.9A of the IRO deems remuneration under certain agreements to be income from an
employment of profit. Broadly, s.9A provides that the remuneration paid to a corporation
for the services of an individual under a service agreement is deemed to be his or her
income from an employment if the corporation is under the control of the individual and/
or the individual’s associate. Similarly, the remuneration paid to a trust for the services of an
individual is deemed to be his or her income from an employment if the beneficiary of the
trust is the individual or his or her associate. When s.9A applies, the individual is deemed to
have commenced employment on the date the individual commenced to carry out services
under the service agreement.

However, s.9A does not apply if all of the six criteria set out in s.9A(3) are met. These
criteria are:

• The service agreement does not provide for benefits that are commonly provided
in an employment contract; for example, annual and sick leave, medical or pension,
and so on.

• If the service agreement requires the services to be carried out personally by an

individual, that individual also provides services to other persons during the term of the
agreement.

• The individual is not subject to any control or supervision on the performance of

services commonly exercised by an employer. On this point, the IRD indicates in DIPN
No. 25 (Revised), paragraph 25, that the IRD will disregard supervisions or control which
are directly attributed to statutory requirements and those that are not dependent on
the existence of an employer–employee relationship.

• The remuneration is not paid periodically or calculated in the same basis as in an

employment contract. In DIPN No. 25 (Revised), paragraph 27, the IRD states that
an employment is likely to have regular payments made based on hours worked or

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position occupied, whereas contractor’s payments are generally based on an agreed

sum for specific work.

• The person paying the remuneration has no right to dismiss the individual as in the
case of an employee. Typically, an employment contract requires notice to be served
and/or certain statutory or award requirements to be met, whereas a service contract is
discharged upon full performance or terminated in the event of a default (DIPN No. 25
(Revised), para. 28).

• The individual is not held out to the public to be an officer or employee of the person
paying the remuneration. The person paying the remuneration cannot act in a
manner that led the public to believe that the individual is an employee or part of its
organisation, for example, issue of name cards, statements made at public events,
press conferences or through materials published.

Further, deemed income from employment under s.9A(1) does not apply if the individual
performing the services establishes to the satisfaction of the commissioner that he is not an
employee of the person paying the remuneration (s.9A(4)).

The Board held in IRBRD D78/06 that the carrying out of services was in substance the
holding by the taxpayer of an employment of profit. In this case, the taxpayer was the director
of a service company (ServiceCo) and owned all shares except one (held by the taxpayer’s
sister-in-law) issued by it. ServiceCo was engaged as resident engineer for a project awarded to
Person A. ServiceCo was engaged for the same services/role by Person B for phase two of the
same project. The Board applied the test in Market Investigations Ltd v Minister of Social Security
(1969) 2 Q.B. 173 (see Economic Reality Test under Section 4.2.2.1) on whether an employment
existed. The Board concluded that what matters most is the substance (see also DIPN No. 25
(Revised), p. 13). The commissioner and the Board were unsatisfied that the performance of
services was not in substance the holding of an employment of profit with Person A and Person
B under s.9A(4):

• The consultancy agreements provided for 25 days of annual leave (s.9A(3)(a)). Person A
or Person B controlled when the annual leave was to be taken, respectively.

• The agreements required services to be carried out personally by the taxpayer

(s.9A(3)(b)).

• Person A and Person B paid annual fees payable in 12 equal instalments. Person B
changed the payment to lump sum progress payment though the total amount was the
same and the Board held that this was a disguise (s.9A(3)(d)).

• The agreements with Person A and Person B contained termination clauses not
dissimilar to dismissal clause in an employment agreement (s.9A(3)(e)).

• Neither ServiceCo nor the taxpayer had financial risk. Person A and Person B arranged
workspace for the taxpayer. Neither ServiceCo nor the taxpayer provided its or his or
her own equipment or hired its or his or her own helpers.

The IRD suggests in DIPN No. 25 (Revised), paragraph 46, that a taxpayer who wishes to
have the commissioner exercised his or her discretion under s.9A(4) to either advise the IRD at

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the time of lodging his or her tax return or by means of a separate application for an advance
ruling. To make the determination, the commissioner will require comprehensive details of the
facts. The commissioner will consider case law and apply the tests set out in Section 4.2.2.1 in
deciding if an employment exists.

Illustrative Example 10 – S.9A Deemed Income from Employment

Bruce is an experience IT consultant in Hong Kong. He worked for Star Consulting, a
Hong Kong registered consulting company for over 20 years. Bruce resigned from the
company in June 2019 to work as a freelance IT consultant.

In January 2020, Star Consulting contracted Bruce as an independent consultant to run

the company’s key IT project in Hong Kong. The consulting agreement requires Bruce to
perform the role of a full-time IT project manager for Star Consulting’s anchor client and, in
return, Bruce receives a daily remuneration of HK$8,000 payable at the end of each month.
Bruce is required to provide a weekly project status report to Star Consulting’s project
director. He must obtain prior approval for any leave of absence from the same project
director. The company also reimburses Bruce for his medical and work-related expenses
as it does for its employees.

Star Consulting presented Bruce as a member of the organisation to its clients and
Bruce carries Star Consulting’s business cards when dealing with its clients.

Advise Bruce how his remuneration from Star Consulting under the independent
consulting agreement would be taxed in Hong Kong. Would the income be assessed under
the salaries tax or profits tax regime?

 nder s.9A, the remuneration from Star Consulting would be deemed as income
U
from an employment subject to salaries tax because:

1. The agreement requires Bruce to carry out the services personally on a full-time
basis (s.9A(3)(b)).

2. Bruce’s leave of absence is subject to the control of Star Consulting’s director

(s.9A(3)(c)).

3. The company pays for Bruce’s medical and work-related expenses, benefits and
reimbursements made to the company’s employees (s.9A(3)(a)).

4. Bruce is held out to be part of Star Consulting to the clients and the public given
that he uses the company’s name and logo in his business cards (s.9A(3)(f)).

4.4.2 Accommodation Benefits

An employer or an associated corporation may provide an employee with accommodation
benefits in different forms. Such Accommodation benefits are chargeable to salaries tax as
shown in Exhibit 4.5.

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Types of benefit Taxable Chargeable amount IRO provision

Housing/rental/mortgage allowance Yes 100% s.9(1)(a)
Rent-free residence Yes Rental value as s.9(1)(b)
stipulated in s.9(2)
Partially subsidised residence Yes Rental value (as above) less s.9(1)(c)
amount paid by the employee

EXHIBIT 4.5 Accommodation benefits chargeable to salaries tax

S.9(6) defines an ‘associated corporation’ as:

a. A corporation over which the employer has control;

b. If the employer is a corporation:

(i) A corporation that has control over the employer; or

(ii) A corporation that is under the control of the same person as is the employer.

‘Control’ in relation to a corporation is defined in s.9(6) to mean the power of a person

to secure:

a. By means of the holding of shares or the possession of voting power in or in relation to

that or any other corporation; or

b. By virtue of any powers conferred by the articles of association or other document

regulating that or any other corporation

so that the affairs of that corporation are conducted in accordance with the wishes of
that person.

Where an accommodation benefit is provided, the actual rent paid by the employer (or an
associated corporation), or the rent refunded by the employer (or an associated corporation)
to the employee, are deemed not to be income in the hands of the employee (s.9(1A)). The
employee will only be taxed on the rental value of the accommodation benefit as stipulated in
s.9(2) – see Exhibit 4.5.

The IRO defines the term ‘place of residence’ to include a residence provided by an
employer or an associated corporation notwithstanding that the employee is required to
occupy that place of residence by or under his or her terms of employment and whether or not
by doing so he can better perform his duties.

In IRBRD D46/87, the Board highlighted that the word ‘residence’ may receive a different
meaning according to the position in which it is found and must be construed according to the
object and intent of the particular legislation, that is, ‘primarily the word “residence” means
the dwelling and home where a man is supposed usually to live and sleep’. If the taxpayer
only made use of the accommodation for the purpose of eating, sleeping and relaxing when
performing his or her duties, he or she received no personal benefit. For the rental value of
a place of residence to be held to be taxable as income arising from employment there must
be some element of benefit to the employee beyond enabling him or her to eat, sleep and
relax while on duty. Further, in IRBRD D36/95, the Board referred to CIR v Chow Hung-kong
(1978) HKLR 475 and concluded that no benefit arose from the provision of the hotel room

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to the taxpayer as he or she had no exclusive control and possession of any part of the
accommodation provided. The room merely enabled him or her to rest and sleep while on duty
and did not qualify as a place of residence for the purpose of s.9(2).

4.4.2.1 Rent-free or Partially Subsidised Accommodation versus Housing Allowance

It is important to distinguish a provision of a rent-free or subsidised accommodation (through
the provision of a place of residence or a refund of rent paid) from a housing allowance as
the salaries tax implication of the two items is quite different and significant. An allowance
for housing is fully assessable under s.9(1)(a) while the former is taxed at the rental value,
typically at 10% of the income of the employee, which often is lower than the actual rent paid
or refunded by the employer.

Given the tax significance, rent refund is a commonly disputed issue in Hong Kong. There
are many court and Board cases on this matter, summarised as follows.

Rent Refund
The IRD has provided in page 8 of its pamphlet ‘How to Tax the Provision of a Place of
Residence to the Employee’ clear guidelines on the control the employer is to put in place with
regards to rent refund to meet the provision of rent-free or subsidised accommodation. In
IRBRD D149/00, the taxpayer claimed that HK$38,000 paid to him each month pursuant to the
following clauses in his contract of employment was a housing benefit and should be classified
as a refund of rent and not an allowance wholly subject to salaries tax:

1. August to October 1995:

Up to 31 August 1995, on full company paid housing; and after 1 September 1995, a
housing allowance HK$38,000 per month plus utilities.

2. November 1995 to March 1998:

A housing benefit up to a maximum amount of HK$38,000 per month in the form of a

refund of rent where employer-provided accommodation was not available.

The Board considered the following key issues:

• The ordinary meaning of ‘refund’ connotes a repayment or reimbursement, not a mere

payment. There must be actual payment of rent in the first place before a subsequent
reimbursement by the employer to constitute a refund of rent (see IRBRD D92/95).

• One of the indicia distinguishing a rent refund from cash allowance is the control
exercised by the employer over a refund to ensure that it cannot be spent in any way
the employee wants. This control must exist as a matter of fact and not just in theory
(IRBRD D33/97).

• The question whether a housing allowance is a rent refund or a cash allowance

also depends on the parties’ intention at the time they enter into the contract of
employment (IRBRD D18/99).

The Board found that for the period from August 1995 to October 1995, the payments of
HK$38,000 per month constituted a fixed cash allowance. There was no evidence of a lease
agreement and rent was not recorded in the profit and loss account of the employer. Further,
the company had not set up any control as to how the taxpayer would spend the allowance.

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With regards to the period from November 1995 to March 1998, the Board held that
the monthly sum of HK$38,000 paid to the taxpayer was a refund of rent as the taxpayer
had entered into a valid tenancy agreement under which he paid a monthly rent, and rental
receipts for each month were passed to the company payroll staff. The Board was satisfied
that sufficient control was exercised by the employer to ensure that the monthly payment of
HK$38,000 was a refund of rent and not simply a cash allowance that the taxpayer could spend
as he wished.

‘What Transpired at the Time of Payment’ Test

In CIR v Peter Leslie Page (2002) 5 HKTC 683 (IRBRD D38/04), the judge acknowledged that the
intention of the parties is the real test but ‘what transpired at the time of payment’ is relevant.
Here, the taxpayer’s contract provided him with a housing benefit capped at a fixed monthly
amount. The contract required him to submit to the employer the evidence of the actual rental
payment made. However, in actual fact, the taxpayer did not do so, and the employer had also
by its conduct agreed that he needed not do so. The taxpayer considered that he was entitled
to be paid the maximum amount capped regardless of whether he actually spent any sum on
rent at all. Given so, the housing benefit received by him could not be a rental refund when
there was nothing in respect to which there could be a refund under the arrangement. Thus,
the court agreed with the commissioner that the monthly housing payments were not rent
refund but allowances.

The correct test ‘what transpired at the time of payment’ was adopted in Roger Jesse
Robertshaw v CIR (2006) HKRC. Other cases of relevance are:

• Yau Wah Yau v CIR (2006) 3 HKLRD 586 (D53/04) – The court held that the lack of a
stamped tenancy agreement did not change the fact that a bona fide tenancy existed
and was performed although informally entered.

• IRBRD D20/09 – The Board stated that considerations must be given to whether or not
the rent was at a market rate. The Board found that the monthly rental far exceeded
the market rents and thus concluded that the tenancy agreement was commercially
unrealistic and artificial.

4.4.2.2 Rental Value
Under s.9(2), the rental value of any place of residence provided (not being hotel, hostel or
boarding house) by the employer or an associated corporation is deemed to be 10% of the
income from the said employer under s.9(1)(a) after deducting:

• Employment expenses or capital allowances under s.12(1)(a) and (b), respectively; and

• Any lump sum payment or gratuity paid upon the retirement or termination of the
employment (s.9(2)).

Note that as the rental value is computed based on s.9(1)(a) income, stock option gains
which are assessed under s.9(1)(d) are excluded from the computation.

Alternatively, the employee may elect to substitute the rental value of the place of
residence other than a hotel, hostel or boarding house with its rateable value included in the
valuation list prepared under s.12 of the Rating Ordinance (Cap.116) or, if the place of residence

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is not so included, the rateable value ascertained in accordance with Part III of that Ordinance.
This alternative is often not beneficial to the taxpayer.

Where the place of residence is a hotel, hostel or boarding house, the percentages used
for the deemed rental value is 8% where the accommodation consists of not more than two
rooms and 4% where the accommodation consists of not more than one room (s.9(2)(a)). This
is a useful tax planning tool. Evidently, deeming rent-free property provided by an employer to
be a relatively modest proportion of the aggregate salary is, in a city like Hong Kong with high
property prices, treating the benefit in kind for tax purposes as well below its market value.

Illustrative Example 11 – Rent-free Residence Provided by the Employer

Tom works as an accounting manager in a Hong Kong company. For the year of
assessment 2019/20, his annual salary was HK$600,000. His employer provided him
with an apartment and reimbursed his medical insurance costs of HK$16,800. Tom has
not incurred any expenses that are eligible for a deduction under ss.12(1)(a) and (1)(b)
(Sections 4.6.1 and 4.6.2). Let us compute the rental value under s.9(2).

Year of assessment 2019/20 HK$

Salary 600,000
Perquisite – medical insurance 16,800
616,800
Rental value:
10% × HK$616,800 61,680

For an employee with a non-Hong Kong employment, the rental value of the residence
provided by the employer is computed based on the portion of the employee’s income that
is attributable to services rendered in Hong Kong.

Illustrative Example 12 – Rent-free Residence Provided to a

Non-Hong Kong Employee under Time Basis Assessment
Wolfgang (Illustrative Example 8) stayed in a room at the Mandarin Oriental Hotel
whenever he was in Hong Kong up until July 2019. From 1 August 2019, GBank
Hong Kong rented a serviced apartment for him. Assuming for the moment that the
income Wolfgang derived from GBank is HK$1,550,000 and he did not receive any other
assessable perquisite, and he did not have any deductible expenses under ss.12(1)(a) and
(1)(b), compute the rental value of the accommodation provided to him.

Wolfgang was in Hong Kong for 146 days (including leave days attributable) during the
period 1 April 2019 to 31 March 2020 (Illustrative Example 8).

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Illustrative Example 12 (continued)

The rental value of Wolfgang’s accommodation benefit for the year of assessment
2019/20 would be computed as follows:

Period Days Leave Total Income attributable Assessable Rental

in HK daysa to services in HK Value ss.9(2), (2)(a)
(HK$) (HK$)
Hotel: 19 2 21 = 21 ÷ 366 × 1,550,000 = 4% × 88,934
1/4/2019–31/7/2019 = 88,934 = 3,557
Apartment: 115 10 125 = 125 ÷ 366 × 1,550,000 = 10% × 529,372
1/8/2019–31/3/2020 = 529,372 = 52,937
Rental value 56,494

a
Leave day attributable to each period in Hong Kong based on the information provided in Illustrative Example 8:

Period
1/4/2019–31/7/2019 (19 ÷ 336 × 30) = 2

1/8/2019–31/3/2020 (115 ÷ 336 × 30) = 10

4.4.2.3 Rental Value – Shared Accommodation

Where the company provides accommodation t is shared by more than one employee, the
value of the accommodation assessable to salaries tax in the hand of each employee is the
percentage of the employee’s taxable emoluments as set out in s.9(2). In IRBRD D78/90, the
Board held that there is no provision for apportionment of the value of quarters provided
by the employer under s.9(2). In Illustrative Example 4 of the IRD’s pamphlet ‘How to Tax
the Provision of a Place of Residence to the Employee’, the IRD has indicated that where an
apartment is provided by the employer and the rooms are shared by the employees, such
form of housing provided is akin to occupying a room in a boarding house. The rental value for
each employee is computed based on 4% of each of the employee’s income. See Illustrative
Examples 13 and 14.

Illustrative Example 13 – Shared Accommodation Provided by an

Employer to Employees I
James and David, both single, worked for an engineering company based in Hong Kong.
The company agreed to provide both James and David with subsidised quarters under
the contracts of employment. James relocated to Hong Kong to take up the position
effective 1 April 2019 and was provided a relocation allowance of HK$20,000. James
and David shared a two-bedroom flat that belongs to the company. They paid HK$1,700
each for the subsidised accommodation and the amount was deducted from their
monthly salary.

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Illustrative Example 13 (continued)

The following are their emoluments for the year of assessment 2019/20:

James David
HK$ HK$
Salary 336,000 380,000
Bonus 56,000 80,000
Cost of living allowance 78,000 78,000
Relocation allowance 20,000
Total (A) 490,000 538,000

Under s.9(2), the rental value of the residence provided to both James and David for
the year of assessment 2019/20 are:

James David
HK$ HK$
Housing benefit: 4% × A (as above) 19,600 21,520
Less:
Rent paid via salary deduction (1,700 × 12) (20,400) (20,400)
Rental value (800) 1,120

 s the rent paid by James is more than the rental value computed in accordance
A
with s.9(2), James is deemed not to have received a housing benefit for the year of
assessment 2019/20.

The housing benefit to be included in David’s salaries tax return is HK$1,120, being
the excess of the rental value over the rent paid by him.

Illustrative Example 14 – Shared Accommodation Provided by an

Employer to Employees II
Heng and Yau worked in the kitchen of Majestic Restaurant in Northern Territory,
Hong Kong. Heng’s annual income was HK$150,000 while Yau earned HK$120,000 in the
year of assessment 2019/20. Their employer provided them lodgings in a flat occupied by
other restaurant employees. Heng and Yau shared a room. What are the rental values of
the accommodation provided to Heng and Yau?

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Illustrative Example 14 (continued)

 ased on Example 4 of the IRD’s pamphlet, the assessable rental value under
B
s.9(2) would be 4% of Heng and Yau’s income, respectively. Such accommodation
provided is regarded as occupying a room in a boarding house. The following are the
assessable rental value:

Taxpayer Rental value computation HK$

Heng 4% × HK$150,000 6,000
Yau 4% × HK$120,000 4,800

4.4.3 Employee Share-based Benefits

Equity-based compensation became popular during the dot.com boom and has since been
used commonly to recruit, retain and reward employees. At the same time, tax rules all over
the world have evolved to deal with taxing equity compensation without undermining the
fairness of the tax systems. In Hong Kong, the relevant taxing provisions are s.9(1)(a) and ss.9(1)
(d), 9(4) and 9(5). Shares granted to an employee are taxable perquisite under s.9(1)(a) and
stock option awards fall within the ambit of ss.9(1)(a), (1)(d), (4) and (5).

4.4.3.1 Stock Options
A stock option is the right to acquire a certain amount of a company’s shares at a pre-
determined price, strike price (commonly the share price at the date of grant) for a specified
period in the future. When a taxpayer is granted a right to acquire shares in a company by
virtue of his employment, such a right is a perquisite under s.9(1)(a) and would normally be
chargeable to salaries tax in the year the right was granted to the taxpayer, that is, the year the
income was derived. However, ss.9(1)(d) and (5) operate to tax the taxpayer on a notional basis,
only at the time when the right was exercised, assigned or released.

In brief, s.9(1)(d) includes in the income from an employment or an office, any gain
realised by the exercise of, or by the assignment or release of, a right to acquire shares in a
company obtained by a person as the holder of an office in or an employee of that or any other
company. The wording of s.9(1)(d) has the effect of taxing stock option benefit:

• Derived by virtue of an employment or office;

• To acquire shares of the corporation or any other corporation, for example, parent
company of the corporation; and

• At the time when a gain is realised upon the exercise, assignment or release of
the right.

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S.9(5) was introduced to ensure that the same stock option benefit is not subject to
salaries tax twice, that is, at the time of grant of the right and when the right was subsequently
exercised, assigned or released.

It is important to note that only gains from stock options derived from Hong Kong (through
a Hong Kong employment, or a non-Hong Kong employment where services rendered in Hong
Kong during visits exceeding 60 days in a year of assessment) are chargeable to salaries tax.

Exercise of Stock Option

The IRO does not define the term ‘exercise’. However, in DIPN No. 38 (Revised), paragraph
16, the IRD clarifies the term ‘exercise’. In brief, a taxpayer is considered to have exercised an
option when he or she has ‘taken whatever steps are necessary to convert the offer contained
in the option agreement into a contract to purchase the relevant shares’.

Gain Realised
S.9(4) provides that income from an employment or office includes the gains realised by the:

• Exercise of the right that shall be taken to be the difference between the amount that
a person might reasonably expect to obtain from a sale in the open market, that is, the
open market value (OMV) at that time of the shares or stock acquired and the amount
or value of the consideration given whether for them or for the grant of the right or
for both; and

• Assignment or release of the right that shall be taken to be the difference between the
amount or value of the consideration for the assignment or release and the amount or
value of the consideration given for the grant of the right.

Thus, the amount of stock option gain chargeable to salaries tax is computed as follows:

Stock option OMV at the time of Any consideration paid

= less
gain ‘exercise’ of right
OR
Consideration given for the Consideration given
= less
assignment or release of right for the grant

The wordings of s.9(4)(a), ‘the gain realised . . . shall be taken to be the difference between
the amount that a person might reasonably expect to obtain from a sale in the open market
at that time of the shares or stock acquired’, refer to a notional gain and not an actual gain.
When a stock option is exercised, the taxpayer might acquire the shares and hold them for
investment purposes. Thus, no sale actually takes place. Nevertheless, the gain from the stock
option benefit is computed notionally for salaries tax purposes at the time of the exercise. This
position is upheld by the Board in IRBRD D66/06.

Exhibit 4.6 shows a summary on the determination of OMV.

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Type of shares OMV Reference

Listed shares • Closing price quoted for shares of the same kind • DIPN No. 38
on exercise date (Revised), para. 22
OR • IRBRD D46/95 and
IRBRD D120/02
• The IRD would consider a lower realistic price
due to downward influencing factors, for
example, volume involved, if it could be proven to
affect the OMV
Shares listed in DIPN No. 38 (Revised),
multiple exchanges: para. 22
• Including HKSEa Closing price on the HKSEa
• Excluding HKSEa Closing price quoted which is more favourable to
the taxpayer
Unquoted shares The price a hypothetical willing, but not anxious, Estate duty case law
purchaser will need to pay a hypothetical willing, but guidance on valuation
not anxious, seller in the open market to acquire the – DIPN No. 38 (Revised),
relevant shares on exercise date paras 25 and 26

a
Hong Kong Stock Exchange:
EXHIBIT 4.6 Determination of OMV

Consideration refers to any amount given for the shares or for the grant of the right
(e.g. brokerage, stamp duty, fees or other charges) or for both. S.9(4) further provides that the
consideration shall be apportioned if it includes something beside the shares covered by the
option. The consideration shall not include any amount in respect of the performance of any
duties in or in connection with the office or employment, and the amount of consideration
given for the grant shall not be deducted more than once (DIPN No. 38 (Revised), para. 20).

Time of Exercise
Given that the gain or notional gain from an exercise of stock options is computed based on the
OMV at the time of exercise, it is important to determine the point in time at which an option
is exercised to obtain the OMV. In IRBRD D84/03, it was held that the taxpayer’s inability to sell
the shares upon exercise of the stock option due to insider trading provisions were not relevant
in determining the correct date to compute the gain under s.9(4). The IRD confirms in DIPN
No. 38 (Revised), paragraph 17, that the gain is required to be calculated by reference to the
open market value on the day of exercise and it will generally not be relevant to consider value
at any later date. However, in view of the Board’s decision in IRBRD D43/99, the IRD would
consider another date if the taxpayer can prove that the other date indeed is the date on which
the acquisition of the shares occurred. Briefly, in IRBRD D43/99, the Board held that the shares
could not be acquired before the company passed a resolution to allot the shares. Thus, there
could not be a notional sale and notional gain when the share certificate had not been issued.

By the same token, the Board concluded in IRBRD D7/15 that the taxpayer had only
acquired the shares when the company decided to allot the shares to him, even though he
could sell the shares on the date he exercised the options under a stock borrowing agreement.
As in IRBRD D84/03, the Board upheld that the personal circumstances of the taxpayer were
irrelevant in the construction of s.9(4).

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Based on the Board’s decisions in the majority of the cases, including the more recent ones,
the relevant date for the purpose of s.9(4) is the date when shares are allotted to the taxpayer,
rather than the actual exercise date.

Assignment or Release of a Right to Acquire Shares

The IRD clarifies the meaning of ‘assignment’ and ‘release’ in DIPN No. 38 (Revised), paragraphs
28 to 31, as follows:

• ‘Assignment’ refers to a situation where the taxpayer transfers the whole of his or her
interest in the rights to acquire shares under an option agreement to a third party.

• ‘Release’ means discharge for valuable consideration or under seal (by deed) of the
right to acquire shares under a share option scheme (without exercising the right).

If the employee were to receive compensation because he or she had suffered a loss as a
result of having to delay the exercise of an option, the compensation would be regarded as a
perquisite. If the perquisite were derived from Hong Kong, it would be chargeable to salaries
tax (see IRBRD D4/91). In DIPN No. 38 (Revised), paragraph 31, the IRD notes that the tax
outcome would be the same for any compensation received by an employee for agreeing to let
an option expire or lapse without exercising it.

Exchange of Rights
Sometimes, a right to acquire shares of a particular type is exchanged for a right to acquire
shares of another type without any monetary consideration, for example, in the case of a
company reorganisation. The IRD accepts that such an exchange does not constitute an
assignment or a release under s.9(1)(d) and thus, no salaries tax liability arises at this time of an
exchange. However, s.9(1)(d) applies to the ‘new’ right received when such a right is exercised,
assigned or released subsequently. The consideration given for the grant of the original right, if
any, is taken into account in computing the gain under s.9(4).

Gain from Stock Options Chargeable to Salaries Tax

The stock option gain derived by a person with a Hong Kong employment is subject to
salaries tax under s.8(1)(a), thus the person will only be relieved from salaries tax when they
qualify for an exemption under s.8(1A)(b)(ii), that is, where all services are rendered outside
Hong Kong. Note that all services would be deemed rendered outside Hong Kong if services
were rendered in Hong Kong during visits not exceeding 60 days in the year of assessment
concerned (s.8(1B)).

According to DIPN No. 38 (Revised), paragraph 37, if a person had a Hong Kong
employment at the time of the grant of the right, the income is regarded as having been
derived from Hong Kong. Any gain realized by the subsequent exercise etc. of the right will be
chargeable to salaries tax unless the gain is excluded by virtue of section 8(1A)(b), i.e. where
the person renders outside Hong Kong all the services in connection with his employment. If
a right is granted to an employee on an unconditional basis during a year of assessment in
which the person renders all services in respect of his employment outside Hong Kong, any
gain subsequently realized, even if realized whilst the person is working in Hong Kong, will not
be charged to salaries tax. Although the gain is considered to accrue to the person in the year
of assessment in which the right is exercised, it is recognised as having been derived from the
services rendered outside Hong Kong.

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Often, employee stock option plans come with certain conditions (conditional stock
options). These include, among others, a vesting period subject to the employee’s employment
with the company. For example, an employee is granted 1,000 stock options on 1 April 2017.
The vesting schedule may state that 200 of the options will be vested on 1 April 2018, another
200 options will be vested on 1 April 2019, and so on. This means that the employee is unable
to exercise (or assign/release, if permissible under the plan) the stock options until such time
when the options are vested. This attribute is common because most employee stock option
plans are designed to retain and reward employees.

Given that the gain from stock options is chargeable to salaries tax, if such gain is arising in
or derived from Hong Kong, the employment status of the taxpayer at the time of grant and the
employment status over the period of vesting will dictate whether the gain from stock options
falls within the scope of salaries tax. Exhibit 4.7 shows a summary of the salaries tax implication
of stock options for a Hong Kong employment.

Stock options taxation for an employee with a Hong Kong employment

Salaries tax implications
Unconditional stock Conditional stock
option option
Relevant time Year of assessment in Any year of assessment
which the option is granted during vesting period
Service All services rendered in HK Fully taxable – ss.8(1)(a) & 9(1)(d)
scenarios
Services rendered outside HK;
visitsa to HK > 60 days
Services rendered outside HK; Exempt – ss.8(1A)(b)(ii) & 8(1B)
visitsa to HK ≤ 60 days
All services rendered
outside HK
a
refer to the 60-day exemption rule under s.8(1B).
EXHIBIT 4.7 Salaries tax implications of stock options for Hong Kong employment

Illustrative Example 15 – Exercise of Conditional Stock Option

(Hong Kong Employment)
Elise Wong works in Wealth Management, GBank Hong Kong. On 2 January 2019, the
bank granted her 1,000 stock options under the GBank Employee Stock Option Plan
(Plan). Under the Plan, 250 stock options will vest every year over a four-year period with
the first vest date falling on 2 January 2020. GBank bears all cost associated with the
exercise of the option under the Plan.

Elise exercised the stock option vested on 2 January 2020 and acquired 250 of GBank
shares. On 3 January 2020, she received a notification from GBank confirming that 250
shares were allotted to her at a total price of €5,160 (based on the option strike price of
€20.64 per share). GBank closed at €28 on 2 January 2020 on the Frankfurt Stock Exchange.
What gain, if any, and when, will be included in Elise’s assessable income?

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Illustrative Example 15 (continued)

 ven though Elise has not sold the GBank shares, it is chargeable to salaries tax on
E
the notional gain derived from the exercise of her stock options in the year that the
stock option was exercised to acquire the shares of GBank under ss.9(1)(d) and (4)(a).

The gain as computed below will be included in Elise’s assessable income:

Assessable stock option gain – notional €

gain:
OMV at the time of exercise, that is, 2/1/2020 7,000 (Time of Exercise and
(€28 × 250) Exchange of Rights under
Section 4.4.3.1)
Less: Consideration paid – strike price €20.64/share (5,160) (Gain from Stock Options
(€20.64 × 250) Chargeable to Salaries
Tax under Section 4.4.3.1)
1,840
Converted to HK$ at 8.6788 (IRD-published HK$15,969
buying rate for January 2020)

The amount of HK$15,969 is subject to salaries tax in the year of assessment 2019/20.

In the case of an employee with a non-Hong Kong employment, the gains from an
unconditional stock option grant is subject to salaries tax if at the time of grant, they:

• Render services in Hong Kong; and

• The 60-day exemption rule does not apply (i.e. visits to Hong Kong exceed 60 days
during the year of assessment).

The stock option gains will be included in the total income of an employee who qualifies for
the time basis assessment in computing the income attributable to Hong Kong.

In the case of a conditional stock options granted and the vesting takes place after the
employee commences rendering services in Hong Kong, the gains would generally be assessed
based on the vesting time basis of apportionment, that is, the days the employee was in
Hong Kong during the vesting period over the total number of days in the vesting period
(see the formula in Exhibit 4.8 in the summary table). This is to recognise that the stock options
granted prior to the employee’s commencement of employment in Hong Kong are partly
attributable to services rendered outside Hong Kong and should not be fully assessable in
Hong Kong. See also DIPN No. 38 (Revised), paragraphs 44–50.

Exhibit 4.8 shows a summary of the salaries tax implications of stock option gain for
non-Hong Kong employment.

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Stock options taxation for an employee with a non-Hong Kong employment

Salaries tax implications
Unconditional stock Conditional stock
option option
Relevant time Year of assessment in which Each year of assessment
the option is granted during vesting period
Service All services rendered in HK Fully taxable – ss.8(1A)(a) & 9(1)(d); DIPN No. 38
scenarios (Revised), para 52
Services rendered outside Time apportionment Time apportionment basisb
and in HK; Visits to HK basis – ss.8(1A)(a) & (all days in HK taken into
> 60 daysa 9(1)(d); DIPN No. 38 account) – DIPN No. 38
(Revised), para 54 (Revised), paras 45 and 46,
Services rendered outside Time apportionment Time apportionment basisb
and in HK; Visits to HK > 60 basis – ss.8(1A)(a) & 9(1)(d); (only days in HK in the YA
daysa in one or more years DIPN No. 38 (Revised), para during which visits to HK
of assessment and ≤ 60 54; The 60-day exemption rule exceed 60 days are taken
daysa in other years applies to options granted in into accountc) – DIPN No.
year of assessment during 38 (Revised), para 47
which visits to HK ≤ 60 days
Option granted before Exempt – DIPN No. 38 Time apportionment basisb
commencing to render (Revised), para 53 (only days in HK in the YA
services in HK during which visits to HK
exceed 60 days are taken
into accountc) – DIPN No.
38 (Revised), para 47d
All services rendered Out of scope – DIPN No. 38 (Revised), paras 43, 51
outside HK or services
rendered in HK during visits
≤ 60 daysa
a
Refer to the 60-day exemption rule under s.8(1B).
b
 he formula to compute the amount chargeable to the salaries tax for a non-Hong Kong employment where services
T
are rendered both in and outside Hong Kong:

Days in HK plus attributable leave days during vesting period .

Gains computed under ss.9 (1) (d) and ( 4 )
Total number of da ays in vesting period

c
If the services are rendered by the taxpayer in Hong Kong during visits of less than 60 days during any year of
assessment that falls within the vesting period, the days concerned are disregarded in computing the proportion of the
gain attributable to services rendered in Hong Kong.
d
In the case of conditional stock option grant, the employee’s tax status for each year of assessment in the vesting
period is relevant to the chargeability, unlike the case of unconditional grant where the time of grant is relevant.
EXHIBIT 4.8 Salaries tax implications of stock options for non-Hong Kong employment

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In computing the days in Hong Kong plus attributable leave days during the vesting period,
the day of arrival and the day of departure will be counted as one day, that is, the same
‘midnight rule’ as in the time apportionment basis (Section 4.3.1).

Illustrative Example 16 – Exercise of Conditional Stock Options

(Non-Hong Kong Employment)
Tom works for a listed Singapore company. On 1 April 2018, he was seconded to
Hong Kong to roll out a new system for the company’s North Asia offices. Tom
travelled frequently to Taipei, Shanghai, Beijing, Tokyo and Seoul to support the
project roll out. On 1 January 2018, Tom was granted a stock option to acquire 2,000
shares in the Singapore company at a strike price of S$15.00 per share. The stock
option is subject to the completion of a vesting period of two years from 1 January
2018. The share price of the company went up to S$38.10 on 1 January 2020 and
Tom exercised his stock option and acquired 2,000 shares. Tom also paid a flat
brokerage fee of S$20. Is the gain from the exercise of Tom’s stock option assessable to
salaries tax?

The following shows Tom’s days in Hong Kong during the relevant periods:

Year of assessment Days in HK for 60-day Days in HK including

exemption purposesa attributable leaveb days
from 1/1/2018 to 1/1/2020
2018/19 48 50
2019/20 > 60 100

a
Any part of a day is counted as one day.
b
 nlike the above 60-day exemption rule, the day of arrival and the day of departure are counted as one day
U
(‘midnight rule’).

 om has a non-Hong Kong employment. The stock option was conditionally granted
T
before Tom commenced rendering services in Hong Kong. Given that the stock option
granted was conditional, part of the gain will be assessable to salaries tax.

As Tom’s days in Hong Kong under the 60-day exemption rule did not exceed 60
days in the year of assessment 2018/19, the 50 days in Hong Kong during the vesting
period (see above) would be disregarded for the purpose of computing the gain
attributable to rendering services in Hong Kong.

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Illustrative Example 16 (continued)

Tom’s stock option gain (notional) is computed as follows:

S$
OMV at the time of ‘exercise’ 76,200 (Time of Exercise and
(S$38.10 × 2,000) Gain from Stock Options
Chargeable to Salaries Tax in
Section 4.4.3.1)
Less: Consideration paid – strike price 30,020 (Gain from Stock Options
S$15/share plus brokerage S$20 Chargeable to Salaries Tax in
((S$15 × 2,000) + 20) Section 4.4.3.1)

46,180
Converted to HK$ at 5.727
HK$264,473
(average exchange rate)

Gain attributable to services 100

rendered in HK (vesting time basis = HK$264,473
730
of apportionment above)

Gain chargeable to salaries tax in =

HK$36,229
YA 2019/20

Apply and Analyse 2
Johann worked in GBank London since 2014. He was seconded from GBank London
to Hong Kong on 3 January 2019 and was entitled to 28 days annual leave. Prior to the
secondment, Johann has never visited Hong Kong. Johann was granted three tranches of
conditional stock options under the GBank Employee Stock Option Plan on 2 January 2017,
2 January 2018 and 2 January 2019, respectively, as follow:

Option tranches I II III

2 January 2017 2 January 2018 2 January 2019
Units granted 4,000 6,000 10,000
Strike price (€) 15.15 19.14 20.64
Vest dates 2 January 2018 2 January 2019 2 January 2020
2 January 2019 2 January 2020 2 January 2021
2 January 2020 2 January 2021 2 January 2022
2 January 2021 2 January 2022 2 January 2023
Units vest at each vest date 1,000 1,500 2,500

Under the plan, the stock options vest evenly over a four-year period. GBank bears all
cost associated with the exercise of the options under the Plan. Johann has been exercising
the stock options as and when vested.

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Apply and Analyse 2 (continued)

On 2 January 2020, Johann did a cashless exercise, that is, exercise and sell, his vested
options. GBank closing share price on 2 January 2020 was €28. Let us analyse the tax
implications on the exercise.

Analysis

First, let us calculate the relevant vesting days in Hong Kong based on Johann’s travel
itineraries for the years of assessment 2018/19 and 2019/20.

Arrival date Departure date Days in HK Days in HK under the

60-day exemption rule
3/1/2019 14/1/2019 11 12
29/1/2019 3/2/2019 5 6
19/2/2019 6/3/2019 15 16
26/3/2019 31/3/2019 5 6
Year of assessment 2018/19 a
36 40 (≤ 60 days)
1/4/2019 3/4/2019 2 3
6/5/2019 14/5/2019 8 9
7/6/2019 16/6/2019 9 10
3/8/2019 22/8/2019 19 20
28/8/2019 18/9/2019 21 22
30/9/2019 15/10/2019 15 16
1/11/2019 17/11/2019 16 17
12/12/2019 20/12/2019 8 9
Days in HK up till 2/1/2020 98 106
Leave days attributable to HK until 2/1/2020 b
8
Total days in HK during vesting period 106

a
 s Johann was in Hong Kong for a total of 40 days for the purpose of the s.8(1B) 60-day exemption in the year of
A
assessment 2018/19, these days shall be disregarded in determining the days in Hong Kong during the vesting
period for computing the gain attributable to services rendered in Hong Kong.
b
Leave days attributable to Hong Kong:

Business days in HK (98)

Leave days (28) 8.19, that is, 8 days.
Total business days (335)

Now, let us look at the stock options exercised on 2 January 2020. The total number of
days for the relevant options in the vesting period, that is, from grant date to vest date are:

Grant date Vest date Total number of days in

the vesting period (A)
2/1/2017 2/1/2020 1,095
2/1/2018 2/1/2020 730
2/1/2019 2/1/2020 365

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Apply and Analyse 2 (continued)

Option tranches 2/1/2017 2/1/2018 2/1/2019 Days in HK during

I II III vesting perioda
Strike price in € (C) 15.15 19.14 20.64
Vested on:
2/1/2018 1,000 –
2 /1/2019 1,000 1,500 –
2/1/2020 (D) 1,000 1,500 2,500 106 (B)
Notional consideration 15,150 28,710 51,600
(C × D)
OMV at time of exercise 28,000 42,000 70,000
(€28 × D)
Notional gain (cashless exercise) 12,850 13,290 18,400
Converted to HK$ at 8.6788 (E) b
111,523 115,341 159,690

Gain attributable to services 10,796 16,748 46,376

in HK: vesting time basis
apportionment
(Section 4.4.3.2)
E×B÷A
Total gain attributable to services rendered in HK (HK$) 73,920

a
Including attributable leave days during vesting period.
b
Based on IRD-published buying rate for January 2020.

See DIPN No. 38 (Revised) for further examples on how stock option gains are taxed
under different scenarios.

Permanent Departure from Hong Kong

A gain realised from the exercise, assignment or release of a stock option after permanent
departure from Hong Kong may still be subject to salaries tax. This is affirmed in CIR v Sawhney,
Subhash Chander (2005) HKRC. The taxpayer was granted stock options during his period of
employment in Hong Kong. A few years later, his employment was terminated and the taxpayer
left Hong Kong. The taxpayer subsequently exercised the stock options and made several
gains. The commissioner assessed him on the gains in the relevant years and the taxpayer
objected. The Board ruled in favour of the taxpayer and the commissioner appealed. The court
construed the provisions of s.11C purposively and held that s.11C is a deeming provision to be
applied to the rules regarding the calculation of assessable income for the purpose of fixing
the day on which a taxpayer would be deemed to commence or cease to derive income from
a source. The court also considered the purpose of ss.9(1)(d) and (4) and concluded that the
provisions when read together, have the effect that the gain was assessable income. The court
quoted: ‘the amount of the gain is calculated when the option is exercised, whenever that may
be, on the difference between what the employee pays for the option, and its market value;

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and where tax may become chargeable in respect of a future gain it is not chargeable under
any other provision . . . the object . . . was not simply to bring option gains into the tax net, but
to bring them in whenever they might be realised’.

With a view to finalising the tax liability of a taxpayer before his departure from Hong Kong,
the IRD will, as a matter of concession, allow a person to elect to have the liability ascertained
on the basis of a notional exercise (and deemed vesting where appropriate) of all stock options
granted but not exercised, assigned or released by accepting:

• That the liability can be finalised based on the gain (calculated in accordance with s.9(4)
(a)) that would have been realised if the option were to be exercised on a day within
seven days before the date of submission of the taxpayer’s final tax return.

• An election made within three months from the date of permanent departure from
Hong Kong if it was not made prior to departure. In this case, the departure date would
be deemed the date of the notional exercise for purposes of calculating the gain.

The notional gain will be returned and assessed on the basis that no further liability will
arise when the option is eventually exercised, assigned or released after departure from Hong
Kong. Once an election is made, it cannot be withdrawn before the actual exercise, assignment
or release, unless:

• The objection is made within the statutory period, that is, one month after the date of
issue of the notice of assessment, or

• There was a total forfeiture of the options with no replacement or compensation before
the actual exercise.

The IRD has indicated that it will consider favourably an application for re-assessment
should the actual gain from an eventual exercise, assignment or a release of the option turned
out to be less than the notional amount assessed (DIPN No. 38 (Revised), para. 73).

Cash flow aside, there is no benefit for an employee to elect for a notional vesting and
exercise unless the person expects a significant increase in the price of the underlying share.
The gains are subjective, that is, the person may leave the employment of the company and
forfeit his or her unvested stock options or there may not be any real gain in a volatile stock
market. Further, non-election means any gains from subsequent exercise will be brought to tax
in that year of assessment where the taxpayer is likely to have no other assessable income in
Hong Kong and a full year of statutory personal allowance. Thus, a lower effective tax rate on
the gains.

Both the employer and the employee have the obligations to notify the IRD of the gains
when the stock options are subsequently exercised, assigned or released if the options
were granted during the taxpayer’s period of employment in Hong Kong – see DIPN No. 38
(Revised), paragraphs 75–83. Note though that the IRD has indicated in DIPN No. 38 (Revised),
paragraph 80, that there is no requirement to notify the IRD if the gain from stock options of an
ex-employee computed in accordance with the IRO is lower than the basic allowance applicable
to the relevant year.

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4.4.3.2 Stock Awards
Stock or share awards are another form of equity-based compensation that have become
popular in recent years. Stock awards are part of a taxpayer’s remuneration, being perquisite
chargeable to salaries tax under s.9(1)(a) of the IRO. While some share awards are granted
upfront unconditionally without any payment, most stock awards are subject to vesting
periods, that is, a certain number of shares to be vested proportionately over a certain period,
typically the next three to five years. The key issues relating to stock awards are:

• The time the benefits accrue to the taxpayer; and

• The assessable value of the benefit.

The IRD has come out with two general approaches to determining the timing of
assessment of stock award benefits (DIPN No. 38 (Revised), paras 60, 61). The IRD applies the
‘upfront’ approach if the shares were allotted to the employee with full economic benefits (e.g.
voting rights and dividends) as any normal shareholders at the time of grant. The employee
may not be allowed to sell the shares until a certain holding period. Where the shares are
only vested over a period of time and the shares are forfeited if the employee leaves the
employment of the company prior to vesting, such a share awards plan is more of a promise
of shares to be vested to ensure the employee remains in the employment of the company. In
such circumstance, the ‘back-end’ approach will be applied.

Exhibit 4.9 deals with the two key issues relating to share awards.

Upfront Back-end
Applicable to Shares allotted with full Shares vested over a period of time and
economic benefits at grant shares are forfeited if employee leaves the
employment prior to vesting
Time of assessment At grant Upon vest
Assessable amount OMV at grant a
OMV at vest
Dividends distributed Not Taxable being perquisite from employment
taxable – investment income (see IRBRD D21/16, Section 4.4.1)
a
 he IRD will consider a discount on the valuation of the shares if restriction on sale is imposed. The discount is gener-
T
ally at 5% for each year, see DIPN No. 38 (Revised), para. 61.
EXHIBIT 4.9 Comparison of share awards

Gain from Stock Awards Chargeable to Salaries Tax

Hong Kong Employment
Stock awards benefit, like other income from an office or employment, is only chargeable to
salaries tax if the gain falls within the charging provisions of the IRO. In the case of an employee
with a Hong Kong employment, the stock awards are chargeable to salaries tax unless the
employee renders all services outside of Hong Kong or renders some services in Hong Kong
during visits not exceeding 60 days in the year of assessment. Any shares vested after the
cessation of a Hong Kong employment are deemed to accrue on the last day of employment
(s.11D(b)(ii)) – see DIPN No. 38 (Revised), paragraph 62.

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Illustrative Example 17 – Stock Awards Back-end Approach (Hong Kong

Employment)
Ms Li joined the subsidiary of a listed Silicon Valley IT company (SVIT) in Hong Kong
on 1 August 2017. Her compensation included stock award of 800 SVIT common stock
that would be vested evenly over a four-year period. Under the SVIT Employee Stock
Plan (ESP), unvested shares are forfeited if an employee leaves the employment of
the company. When Ms. Li was granted the stock award, SVIT closed at US$56.58.
Two hundred (200) shares each were vested on 31 August 2018 and 2019, respectively.
SVIT closed at US$74.77 on 1 September 2018 and US$112.33 on 1 September 2019.

 he back-end approach applies to the stock award granted to Ms. Li as she is not
T
entitled to the 800 common stocks of SVIT until the completion of a four-year service
period. The gain of US$14,954 (US$74.77 × 200) and US$22,466 (US$112.33 × 200)
would be included in her salaries tax returns for the years of assessment 2018/19
and 2019/20, respectively.

In the case of an employee with a non-Hong Kong employment, stock awards subject
to vesting period accrue to the employee in the year in which vesting takes place. For an
employee who is subject to tax on a time basis of apportionment, the value of the share
awards chargeable to salaries tax is apportioned based on the days the employee is in
Hong Kong during the year of assessment (YA):

Days in HK in the YA that vesting takes place .

Assessable gain Value of shares at vest date
Days in the YA that vesting taakes place

Non-Hong Kong Employment

If shares are subject to a vesting period, they are perquisite accruing to an employee in
the year of assessment in which vesting takes place. For an employee with non-Hong Kong
employment who is entitled to time basis apportionment, the value of the shares should be
added to the employee’s other taxable income for that year and the time apportionment factor
relevant to that year be applied to ascertain income chargeable to tax in Hong Kong. Except in
commencement and cessation cases, the factor is to be determined as follows – Days in Hong
Kong in the year of assessment that vesting takes place / Days in the year of assessment that
vesting takes place.

The factual situation between share award and share option is not the same. Share options
involving vesting periods may be exercised by an employee a few years after the options are
vested. In such case, a time apportionment factor by reference to the days-in-days-out in the
vesting period is adopted for ascertaining the chargeable portion of the gain when the options
are exercised. This approach is not suitable for share award cases. If it is accepted that the
perquisite accrues at the moment of time of vesting, it is only necessary to apply the time
apportionment factor in the year of vesting, i.e. the year that the perquisite accrues to the
employee. S.8(1) provides that salaries tax shall be chargeable for each year of assessment in
respect of income arising in or derived from Hong Kong from an office or employment.

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In s.11B, the assessable income of a person in any year of assessment shall be the
aggregate amount of income accruing to him in that year of assessment. S.8(1A) which is an
extension of s.8(1), provides that income arising or derived from Hong Kong includes income
derived from services rendered in Hong Kong. The approach to assess shares accruing in a year
of assessment by reference to the time apportionment factor for that year is consistent with
the aforementioned provisions.

Inbound Employees with a Non-Hong Kong Employment

The preceding taxation for a non-Hong Kong employment taxpayer does not apply in the case
of an inbound employee holding a non-Hong Kong employment who was granted share awards
subject to vesting period prior to taking up the assignment in Hong Kong. If shares are vested
in the employee and the terms of the stock award clearly state that the vesting of the shares
depends on a period of employment, then the IRD will exclude a portion of the gain on time
apportionment referable to the vesting period before his or her transfer to Hong Kong (see
DIPN No. 38 (Revised), para. 66).

Illustrative Example 18 – Stock Awards Inbound Employee

(Non-Hong Kong Employment)
Paul Uchida has worked in SVIT in Seattle since 2006. He was seconded from the United
States to SVIT Hong Kong on 1 July 2018 to manage the company’s gaming division
for the Asia Pacific region. Paul travels often to Japan to meet with various Japanese
game developers in addition to other frequent visits to the region and Seattle. Paul’s
employment remains with SVIT US, and he reports to the vice president for the game
division in Seattle. Paul is entitled to 30 days annual leave.

The following are the relevant ESP (same ESP as in Illustrative Example 17) granted to
Paul over the last few years.

Number of shares – vest equally over a four-year period ending on

SVIT 31/8/17 31/8/18 31/8/19 31/8/20 31/8/21 31/8/22
Nasdaq
closing price 57.46 74.77 112.33
on 1/9 (US$)
Grant date:
1/9/2014 250 250
1/9/2015 300 300 300
1/9/2016 600 600 600 600
1/9/2017 800 800 800 800
1/9/2018 1,000 1,000 1,000 1,000

Using the ‘midnight rule’, the following are the days Paul was in Hong Kong, including
leave days attributable to Hong Kong services. Paul spent most of his time in Seattle and.
Tokyo due to a major launch in Japan.

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Illustrative Example 18 (continued)

Year of assessment Days in HK Days outside Total

HK
YA 2018/19 (transfer date 1/7/2018–31/3/2019) 125a 149 274
YA 2019/20: 60 305 366
Arrived HK Departed HK
1/4/2019 1/5/2019 30
31/5/2019 2/6/2019 2
1/7/2019 5/7/2019 4
1/8/2019 6/8/2019 5
3/9/2019 9/9/2019 6
28/11/2019 2/12/2019 4
3/1/2020 7/1/2020 4
55
Attributable leave daysb 5

a
Including leave days attributable to Hong Kong.
b
Leave days attributable to Hong Kong:

Business days in HK (55)

Leave days (30) 5 days.
Total business days (336)

Applying what we have learned, advise Paul which of his stock awards are chargeable
to salaries tax in Hong Kong.

 aul continues to be employed by SVIT in the United States and he reports to a

P
manager in the United States. Thus, Paul has a non-Hong Kong employment. As the
vesting of the stock awards is tied to his period of service with the company, the
back-end approach applies. Therefore, a portion of the gain computed based on the
vesting period before Paul’s secondment to Hong Kong is excluded from salaries tax
(DIPN No. 38 (Revised), para. 66).

Given that Paul was seconded to Hong Kong on 1 July 2018, the stock awards vested
on 31 August 2017 were vested prior to his secondment and would be out of scope
for salaries tax purposes.

Part of the gain from the stock awards vested after his secondment to Hong Kong will
be subject to salaries tax for the YA 2018/19 and YA 2019/20. We will now compute
the amounts chargeable to salaries tax for YA 2018/19 and YA 2019/20. We were told
that Paul was in Hong Kong for a total of 60 days (including leave days attributable
to Hong Kong). To determine if Paul meets the ss.8(1A)(b)(ii) and 8(1B) exemption
for the YA 2019/20, we need to calculate the days Paul was in Hong Kong under the
60-day exemption rule. As we have learned in the earlier sections, for the purpose of
the 60-day exemption rule, part of a day in Hong Kong is counted as one day. Thus,
Paul would have visited Hong Kong for more than 60 days in the YA 2019/20 (see
below) and his employment income would therefore be chargeable to salaries tax.

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Illustrative Example 18 (continued)

YA 2019/20
Midnight rule 60-day exemption rule
Arrived HK Departed HK
1/4/2019 1/5/2019 30 31
31/5/2019 2/6/2019 2 3
1/7/2019 5/7/2019 4 5
1/8/2019 6/8/2019 5 6
3/9/2019 9/9/2019 6 7
28/11/2019 2/12/2019 4 5
3/1/2020 7/1/2020 4 5
55 62

To compute the amount chargeable to salaries tax, we need to first compute the gain
attributable to the vesting period after Paul’s secondment to Hong Kong.

SVIT closing price as listed 1/9/2018 (B1) US$74.77

1/9/2019 (B2) US$112.33
YA 2018/19
Vesting period from transfer: 1/7/2018–31/8/2018 (C1) 62 days

Share Value US$ Number of days Amount before time

awards grant to vest basis apportionment
US$
Period from
grant to vest A D = (A × B1) E C1 ÷ E x D
1/9/2014–31/8/2018 250 18,692 1,461 793
1/9/2015–31/8/2018 300 22,431 1,096 1,269
1/9/2016–31/8/2018 600 44,862 730 3,810
1/9/2017–31/8/2018 800 59,816 365 10,161
Total US$ 16,033
HK$ 125,330a

YA 2019/20
Vesting period from transfer: 1/7/2018–31/8/2019 (C2) 427 days

Share Value US$ Number of days Amount before

awards grant to vest time basis
apportionment US$
Period from grant
to vest A D = (A × B2) E C2 ÷ E × D
1/9/2015–31/8/2019 300 33,699 1,461 9,849
1/9/2016–31/8/2019 600 67,398 1,095 26,282
1/9/2017–31/8/2019 800 89,864 730 52,564
1/9/2018–31/8/2019 1,000 112,330 365 131,411b
Total US$ 220,106
HK$ 1,717,883a
a
Based on an exchange of 7.817 and 7.8048 for September 2018 and 2019, respectively – IRD’s published buying rate.
b
This share award was granted to Paul after his secondment to Hong Kong.

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Illustrative Example 18 (continued)

After calculating the gain attributable to Hong Kong, we compute the portion of gain
attributable to services rendered in Hong Kong using the time apportionment basis:

Gain attributable to services in HK for6.; and

125
YA 2018/19 125,330 HK$57,176; and
274
60
YA2019/20 1, 717,883 HK$281,620.
366

The gains from share award chargeable to salaries tax in Hong Kong are:

YA 2018/19: HK$57,176; and

YA 2019/20: HK$281,620.

Outbound Employees with a Non-Hong Kong Employment

Similarly, for outbound employees, stock awards that are subject to a vesting period may be
vested after the employee with a non-Hong Kong employment has been transferred outside
Hong Kong and such awards may have been granted to the employee during the period of
assignment in Hong Kong. If the terms of the stock award clearly state that the vesting of the
shares depends on a period of employment, the value of the shares attributable to the vesting
period before the employee was transferred outside Hong Kong, that is, for services rendered
in Hong Kong, should be chargeable to salaries tax.

In an unusual case where an employee continues to be entitled to vesting of unvested

shares after resignation, the value of the share award granted during the taxpayer’s time of
employment in Hong Kong should be included as assessable income in the year of resignation.

Valuation
The valuation adopted by the IRD is similar to that used for stock options, that is, the OMV of
shares – see Section 4.4.3.1.

Permanent Departure from Hong Kong

If an employee leaves Hong Kong and stock awards were granted but not yet vested at the time
of departure and the back-end approach applies, as a matter of administrative concession, the
taxpayer may elect to be assessed based on:

• Deemed value on a day within seven days before submitting his or her return for the
final assessment applicable to the year of assessment in which he or she permanently
departs from Hong Kong, if an election is made before the taxpayer departs
Hong Kong; or

• Deemed value on the date of his or her departure if an election is made within three
months from the date of permanent departure from Hong Kong (DIPN No. 38 (Revised),
para. 74).

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Once an election is made, it cannot be withdrawn. No partial election is allowed. The IRD
will only accept the election if it applies to all unvested shares chargeable to tax. When an
assessment is issued in accordance with the election, a subsequent request to amend the
assessment will not be entertained, unless an objection is made within the statutory time, that
is, one month after the date of issue of the notice of assessment. By the same token, the IRD
will not seek to increase the assessment for the sole reason that the value upon vesting has
increased. A sample of the election form is attached to DIPN No. 38 (Revised), appendix 2.

Illustrative Example 19 – Stock Awards Employee Departing Hong Kong

Permanently (Hong Kong Employment)
Maggie Wong works for SVIT Hong Kong. She was granted Australia permanent residency
and decided to migrate to Sydney. Her manager at SVIT arranged for her transfer to
SVIT Sydney effective 1 November 2019. Maggie’s last day at work with SVIT Hong Kong
was 15 October 2019 and she departed Hong Kong on 24 October 2019. At the time of
departure, Maggie had the following unvested stock awards.

SVIT closing price on 24/10/2019 US$102.32

Vesting period ends on: Total Total (US$)
Grant date 31/8/2020 31/8/2021 31/8/2022 31/8/2023
1/9/2017 100 100 – – 200 20,464
1/9/2018 120 120 120 – 360 36,835
1/9/2019 150 150 150 150 600 61,392
US$ 118,691
HK$ 926,490a

a
Based on an exchange of 7.8059 – IRD’s published buying rate for October 2019.

If Maggie were to elect for the unvested stock awards to be assessed on a deemed
vesting on the date of her departure, she will be assessed on a deemed vested value
of HK$926,490. If Maggie does not elect for a deemed vesting, she will be charged
salaries tax on the share award gains upon vesting. The assessable amount, that is,
number of shares vested multiply by SVIT closing price at the respective vest date, are
deemed to accrue to Maggie on the last day of her employment, that is, 15 October
2019 (s.11D(b)(ii)). Thus, Maggie will receive notices of additional assessment for the
year of assessment 2019/20 as and when the shares vest on her.

Cash flow aside, the gains from the unvested stock awards are not definite. Should
Maggie leave the employment of SVIT, she would not be entitled to the unvested
shares. Unless Maggie is very sure of her employment with SVIT and expects only an
upside on the share price of the company, there is really no incentive for her to elect
for a deemed vesting other than the administrative aspect of having to remember to
report the gains to the IRD as and when vesting takes place (s.51(2)). See DIPN No. 38
(Revised), paragraphs 75–78, on the reporting requirements.

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Illustrative Example 20 – Stock Awards Employee Departing Hong Kong

Permanently (non-Hong Kong Employment)
Stan is employed by SVIT Singapore. He is required to travel to support SVIT customers
and partners in the region. Stan was seconded to SVIT Hong Kong on a three-year
assignment on 1 July 2017. On 1 September 2017, Stan was granted 1,000 SVIT stock
under SVIT ESP, which would be vested evenly over the following four years, that is, 250
shares each year.

Stan was granted a second tranche of 1,200 SVIT ESP on 1 September 2018. Due
to family reasons, Stan asked his manager for a transfer back to Singapore. He was
repatriated on 15 August 2019.

Stan’s days in Hong Kong for YA 2019/20 were computed based on the ‘midnight rule’,
including attributable leave days up to the date he left Hong Kong are as below:

Basis period Days in HK Days outside HK Total

1/4/2019 to 14/8/2019 70 66 136

 he amount of gains from share award to be included in Stan’s YA 2019/20 tax return
T
if he had not elected for a deemed vesting is:

SVIT closing price as listed 1/9/2019 (B) US$112.33

Grant Share Value of Days from Days from Amount before time
date vested on shares grant to grant to basis apportionment
1/9/2019 31/8/2019 14/8/2019 US$
A C = (A × B) D E E÷D×C
1/9/2017 250 28,082 730 713 27,428
1/9/2018 300 33,699 365 348 32,129
Total US$ 59,557
Gains attributable to vesting period before repatriation: HK$ 464,830a
a
Based on an exchange of 7.8048 – IRD’s published buying rate for September 2019.

70
Gains attributable to services in HK for YA 2019/20 464,830 HK$239, 251
136

Apply and Analyse 3
Let’s have a look at Stan’s stock awards scenario if he had elected for a deemed vesting
within three months from the date of his departure from Hong Kong. The gains would be
computed as follows based on DIPN No. 38 (Revised):

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Apply and Analyse 3 (continued)

SVIT closing price on 15/8/2019 (B) US$105.18
Grant Vesting period ends on: Deemed Amount
date vested US$
31/8/2019 31/8/2020 31/8/2021 31/8/2022
SVIT A C = (A × B)
1/9/2017 250 250 250 750 78,885
1/9/2018 300 300 300 300 1,200 126,216
Total US$ 205,101
70 US$105,567
Gains attributable to services in HK for YA 2019/20: 205,101
136
HK$823,898a

a
Based on an exchange of 7.8045 – IRD’s published buying rate for August 2019.

Analysis

Absent an election, the following would be the gains applicable to vesting period in
Hong Kong:

Days: Days: Share Closing Amount before

grant grant to awards pricea time basis
to vest transfer US$ apportionment
Grant date Vest date US$
C D A B (D ÷ C) × (A × B)
1/9/2017 31/8/2019 730 713 250 112.33 27,429
1/9/2018 31/8/2019 365 348 300 112.33 32,129
Gains assessable in HK when vested on 31/8/2019 b
US$ 59,558

1/9/2017 31/8/2020 1,096 713 250 108.22 17,601

1/9/2018 31/8/2020 731 348 300 108.22 15,456
Gains assessable in HK when vested on 31/8/2020 b
US$ 33,057

1/9/2017 31/8/2021 1,461 713 250 118.10 14,409

1/9/2018 31/8/2021 1,096 348 300 118.10 11,250
Gains assessable in HK when vested on 31/8/2021 b
US$ 25,659

1/9/2018 31/8/2022 1,461 348 300 123.23 8,806

Gains assessable in HK when vested on 31/8/2022 b
US$ 8,806
Total gains attributable to vesting period in HK US$ 127,080

a
Based on SVIT close price on the date of vest.
b
To be converted to HK$ based on the buying rate published by IRD for August of the respective year.

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Apply and Analyse 3 (continued)

The above gains will then be applied to the time apportionment ratio applicable to Stan’s
days in Hong Kong for YA 2019/20, that is, the departure year. This is because the gains
would be deemed to accrue to Stan on the date that he departed from Hong Kong under
s.11D(b)(ii). The IRD would raise additional assessments for YA 2019/20 on each of the gain
upon vesting as follows:

1. Amount relating 2. Apportionment Assessable gains

to vesting period in ratio YA 2019/20 in HK (US$), that is,
Vest date HK (US$) (1 × 2)
31/8/2019 59,558 70 30,655
31/8/2020 33,057 136 17,015
31/8/2021 25,659 13,207
31/8/2022 8,806 4,533
US$ 65,410

In practice, it is unlikely for a taxpayer with a non-Hong Kong employment to elect for an
upfront assessment with regards to the unvested stock awards given that deemed vesting
would result in a bigger portion of the gain attributed to services rendered in Hong Kong as
the vesting period after the taxpayer has left Hong Kong will be disregarded as illustrated the
preceding example.

As in the case of stock option gains, both the employer and the employee have the
obligations to notify the IRD of the gains when the stock awards are vested if these were
granted during the taxpayer’s period of assignment in Hong Kong.

4.4.3.3 Phantom Share Awards

A phantom share plan is essentially a deferred compensation plan that gives an employee the
right to receive a cash payment tied to the value of the company’s share at a future date. Tax
is not charged at the time an employee is granted the phantom shares. Salaries tax is only
chargeable at the time when the cash payment is made to the employee. Given that phantom
share award is a form of deferred pay, the employee may apply to have the payment related
back to the years of assessment in respect of which the payment was made under s.11D(b)(i), if
relating back would reduce his or her tax liability (See Section 4.9.2).

4.4.4 Education Benefits

In Section 4.4.1, we have learned that payments in relation to the education of an employee’s
child are excluded from the ‘liability test’. Thus, such payments are specifically subject to
salaries tax under ss.9(1) and (2A)(b) irrespective of whether the payment is made directly to

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the school or capable of being converted into cash. For the purpose of s.9(2A)(b), ‘child of an
employee’ is defined to mean any child, including adopted or stepchild of an employee or of the
employee’s spouse or former spouse.

The IRD provides, in DIPN No. 16 (Revised), paragraph 24, its view on what constitutes
a payment in connection with the education of a child. Besides tuition fees, payments for
incidental education expenses including, among others, boarding fees and the cost of school
outings are considered assessable education benefits for salaries tax purposes. However, a
nursery school provided by an employer for the children of all its employees are considered
not chargeable to the employees on the basis that such benefits are not convertible to money
or attributable wholly or proportionately to an employee (see DIPN No. 16 (Revised), para. 11).
Further, the IRD adopts the position that there is no chargeable benefit to an employee if his
or her child education expenses are made through a genuine discretionary education trust
funded by the employer (Barclays Bank v Naylor (1958–1961) 39 TC 256) – DIPN No. 16 (Revised),
paragraph 25.

4.4.5 Holiday Journey Benefits

Similar to the child education benefit, s.9(2A)(c) excludes from the ‘liability test’ any amount
paid by an employer in connection with a holiday journey. Thus, a holiday journey amount
provided by an employer for an employee is chargeable to salaries tax under ss.9(1) and (2A)(c)
irrespective of whether the holiday journey is convertible into cash or if the primary liability for
the benefit belongs to the employee.

4.4.5.1 Assessable Value of Holiday Journey Benefit

Holiday journey benefit is assessed based on the actual amount paid by the employer. The
benefit is assessable even if the employer may not incur additional cost for the benefit, for
example, an employee who is entitled to travel on a business class seat exchanged the ticket
for two economy seat tickets. The other ticket is for the employee’s spouse/partner or family
member to travel with them. Under such a scenario, the amount relating to the economy ticket
for the employee’s spouse/partner or family member is taxable.

Expenses in relation to a holiday journey include all expenses incurred in connection with
the said journey, for example, airfare and other transportation costs, accommodation, meals,
sight-seeing tours, travel insurance, and so on. Annual home leave passages provided to
employees and their family members are taxable holiday journeys. However, amounts paid by
an employer to relocate an employee and his or her family members when the employee took
up an assignment or on repatriation would not be considered as holiday journey benefits. For
any such trips, the IRD has indicated that stopover visits to another location en route to or from
Hong Kong would also be disregarded (DIPN No. 41, para. 19).

4.4.5.2 Business-cum-holiday Journeys
Holiday journey means a journey taken for holiday purposes; or where the journey is taken
for mixed purposes, the part of the journey taken for holiday purposes (s.9(6)). Thus, when
an employee took a holiday in conjunction with a business trip, it would be necessary to

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identify the portion of the expenses paid by the employer that related to ‘holiday’ as these
are assessable benefit. The IRD provides the following guidance, in DIPN No. 41, paragraphs
15–17, on the approach that the IRD would take in relation to business-cum-holiday journey
assessment:

• Distinct and separable expenses, for example, accommodation costs for extra nights
spent on holidays paid by the employer are assessable.

• Other combined expenses will be allocated based on ‘holiday days basis’, that is,

Number of days spent on holiday .

Total amount spent for the combined journey
Total number of days in the journey

• Cost for the air ticket will not be apportioned on the basis that the cost is incurred
irrespective of the holiday component.

• For business trips spanning over Saturdays and Sundays, such weekend days will not
be considered as ‘holiday journey’. However, weekends prior to and at the end of the
business trips will be considered based on the circumstances. The IRD will most likely
not tax a holiday that is merely incidental to the business trip. By the same token, if the
business component is incidental to the holiday journey, then the entire journey will be
taxed as holiday journey.

• Stopovers are considered incidental if the stopover days are not excessive when taking
the circumstances into consideration.

4.4.5.3 Organised Holiday Journeys for Staff

When an employer provides holiday journeys, for example, group tour for the staff and
the amount paid is not separately identifiable, an appropriate (practical, consistent and
reasonable) allocation driver, for example, headcount, may be used. This deviates from
the non-chargeability of nursery school benefit provided to the children of the employees,
being benefits not convertible to money or not attributable wholly or proportionately to
an employee.

4.4.6 Other Fringe Benefits

We have earlier discussed the amendment to the IRO to include the ‘liability test’, that is, s.9(1)
(a)(iv) post Glynn Case (Section 4.4.1). DIPN No. 16 (Revised) provides the IRD’s view on the
assessability of various non-cash fringe benefits derived by an employee or an office holder
from his or her employer or others. The following reflects the IRD’s view as set out in DIPN
No. 16 (Revised).

4.4.6.1 Certain Assets Made Available by an Employer for the Private Use

of an Employee
Where an employee is allowed to use certain assets, for example, car or boat of the employer
for private purposes, the benefit is not assessable as long as the use of the assets cannot in

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 TAXATION

any way be converted into money. Note that benefits that are not convertible into money by
sale may be convertible by other means. For example, an employee is given the free use of a
car (though not ownership) under an arrangement whereby an employee has the choice of
opting for money instead of the car usage. In such a situation, the benefit is treated as a benefit
convertible into money and assessed accordingly (DIPN No. 16 (Revised), para. 22). The value of
such a benefit is the sum the employee would have received if they had chosen not to take the
car benefit. If ownership of the said asset is transferred to the employee, the value of the asset
at the time of transfer is considered a taxable benefit. This is on the basis that the employee is
able to dispose of the asset and convert it into money.

Recreational facilities and holiday homes provided by an employer for the private use of
employees are also not chargeable as long as such benefits are not convertible into money. In
the event that the employer discharged an amount relating to the private use of an asset for
which an employee is liable, the amount paid by the employer would be an assessable benefit
to the employee.

4.4.6.2 Benefits Relating to the Employee’s Residence

If an employer paid for utilities, telephone and costs associated with a domestic helper, such
benefits are not taxable provided that the employer is the only party liable for the expenses
and the employee cannot convert the benefits into money. The IRD accepts that the employer
is the only party liable for the costs if the utility or telephone account or domestic helper
agreement, and so on, is in the name of the employer.

4.4.6.3 Interest-free Loans or Loans Provided at Reduced Rates

The IRD accepts that interest-free loans or loans provided by an employer to an employee at
less than market rates are not assessable benefits if the costs of providing such loans are the
sole liability of the employer and the benefits are not convertible to money.

4.4.6.4 Credit Cards Used for Private Purposes

If an employer paid for the private charges accruing on a credit card provided to an
employee, the benefit is assessable to salaries tax. The employer by paying for the private
charges on the credit card is essentially discharging the private liabilities of the employee
who used the card.

4.4.6.5 Club Memberships
The costs incurred by an employer to acquire corporate club membership are not assessable
benefits to the employees who are entitled to use of the club membership benefits. Corporate
club memberships may be transferred from one employee to another and the costs incurred
cannot be attributed to a specific individual. However, if the employer paid for an individual
club membership fee or expenses of an employee for which the employee was personally
liable, such payments are benefits assessable to salaries tax.

Exhibit 4.10 provides the decision flowchart on the chargeability of fringe benefits to

salaries tax.

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Benefits specifically chargeable? e.g. Yes

housing (s.9(1)(b)),
and stock option grant (s.9(1)(d))

No

Benefit being some form of cash Yes Chargeable to

allowances (s.9(1)(a))? salaries tax

No

Liability discharged by employer Yes

for employee (s.9(1)(a)(iv))?

No

Liability test exclusion: benefit

Yes
Not chargeable being child education (s.9(2A)(b))
to salaries tax or holiday journey (s.9(2A)(c))

No

No Liability test exclusion: benefit Yes

convertible into money by sale
or other means (s.9(2A)(a))?

EXHIBIT 4.10 Fringe benefits (not being retirement benefits)

chargeable to salaries tax

4.4.7 Retirement Benefits

There are two main recognised retirement schemes governed by different regulations in Hong
Kong, namely:

1. Mandatory defined contribution schemes governed by the MPF Schemes

Ordinance; and

2. Voluntary retirement schemes set up by the employers under the Occupational

Retirement Schemes Ordinance (ORSO) prior to the introduction of the MPF.

For retirement schemes, salaries tax liability arises at the time when an amount is received
or taken to have been received (Section 4.4.7.3). Only the voluntary contributions made by
the employer are of relevance for salaries tax purposes. The employee’s contributions are
considered savings and the investment income thereon is not assessable to salaries tax. Thus,
any withdrawal of accrued benefits from the fund attributable to the employee’s contributions
is not taxable to the employee (DIPN No. 23 (Revised), para. 24). Any amount received by an
employee from a non-recognised occupational retirement (non-ROR) or non-MPF scheme,
provident fund or society to the extent attributable to the contributions made by the employer,
is defined as income from an employment or office subject to salaries tax (s.9(1)(aa)). Further,
any amount attributable to the voluntary contributions of an employer:

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• Received by an employee from a ROR scheme; or

• Received or deemed received (see Sums Received on Termination of Services under

Section 4.4.7.1 on taken to have received) by an employee from an MPF scheme

Other than on retirement, death, incapacity, terminal illness or termination of service is income
from an employment or an office subject to salaries tax (ss.9(1)(ab)(i) and 9(ad)).

For the purpose of retirement benefits provisions, s.8(3) defines the following terms:

• ‘Retirement’ means whichever is later of:

°° Retirement from the service of the employer at a specified age of not less
than 45 years;

°° Retirement after a service period with the employer of not less than 10 years; or

°° Reaching the specified retirement age or 60 years.

• ‘Incapacity’ is permanent unfitness to perform the duties that the person was
performing prior to becoming incapacitated.

• ‘Terminal illness’ follows the definition for MPF purposes and means an illness that is
likely to reduce the life expectancy of the individual to 12 months or less.

• ‘Termination of service’ means a termination of employment with the employer other

than upon retirement, death, incapacity or terminal illness.

4.4.7.1 Mandatory Provident Fund Schemes

MPF schemes are mandatory since MPF’s inception on 1 December 2000. Mandatory
contributions are 5% of the earnings each by the employee and the employer subject to a
current maximum earning limits of HK$30,000 per month, respectively. Employers, employees
and self-employed persons are required to contribute to MPF schemes. In addition to the
mandatory contributions, voluntary contributions can also be made to the MPF schemes.

With regards to accrued benefit received from an MPF scheme, the payment method
does not play a role on how the receipt is taxed. The receipt can be made in a lump sum or an
instalment. However, the circumstances under which the benefit is received must be taken into
consideration in determining if the receipt is tax exempt or taxable. To provide for a person’s
retirement, the government discourages early withdrawal from retirement schemes. Thus,
s.8(2)(cb) exempts from tax all receipts of accrued benefits from MPF schemes upon retirement,
death, incapacity, terminal illness or permanent departure from Hong Kong, as is attributable
to mandatory contributions.

Sums Received on Termination of Services

Under s.8(2)(cc)(ii) and s.8(4)(b), a sum equal to as much of the accrued benefit received from
the approved trustee of MPF scheme, or taken to have been received by an employee from a
MPF scheme upon termination of service (see the following definition), is exempt to the extent
that it is attributable to voluntary contributions made by the employer and does not exceed
an amount equal to the proportionate benefit stipulated under s.8(5). If the receipt exceeds
the proportionate benefit, the excess is income from an employment or an office, which is
chargeable to salaries tax (s.9(1)(ae)).

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A person is taken to have received from the MPF scheme on the date of termination of
service such part of the person’s accrued benefit as is attributable to the employer’s voluntary
contributions, if the services of a person is terminated and the said benefit is retained within
the scheme or is transferred to another MPF scheme (s.8(9)). Once the accrued benefit is
deemed received by the employee, this part of the accrued benefit will not be subject to the
proportionate benefit rule again when the employee subsequently receives the accrued benefit
(s.8(10)).

S.8(5) provides the following formula for calculating the proportionate benefit that is
tax exempt:

completed months of service

Proportionate benefit Accrued benefit
120

‘Accrued benefit’ is defined in s.8(6)(b) to mean the accrued benefits received by the
employee attributable to voluntary contributions paid paid the the scheme i.n respect of the
person for that service.

DIPN No. 23 (Revised), paragraph 35, has multiple examples on how the proportionate
benefit applies under various scenarios. See Illustrative Example 21 on the application of
the proportionate benefit rule under ss.8(4) and 8(5) and on using MPF scheme accrued
benefits to offset statutory entitlement calculated under the Employment Ordinance in
Section 4.4.8.3.

4.4.7.2 Recognised Occupational Retirement Schemes

Recognised occupational retirement (ROR) schemes is defined under s.2 of the IRO as an
occupational retirement scheme registered in accordance with ORSO or a retirement scheme
approved by the commissioner and such approval has not been withdrawn. ROR schemes were
the main retirement schemes prior to MPF schemes in Hong Kong. With MPF schemes, ROR
schemes are being phased out over time.

As in the case of MPF, a termination payment attributable to the voluntary contributions

of the employer made to an employee whose employment is less than 10 years is subject
to the proportionate benefit rule described above – see Sums Received on Termination of
Services in Section 4.4.7.1. Appendix 4.B provides a summary of the taxation of accrued
benefits received from ROR schemes. Accrued benefit is defined under s.8(6)(a) as the
maximum benefit that the person would have been entitled to receive from the scheme
for the person’s service recognised for the purposes of the scheme if, at the date on which
the person’s employment was terminated, the person had retired (within the meaning of
s.8(3) – see Section 4.4.7).

Exhibit 4.11 is a summary of the taxation of accrued benefits received from retirement

schemes (adapted from DIPN No. 23 (Revised), para. 25).

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Circumstances Accrued benefit or sums attributable to employer’s contributionsa

under which the
MPF schemes Recognised Other non-approved
accrued benefits
occupational schemes
are received
retirement schemes
Retirement Exempt (s.8(2)(cc)(i)) Assessable in full
(s.9(1)(aa))
Death Exempt (s.8(2)(cb),
Incapacity s.8(2)(cc)(ii))

Terminal illness
Termination of service Mandatory: Exemptb Exempt but Assessable in full
  ‘Proportionate Benefit (s.9(1)(aa))
Rule’ applies (s.8(2)(c)(i),
Voluntary: Exempt but
s.8(2)(cc)(i), s.9(1)(ab)(ii))
‘Proportionate Benefit
Rule’ applies (s.8(2)(cc)
(ii), s.9(1)(ae))
Permanent departure Mandatory: Exempt Assessable in full Assessable in full
from HK without (s.8(2)(cb)) (s.9(1)(ab)(i)) (s.9(1)(aa))
termination of service  
Voluntary: Assessable in
full (s.9(1)(ad))
Circumstances other Assessable in full Assessable in full Assessable in full
than those listed above (s.9(1)(ad)) (s.9(1)(ab)(i)) (s.9(1)(aa))
a
An employer who is subject to profits tax in Hong Kong.
b
The accrued benefit received under the circumstance is not regarded as income in s.9(1)(ad).
EXHIBIT 4.11 Taxation of accrued benefits received from retirement schemes

4.4.7.3 Employers Who Are Not Chargeable to Profits Tax

Under s.8(7) when an employee:

• Withdraws on retirement, death, incapacity, terminal illness or termination of service,

the accrued benefits attributable to the voluntary contributions made by his or her
employer to a ROR scheme or a MPF scheme; and

• The employer is not chargeable to profits tax.

The amount exempted under s.8(2)(cc) subject to the proportionate benefit shall not exceed
the amount computed in accordance with s.8(8).

s.8(8) formula:

15
Amount to be exempt Annual income1 Completed yearsof services2
100
Accrued benefits received by the employee attributable to mandatory
contributions paid to the MPF scheme by the employer.

1
  The employee’s income for the period of 12 months preceding the date on which the relevant
benefit is received or taken to have been received.
2
  The employee’s completed years of service with the employer.

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This applies to employees of charitable organisations or non-profit organisations, for

example, a university as most other businesses in Hong Kong would be chargeable to profits tax.

4.4.8 Termination Payments

Companies typically offer termination payments to employees when they downsize, for
redundancies or to protect confidential information post termination. There are different types
of termination payments:

• Compensation for loss of office;

• Sums paid pursuant to employment contracts, for example, payment in lieu of notice,
gratuities;

• Payments governed by employment law, for example, long service pay,

severance pay; and

• Restrictive covenants and so on.

Depending on the type of termination payments, the salaries tax implications are different.

Termination payments made to abrogate the rights of an employee under the contract of
employment are not taxable, whether the payments were compensation for loss of office or
settlements for wrongful dismissal. This is because they are not consideration for past, present
or future services in employment. However, termination payments made to an employee under
the contract of employment or for past, present or future services are chargeable to salaries
tax. Whether a termination payment made to an employee is subject to salaries tax has often
been considered in the courts in Hong Kong. In summary, the relevant distinction is as follows:
If the payment is contemplated in the employment contract or otherwise has the character of a
reward for past, present or future services as an employee, then it will in general be taxable. If,
however, the payment is to compensate the employee for a breach of the employment contract
or to obtain from the employee some consideration that is not related to the services he or she
renders in employment (such as buying his cooperation or silence in a sensitive matter) then it
will not in general be taxable.

4.4.8.1 Compensation for Loss of Office

The recent case Poon Cho Ming, John v CIR CACV 94/2016 (2018) HKCA 297 has reaffirmed
that terminal payments that were paid for the abrogation of an employee’s right under the
contract of employment are not taxable. In this case, the taxpayer, Mr. Poon, was the group
chief financial officer and executive director of a Hong Kong listed company. His contract
provided for a two-year service period and thereafter until terminated by either party by giving
a six-month notice period. The management terminated his employment after they fell out.
Subsequently, the taxpayer entered into a separation agreement with the company. Under the
separation agreement, the parties agreed to the following in addition to the six-month payment
in lieu of notice and other statutory entitlements:

• A payment in lieu of discretionary bonus in the sum of €500,000; and

• Acceleration of the vesting dates in respect of three tranches of stock options

to the termination date. These options were exercised and the taxpayer made a
substantial gain.

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The IRD assessed the taxpayer on the above payments and he appealed to the Board and
then to the Court of First Instance. Both the Board and court upheld the position of the IRD
and the taxpayer brought his case to the Court of Appeal. The Court of Appeal overturned
the decisions of the Board and Court of First Instance. The Court of Appeal applied the
fundamental test set out in Fuchs, Walter Alfred Heinz v CIR (2011) HKCFAR 74. The test being:
‘What was the purpose of the payments? Was it a reward for his services, past, present or
future (in which case it was ‘from his employment or office’), or was it for some other reason
(in which case it was not)?’

Although the taxpayer’s contract provided for a discretionary bonus, the judge noted
that the taxpayer’s employment was terminated prior to the three stages for the exercise of
discretion for the award of the discretionary bonus. The group’s results and the taxpayer’s
performance were not considered in deciding if a bonus should be awarded to the taxpayer.
Applying the Fuchs test of purpose, the court held that the purpose of the payment was to
avoid any litigation from the taxpayer. The payment did not flow from his or her contract of
employment.

If the employer had not accelerated the vesting date of the stock options as part of the
separation agreement, they would have lapsed. When the IRD asked the company about the
acceleration of the stock option vesting date, the company responded ‘It was allowed so with a
view to settling all outstanding matters upon the cessation of the taxpayer’s employment’. The
Court of Appeal concluded that the benefits offered by the company to the taxpayer, including
the discretionary bonus were consideration to make the taxpayer ‘go away’ quietly. Neither the
discretionary bonus of €500,000 nor the share option gain is chargeable to salaries tax.

For this case, note that the commissioner has applied to the Court of Appeal for leave
to appeal.

4.4.8.2 Termination Payments Provided in a Contract of Employment

Either the employer or the employee may terminate an employment contract by giving the
other party a notice of termination. The notice period often is stipulated in the contract of
employment. Payment made in lieu of notice is chargeable to salaries tax when the payment
is made pursuant to the contract of employment or paid in accordance with s.7 of the
Employment Ordinance. This was established in Fuchs, Walter Alfred Heinz v CIR (2011) HKCFAR
74 where the Court of Final Appeal held: ‘The rights that accrued to the taxpayer under clause
9(c) upon termination were obviously enforceable at law . . . sums were paid in satisfaction of
the rights that had accrued to the taxpayer under clause 9(c) and were plainly amounts derived
from his or her employment’.

When an employee has leave outstanding at the time of termination, the leave may
either be taken or cashed out. The leave payment or payment in lieu of leave is income from
an employment and chargeable to salaries tax. Similarly, where a contract of employment
provides for a contract gratuity payable upon satisfactory completion of the contract, the
gratuity is income from an employment chargeable to salaries tax.

Based on the preceding case and past precedents, it is obvious that besides
documentation, the true intent of the parties is just as crucial in substantiating the nature and,
thus, assessability of the termination payments. In Murad v CIR (2010) 1 HKLRD C6, the court
applied the substance over form principle and held that the true nature of the payments is the
determining factor and not the label attached to them in a contract (see also IRBRD D40/11).

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4.4.8.3 Long Service Payments and Severance Payments

It is the current practice of the IRD to exempt from salaries tax severance payment and long
service payment made strictly in accordance with the provisions of the Employment Ordinance
(EO). See ss.31B, 31G,31I, 31R, 31V and 31Y of EO on the relevant details.

Illustrative Example 21 – Offsetting of Statutory Entitlement and

Assessability of Accrued Benefit in Excess of the Proportionate Benefit
Under s.8(5)
Eddie Kwok was made redundant on 31 July 2019 when his employer, JSDesign Hong
Kong, merged with another company after 7 years and 11 months of service with the
employer. Eddie’s last drawn salary was HK$48,000 per month. Under the EO, he was
entitled to a long service payment of HK$118,750. The accrued benefit attributable
to his employer’s contributions retained in his MPF scheme account was HK$220,000
(mandatory HK$180,500 and voluntary HK$39,500). His employer did an offset and no
long service payment was made as a result.

 ddie is deemed to have received from the MPF scheme the accrued benefit that is
E
attributable to his employer’s voluntary contributions as the benefits are retained in
his MPF scheme account.

Therefore, under ss.9(1)(ae) and 8(2)(cc)(ii), the accrued benefit in excess of the tax-
exempt amount computed under s.8(5) as below, would be subject to salaries tax
(see Section 4.4.7.1):

completed months of service (95)

Proportionate benefit HK$39, 500
120
HK$31, 271.

The amount chargeable to salaries tax is HK$39,500 – HK$31,271 = HK$8,229.

Illustrative Example 22 – Contract Gratuities and Offsetting

of Statutory Entitlement
Eddie (Illustrative Example 21) was entitled to a contract gratuity of HK$140,400 being
10% on his basic salary drawn during his period of employment less the employer’s
contributions to MPF.

The gratuity of HK$140,400 would be chargeable to salaries tax in addition to the

taxable accrued benefit of HK$8,229. However, Eddie can apply to have the gratuity related
back to the service period for which they were made (up to 36 months immediately prior to
his entitlement to the gratuity or his last day of employment, whichever is earlier) if relating
back would reduce his overall tax liability (see Section 4.9.2).

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4.4.8.4 Restrictive Covenant
Payments made in consideration of a post-employment restrictive covenant are generally
not chargeable to salaries tax. This position is affirmed by the High Court in CIR v Yung Tse-
Kwong (2003) HICA 5. The taxpayer’s employment letter contained a clause ‘as an insurance
policy for peace-of-mind if you should be terminated from your assignment as president of
ACNielsen Media International for other than ‘cause’, we will reassign you to another ACNielsen
opportunity or offer you severance pay for 12 months equal to your base salary at the time
in accordance with our Career Transition Plan’. The taxpayer’s employment was terminated
and he was offered ‘severance pay’ if he signed the Severance Agreement. The Severance
Agreement contained a restrictive covenant clause. The High Court had to determine the
portion of the payment that related to the restrictive covenant given that the restrictive
covenant was not made as a reward for the taxpayer’s past, present or future services. Note
that if the restrictive covenants were stipulated in the original contract of employment,
consideration attributable to those restrictive covenants may be treated as income for services
in employment.

Key Learning Point

S.9 of the IRO brings into the salaries tax net the following income and benefits, whether
they are derived from an employer or others:

• Wages, salary, leave pay, fee, commission, bonus, gratuity, perquisite or allowance;

• Accommodation provided or subsidised;

• Gains from stock option or share award;

• Child’s education benefit;

• Holiday journey benefit;

• An amount paid by an employer to discharge the employee’s liability;

• Any benefit that is convertible into money by sale or other means; and

• Certain retirement benefits.

Knowledge Check Questions

Question 6
Identify which of the following is not a taxable benefit.
A Gabriel lives in Kowloon Tong with his wife and two young kids. He is the head chef
at one of the leading hotels in Hong Kong and he was provided a hotel room for his
exclusive use at work.
B When Alice Chan was assigned to work at her employer’s office in Shenzhen, she had
to drive during weekdays to work. Her employer reimbursed her part of the travelling
expenses, that is, the petrol cost she incurred due to the additional distance from her
home to the new office location.

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Knowledge Check Questions (continued)

C Jack was provided a fully maintained company car. Employees who opt not to receive the
car benefit are paid a monthly transport allowance.
D Reimbursement to the managing director of his monthly subscription fees to a private
health club.

Question 7
Identify which of the following statement is correct.
A Tim exercised his employee stock option (ESO) to acquire 100 shares at a strike price
of US$20 per share on 31 August 2018. The closing price of the share on Nasdaq was
US$32. Under the ESO plan, Tim could also do a cashless exercise, that is, exercise to
buy and sell immediately. Tim was advised that 100 shares were registered in his name
on 3 September 2018 and the closing share price on Nasdaq was US$33. Tim will be
assessed on the notional gain of US$1,300.
B Mr. Park works for a Korean company in Hong Kong. His employer paid for his two-
room serviced apartment. The housing benefit is assessed at 8% of Mr. Park’s total net
assessable income from the company.
C Stanley was provided with a weekend stay for free at the company’s Repulse Bay
bungalow when he won the ‘Employee of the Month’ award. The award is not
transferrable, but Stanley can exchange it for a HK$4,000 Starbucks card. The award is
not chargeable to salary tax.
D Mr. Cheong should not be taxed on the accrued benefits relating to his employer’s
mandatory contributions to MPF scheme when he resigned from his job after five years.

4 . 5
BENEFITS SPECIFICALLY EXCLUDED
FROM SALARIES TAX

Under s.9(1)(a)(iv), income from an employment is defined to exclude specifically any payment
made by the employer to the benefit of the employee and where it is paid in discharge of the
employer’s sole and primary liabilities, not being a liability for which any person was a surety.
Such excluded payment does not include the following taxable fringe benefits provided to
the employee:

• Holiday journey benefits;

• Child education benefits; and

• Any benefits that are capable of being converted into money by the recipient.

Besides the above general exclusion, the following are items that are specifically excluded
from the definition of income from any office or employment.

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4.5.1 Payment or Refund of Rent

We have learned in Section 4.4.2 that employer-provided housing is chargeable to salaries tax
based on the rental value of the accommodation (ss.9(1)(b) and (c)). The rental value is deemed
to be 10% (8 or 4% if the accommodation provided were hotel or hostel of a certain size as
the case may be) of the total emolument of the employee from the said employer less any
deductible outgoings, expenses and capital allowances, and any lump sum payment or gratuity
received (s.9(2)). In view of this, rent paid, in part or in full, by an employer or an associated
corporation for an employee, or any rent refunded by an employer to an employee, is deemed
not to be income under s.9(1A) to ensure that the same perquisite is not taxed twice in the
hands of the employee.

However, if the amount paid or refunded by an employer or an associated corporation

to an employee was not housing fringe benefit in nature, the exclusion from income under
s.9(1A) would not apply. In such a scenario, the employee would be taxed on the amount
paid or refunded by the employer instead of the rental value of the accommodation
(see Section 4.4.2.1).

4.5.2 Lump Sum Receipts from Retirement Scheme

Lump sum receipts being commutation of pension under ROR schemes upon termination of
service, death, incapacity, terminal illness or retirement are tax exempt under s.8(2)(c)(i). All
lump sum or instalment payments from MPF schemes on retirement, death, incapacity and
terminal illness are also tax exempt under ss.8(2)(cb) and 8(2)(cc)(ii).

A lump sum receipt from a ROR scheme on termination of employment is tax exempt if
the employee’s period of service with the employer making the voluntary contributions is at
least ten years. Similarly, accrued benefits from an MPF scheme received or deemed received
(see Sums Received on Termination of Services under Section 4.4.7.1) by an employee on
termination of service after a minimum service period of ten years are tax exempt. If the
employee’s period of service was less than 10 years, the tax exemption is capped at an amount
computed based on the proportionate benefit formula provided in s.8(5) (see Sums Received
on Termination of Services under Section 4.4.7.1).

A further limitation is imposed on the amount exempted from salaries tax if the employer is
not subject to profits tax as discussed in Section 4.4.7.3.

Exhibit 4.5 at the end of Section 4.4.7.2 provides a summary of the tax implications on

payments from the different retirement schemes.

Key Learning Point

Two items are specifically excluded from salaries tax, namely:

1. Rent paid or refunded by an employer if the employee is provided with

accommodation or subsidised accommodation, and assessed on the rental value
of the accommodation; and

2. Lump sum receipts from ROR schemes or MPF schemes, on retirement, death,
incapacity, terminal illness or termination of service where the service period is at
least ten years.

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Knowledge Check Question

Question 8
Identify which of the following is exempt from tax.
(I) Pete was paid a lump sum amount from an occupational retirement scheme when he
retired at the age of 43.

(II) Pensions from a ROR scheme.

(III) A lump sum receipt from the employer’s mandatory contribution to MPF scheme on
permanent departure from Hong Kong.

(IV) Various payouts from an MPF scheme to Jane who was diagnosed with terminal
stage cancer.

(V) Mrs. Li resigned from her employer after 12 years of employment and the accrued
benefits were kept in her MPF scheme account.

A I, II and III
B I, III and IV
C II, IV and V
D III, IV and V

4 . 6
ALLOWABLE DEDUCTIONS

There are two main categories of deductions available under salaries tax assessment.
These are:

1. Deductions under s.12 for outgoings or expenses incurred in the production of

assessable income, where there exists a nexus between the deductions and the
assessable income; and

2. Concessionary deductions under Part 4A of the IRO. These are specific items
comprising approved charitable donations, elderly residential care expenses, home
loan interest, contributions made to recognised retirement schemes, qualifying health
insurance premiums, qualifying annuity premiums, and tax-deductible MPF voluntary
contributions.

S.12(1) of the IRO provides a limited list of items which may be deductible against the
income of an individual to arrive at the net assessable income for any year of assessment. Net
assessable income is defined in s.2 to mean assessable income as adjusted in accordance with
s.12. S.11B provides guidance on the ascertainment of assessable income. We shall discuss the
ascertainment of assessable income in Section 4.8.1.

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Exhibit 4.12 is a decision flowchart on the deductibility of expenses or outgoings under

ss.12(1)(a) and (b).

Questions to ask Expenses or Outgoings

No
Paid/a liability exists? Incurred?
Not
Yes deductible
under
s.12(1)(a)
Personal/household Yes
Domestic/private?
matters?

No

No
Capital in nature?

Yes
Is there a choice?
Duties cannot be
performed otherwise? No
Essential to Necessarily?
production of
assessable Yes
income?

Yes No

No Allowed as
In the course of In production of
extra-statutory
performing the duties? assessable income?
concession?
Yes
Yes

Yes Deductible
Partially private? Wholly/exclusively? under
s.12(1)(a)

Apportionment
No of expenses
(IRD concession –
Yes No DIPN No. 9, para. 6)
Capital
expenditure s.12(1)(b) ss.39B, 39D capital ss.39A, 39C capital
allowances allowances
Non-capital s.12(1)(b) s.12(1)(b)
expenditure s.12(1)(a)

EXHIBIT 4.12 Ss.12(1)(a) and (b) deductions

4.6.1 Outgoings and Expenses

Under s.12(1)(a), all outgoings and expenses, other than expenses of a domestic or private
nature and capital expenditure, wholly, exclusively and necessarily incurred in the production
of the assessable income are deductible expenses. Broadly, an expense is deductible if and
only if it satisfies all the requirements of s.12(1)(a):

• Not domestic or private expenses;

• Not capital in nature;

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• Wholly, exclusively;

• Necessarily;

• Incurred; and

• In the production of an assessable income.

4.6.1.1 Domestic and Private Expenses or Outgoings

A deduction will be denied if the expense or outgoing is a domestic or private expenditure.
Domestic expenditure is expenditure relating to the taxpayer’s household or domestic affairs
while private expenditure relates to the taxpayer’s personal matters. Typical domestic or
private expenses are:

• Personal living and family expenses, for example, food, household and entertainment
expenses for the taxpayer and the taxpayer’s family members and friends;

• Costs of travelling to and from home and office; and

• Medical insurance costs.

In IRBRD D54/94, the taxpayer, ordinarily resident in the UK, worked in Hong Kong for over
six months. He stayed in a hotel and was provided living expenses. The Board held that the
expenses that the taxpayer claimed, that is, his hotel accommodation and living expenses in
Hong Kong were not expenses deductible for the purposes of salaries tax. Such expenses were
expenses of a domestic or private nature and were also not wholly, exclusively and necessarily
incurred in the production of the assessable income.

4.6.1.2 Capital Expenditure
The IRO does not provide guidance on what constitutes capital or revenue expenditure.
However, case law has developed a number of indicia that help in distinguishing between
capital and revenue expenditure. Examples of capital expenditure are assets acquired (e.g.
computers) and entrance fees for club membership. Capital expenditure, the use of which is
essential to the production of assessable income, is deductible under depreciation allowances
(Section 4.6.2). For further details on what constitutes capital and revenue expenditure, refer to
Chapter 3, Section 3.6.2.

4.6.1.3 Wholly, Exclusively and Necessarily Incurred

Expenses or outgoings must be wholly, exclusively and necessarily incurred in generating the
assessable income in order to qualify for a deduction. Though the term ‘wholly and exclusively’
in its strict sense means no deduction will be given where an expense is incurred partly
for business and partly for non-business purposes, the IRD states in DIPN No. 9 (Revised),
paragraph 6, that if an expenditure is incurred for more than one purpose, such expenditure
should be apportioned, and the part attributable to the employment would be allowed,
provided the other tests under s.12(1)(a) are satisfied. The IRD made reference to a car used for
business and private purposes whereby the expenses can be apportioned based on mileage
basis. A word of caution though that based on precedence, the words ‘wholly’, ‘exclusively’
and ‘necessarily’ were given very precise interpretations when a deduction under s.12(1)(a)
was claimed.

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Necessarily
The test to ‘necessarily incurred’ is not whether the employer imposes the expense but whether
the duties do, that is, the duties cannot be performed without incurring the expenditure. In
Brown v Bullock (1959–1963) 40 TC 1, a bank manager who was expected as part of his job
to join and entertain clients in a club was disallowed a deduction for the expenditure. The
expenditure was not necessarily incurred as his duties could be performed without the club
membership.

DIPN No. 9 (Revised), paragraph 7, comments that if the employer requires the employee
to incur an expense or outgoing in performing his or her duties, the employer would
generally reimburse for these expenses. Thus, it would be difficult for an employee to
claim that the job required them to incur the expense, unless the contract of employment
provided for it.

Incurred
The deduction under s.12(1)(a) requires an expense or outgoing to be incurred by the taxpayer
in the year of assessment in order for the expense or outgoing to be deductible in that year.
The term ‘incurred’ is not defined in the IRO, thus, it is necessary to have regard to common
law principles. Generally, an expense or outgoing that is not paid is incurred if the taxpayer
is definitively committed to it or there is a presently existing liability of a known amount (see
Ogilvy and Mather Pty Ltd v FCT (1990) 90 ATC 4836). That is, there exists a liability, as opposed to
just a pending, contingent or anticipated obligation, no matter how certain the obligation may
appear. An amount that has been paid would have been incurred.

4.6.1.4 Production of the Assessable Income

A deduction is only allowed if there exists the requisite link between the expenditure and the
production of assessable income. However, an expense or outgoing, necessarily incurred to
enable the taxpayer to earn the income does not automatically mean that it is necessarily
incurred in the production of the income.

The term incurred in the production of assessable income was considered by the court
in Hong Kong in CIR v Humphrey (1970) HKTC 451 where the court held that the expression ‘in
the production of assessable income’ bore the same meaning as ‘in the performance of the
duties of the office or employment’. Thus, the travelling expenses between home and office
claimed by the taxpayer were held not to be incurred in the performance of duties, but to
enable the duties to be performed. Although expenses might be incurred in order to place
the taxpayer in a position in which they were able to earn part of the assessable income,
they might not be incurred in the production of the income – see CIR v Robert P. Burns (1980)
1 HKTC 1181 and CIR v SIN Chun-wah (1988) 2 HKLR 496 at 498 and CIR v Franco Tong Sui Lun
(2006) HCIA 2/2006.

DIPN No. 9 (Revised), paragraph 9, provides examples of expenses that are not incurred in
the performance of the duties, but to enable the duties to be done. These include expenditure
to acquire an employment or appointment and the costs of memberships to social or sports
clubs whether or not required by the employer.

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Illustrative Example 23 – S.12(1)(a) Domestic/Private and Necessarily

Incurred in the Production of Assessable Income
Marcus works as a graphic designer in a Hong Kong company. He met Kong, the creative
director of a reputable company, and invited Kong for a drink at a pub nearby. Marcus’s
main purpose of inviting Kong for a drink was to get Kong’s insight into the current
graphic design trend. The information would be useful to Marcus’s work. On his way
home, Marcus walked past a stationery shop. He likes to write with the ABC brand pen as
the ink is very smooth. His employer only provides simple pens at work. Marcus picked
up a dozen of the ABC brand pens for his office use. Can Marcus claim a deduction for
the drinks at the pub and the dozen ABC brand pens he bought?

 o satisfy the provisions of s.12(1)(a), the expenses must not be a domestic or private
T
in nature. Marcus is not required to invite and pay for the drinks to do his work. The
pens are his personal choice and not required for his work as well. He can do his
work using the simple pens provided by his employer. Both expenses are private and
domestic in nature. Further, both are not necessarily incurred in the production of
assessable income.

In IRBRD D76/90, the Board summarised the meaning of wholly, exclusively and
necessarily incurred in the production of income: ‘wholly means that if an expense is
incurred partly for the production of the assessable income but partly for the benefit
of the taxpayer or any other person, the expense is not deductible. It does not matter if
the principal object of the expense or the majority of the expense is attributable to the
employment . . . necessarily . . . this test has two limbs. The expense must be something
that the employee must incur and has no choice. If there is any choice, then it is not
necessarily incurred. Second, it must be necessarily incurred in the production of the
assessable income. This means that it is not sufficient for the employment contract or
employer to impose a condition upon the employee if the expense is not incurred in the
production of the assessable income’ (see Brown v Bullock under Section 4.6.1.3). Thus, this
test requires a connection between the expenses or outgoing and the performance of the
duties. A mere connection to the employment is not sufficient.

4.6.1.5 Other Specific Expenditures

DIPN No. 9 (Revised) addresses the following specific expenditures that may be deductible
under s.12(1)(a) being work-related expenses wholly, exclusively and necessarily incurred in the
production of assessable income – see paragraphs 13 to 19.

Clothing
Replacement costs of specific clothing required in the performance of the taxpayer’s job, for
example, uniform or overall, and the like, are allowed for deduction. Otherwise, the IRD has
indicated that the prerequisite ‘wholly and exclusively’ incurred would not be satisfied. In IRBRD
D41/92, the Board upheld the commissioner’s disallowance of 50% of the clothing expenses
claimed by the taxpayer, who is a solicitor. The Board referred to the UK case Mallalieu
v Drummond (1983) 2 AC 861 where the House of Lords held that ‘The effect of the word
exclusively is to preclude a deduction if it appears that the expenditure was not only to serve

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the purposes . . . but to serve some other purposes . . . the private purposes of the taxpayer’.
Further, the expenses did not meet the necessarily prerequisite given they were incurred in
relation to her office that are personal to herself (Ricketts v Colquhoun (1926) AC I).

On the apportionment of the expenses, the Board held that s.16 of the IRO tacitly
recognises that apportionment is permissible with the wording used ‘to the extent to which
it was incurred’. However, s.12(1)(a) contains no similar wordings. Thus, the 50% cost was not
wholly, exclusively and necessarily incurred and the apportionment was not permissible.

Commission Payment for Services

The IRD has indicated that in a situation where a commission earner taxpayer paid
commissions to others in order to earn the income, deduction is available if the conditions
under s.12(1)(a) are met. Full information about the nature of the payment and the recipients
should be provided to the IRD.

Entertainment Expenses
A deduction is permissible if the taxpayer can prove that the entertainment expenses were
necessarily incurred and that it would not have been possible to produce the income from the
employment without incurring the expenditure. For example, the entertainment would need
to have a direct correlation with a business negotiation and the taxpayer would need to have
kept records of the names of the people entertained and the nature of the business in question
besides costs (DIPN No. 9 (Revised), para. 15). The IRD has clearly indicated that mere social
entertaining would not meet the wholly and exclusively requirement. Further, the IRD has made
it clear that any round sum entertainment allowances in excess of admissible entertainment
expense deductions would be assessable to salaries tax.

In IRBRD D5/93, the taxpayer claimed as a deduction certain expenses being entertainment
and travelling. The taxpayer was entitled to claim reimbursement from his employer of all
entertainment expenses that were legitimately incurred in the performance of his duties which
were supported by valid bills. He claimed some of them that were duly reimbursed to him and
sought to claim other entertainment expenses that he did not recover from his employer. The
Board was not convinced that the entertainment expenses were incurred in the performance
of the taxpayer’s duties. The view taken is that no one is better qualified to adjudicate on the
validity of business expenses than the employer.

Payments to Assistant
Such expenses are generally not necessarily incurred unless it can be clearly established that
assistance is justifiable based on the volume of work or business transacted and the expenses
incurred was reasonable relating to it.
Subscription to Professional Institution
Subscriptions paid to professional institutions are generally not deductible under the strict
interpretation of the provision (see IRBRD D11/01). However, as an extra-statutory concession,
it is the IRD’s policy to allow a deduction for the subscription fee paid to one professional
association if the holding of a full professional qualification is a prerequisite of employment and
the membership retention and the keeping abreast of current developments in the profession
are of regular use and benefit in the performance of the taxpayer’s duties, for example,
accountants subscriptions to the HKICPA. Only full membership qualifies. Student membership
is not eligible.

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Further, the IRD has stated that trade union subscriptions would not qualify for such extra-
statutory concession.

Travelling Expenses
While travelling expenses between home and office are not deductible under s.12(1)(a)
(see Section 4.6.1.4), reasonable travelling expenses from a place of employment to another
are deductible, although often, the employer would reimburse such expenses. Note that
admissible expenses must be necessarily incurred in the performance of the taxpayer’s duties.
The IRD has stressed that for a taxpayer who claimed motor vehicle expenses, regard would be
given to whether the amount claimed is reasonable given the availability of public transport. In
IRBRD D25/87, it was held that the taxpayer’s car expenses did not meet the requirements of
s.12(1)(a) as it was a matter of convenience and not practical necessity.

If the employment required the use of a car in order for the taxpayer to carry out his duties,
the claim should specify the basis on which the employer reimbursed expenditure incurred,
and the extent to which the car was used for non-work purposes. The cost of repairs and
running expenses would be apportioned between use for employment and other (private)
purposes. The latter is not deductible.

Flat Rate Deductions for Certain Employment

On page 5 of the IRD pamphlet ‘A Guide to Salaries Tax 2’, the IRD has indicated that, as an
extra-statutory concession, a taxpayer who must work in uniform may claim deduction for
laundry expenses. To minimise the need for the IRD to review numerous small claims, the
IRD applied as a matter of discretion a flat standard deduction of HK$2,400 given to certain
categories of employment. These are employees in disciplined services who must work in
uniforms. Examples are the Hong Kong Regiment, Police Force, Fire Services, Auxiliary Air Force,
airline pilots and so on.

Similarly, it is the practice of the IRD to allow as a concession a deduction at a set 10% of
the commission income to cover allowable outgoings and expenses incurred in earning the
commission income of certain employment that is commission based, for example, insurance
agent employee, sales representatives, club hostesses and so on. See various Board’s decisions,
for example, IRBRD D76/90 and IRBRD D25/87.

An employee who incurred a higher amount of deduction may claim the actual amount of
expenses incurred if the expenses satisfy all the requirements of s.12(1)(a). The onus of proof,
as we have learned is on the taxpayer and given the stringent provision of s.12(1)(a) and the
set 10% of commission being an administrative practice of the IRD, it would be difficult for the
taxpayer to meet the ‘wholly, exclusively and necessarily incurred’ tests.

4.6.1.6 Expense Allowances from Employer

The IRD indicates in DIPN No. 9 (Revised), paragraph 12, that reasonable allowances from an
employer that are intended to cover the work-related expenses, for example, traveling, hotel
accommodation and other related expenses when the employee is required to travel for
work away from his usual base or place of residence would not be assessed. However, any
claim for expenses in excess of the employer’s reimbursements would fail the ‘necessarily’
incurred prerequisite. Further, a reimbursement by the employer for disallowable expenses, for
example, private or personal expenses, would be chargeable to salaries tax.

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4.6.1.7 Summary
As we can see from the preceding text, the requirements of s.12(1)(a) are so stringent that
other than the items specifically permitted under extra-statutory concessions, there are limited
deductions under the salaries tax assessment. Note that there is no merit in appealing when it
concerns extra-statutory concession. In IRBRD D24/87 and D23/14, the Board held that it had
no power to extend the scope of an extra-statutory concession since it was an administrative
measure devised by the commissioner.

4.6.1.8 Record-keeping and Substantiation
A taxpayer may claim various deductions to the extent that the expenses incurred meet
the requirements of s.12(1)(a). Receipts and other supporting documentation need not be
submitted but must be kept for verification when requested. Given that s.64(2) places the onus
of proof on the taxpayer, it is in the interest of the taxpayer to keep all receipts, car logbook
and other relevant supporting documents in respect of the expenses claimed (see DIPN No. 9
(Revised), para. 2). It is crucial for the taxpayer to prove the quantum of the expenses claimed
for deductions. S.68(4) of the IRO places the onus on a taxpayer to prove in an appeal to the
Board of Review that the assessment is excessive or incorrect. The Board held in IRBRD D25/87
in relation to the claim for transportation expenses, that the taxpayer had to first prove that the
transportation expenses satisfied the prerequisites of s.12(1)(a). Secondly, the taxpayer had to
prove the quantum of the expenses so incurred. See also IRBRD D37/92.

Receipts or documentation must be kept for six years after the expiration of the year
of assessment. We have learned in Chapter 2 that the statute of limitation is six years after
the year of assessment (s.60(1)). Thus, records must be kept for the same time period for
substantiation.

Discharging the Onus of Proof

The IRD and the Board adopt the approach of the Australian Board of Review (10 CTBR Case
47) in determining if the taxpayer has discharged the onus of proof – see IRBRD D25/87 and
D37/92. The Board has in various cases stated, in connection with entertainment expenses
claimed: ‘In our opinion, it is necessary in order to establish an outgoing or outgoings in a
case of this kind, for the taxpayer to provide details of the expenditure incurred, showing with
reasonable precision when, where, upon whom the sum or each of the sums concerned was
spent, and the person or persons entertained in the process’.

The Board went further and commented, ‘Having in mind the nature of the outlays we can
appreciate the difficulty of procuring vouchers, but we consider it incumbent on the taxpayer
to maintain a contemporaneous written record in a notebook (or similar book possessing a
measure of permanence) of the expenditures outlaid by him’. If the taxpayer had no records
to substantiate his claim, not even a diary record, he was not in a position to discharge the
statutory onus placed on him’.

In IRBRD D43/00, the taxpayer was denied a deduction for payments he allegedly paid to
his subagents as he failed to discharge the onus of proof that he indeed were incurred and the
payments were made wholly, exclusively and necessarily in the production of the commissions
that he earned.

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It is therefore crucial for taxpayers to keep all records relevant to substantiate the expenses
claimed. Lack of evidence will result in the deductions being denied. For further cases relating
to rejections of expense deductions due to the taxpayer’s inability to prove the requirements of
s.12(1)(a), see IRBRD D6/17, D98/00, D121/97, D37/92, D76/90, D36/90 and D25/87.

4.6.2 Depreciation Allowances

In arriving at the net assessable income of a taxpayer, depreciation allowances are granted
in respect of capital expenditure on machinery or plant the use of which is essential to the
production of the assessable income (s.12(1)(b)). The capital allowances are calculated in
accordance with Part 6 of the IRO (see Chapter 3, Section 3.7.1, on depreciation allowances
for machinery or plant and DIPN No. 7 (Revised)). The deduction under s.12(1)(b) is a lot
less stringent compared to s.12(1)(a). As long as the plant or machinery is essential to the
production of assessable income, deductions by way of capital allowances are granted.

In claiming a depreciation allowances under s.12(1)(b) the provisions of ss.39A, 39B, 39C
and 39D are relevant. If the machinery or plant is used wholly and exclusively in the production
of a taxpayer’s assessable income, depreciation allowances are claimable under ss.39B and
39D. Where any machinery or plant is not used wholly and exclusively in the production of
assessable income, the amount of the allowances provided for in s.12(1)(b) shall be reduced in
the proportion considered by the assessor to be fair and reasonable (s.12(2)). The applicable
depreciation allowance provisions are ss.39A and 39C.

In IRBRD D7/04, the taxpayer, a first associate concertmaster whose main duty was to
play violin in concert performances, bought the violin of his choice after he had accumulated
enough funds. He claimed depreciation allowances in respect of the violin. The commissioner
disallowed his claim on the basis that the particular violin purchased was not ‘essential’
given the alternatives available to the taxpayer to buy, hire or borrow a good fine violin. The
commissioner was of the view that the purchase was the taxpayer’s own volition as there
was nothing inherent in his duties that required him to use a violin of such quality. The Board
concluded in favour of the taxpayer and the following were the pertinent findings:

• Both the commissioner and the taxpayer agreed that it was essential that the taxpayer,
as the first associate concertmaster (and first chair) used a good fine violin in the
performance of his duties. This illustrates the point that the ‘objective necessity test’
must be judged according to the substantive requirements of the employment.

• It follows that the higher the degree of virtuosity required to properly discharge the
performance duties of a musician’s employment, the standard of what is ‘objectively
necessary’ is also commensurately higher.

• The objective character of the deductions allowed relates to their nature, not to
their amount.

• There was no evidence that the taxpayer could have bought or hired or borrowed any
other suitable violin for his first chair post than the one he eventually purchased to
ensure that it was exclusively available to him in the performance of his duties with
his employer.

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• It was a common practice within the industry for an instrument to be loaned for a
lengthy period but not indefinite. It was not realistic for someone in his position to
borrow the violin for life.

• Though the violin gave the taxpayer personal enjoyment and pride of possession to
such an extent that it could be concluded that the purchase contained elements of
personal choice and a predictable benefit quite separately from the necessities of
the taxpayer’s employment, the benefit was held to be an incidental and unavoidable
benefit of the fact that a violin of such quality was essential for the taxpayer’s
employment.

• Any private playing by a dedicated professional musician who must practise on his own
did not mean that the wholly and exclusively test was not met. Even if the taxpayer
played at home for love and occasional family gathering, he did not use the violin in any
way incompatible with his employment other than to a purely de minimis extent.

Let us have a look at the applicability of s.12(1)(b) in Illustrative Example 24.

Illustrative Example 24 – S.12(1)(b) Depreciation Allowance

Lisa is a full-time teacher. Her school provided permanent teaching staff with desktop
computers for general usage. Lisa found it hard to do all her teaching preparation at
school and bought a laptop so that she could do her class preparation work at home
after school hours. She uses the laptop to video chat with her family in the UK once a
week. Can Lisa claim depreciation allowances on her laptop?

 .12(1)(b) provides that depreciation allowances shall be granted to a person

S
on capital expenditure (in this instance the expenditure on the laptop) incurred,
if the use of the laptop is essential to the production of her assessable income
from teaching.

In IRBRD D11/08, a teacher was denied the capital allowances on the computer she
used to prepare for schoolwork after school hours. Similarly, to Lisa, the employer
provided desktop computers at school for general usage of all teaching staff. In this
case, the Board concluded that the ‘essential’ criteria for a deduction under s.12(1)
(b) is the same as ‘necessarily’ under s.12(1)(a) except that s.12(1)(a) deals with
revenue expenditure and s.12(1)(b) deals with capital expenditure. For a deduction
under s.12(1)(a), the taxpayer must show that he or she has no choice, that is, in the
preceding case, without the laptop computer, she could not perform her teaching
duties. The test in allowing a capital deduction should not be different. Thus, if there
were a choice the expenditure would not be ‘essential’ to the production of the
assessable income.

In view of the above, Lisa would not be able to claim capital allowances on the laptop.

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4.6.2.1 Computation of Depreciation Allowances

When a taxpayer incurs a capital expenditure that qualifies for a deduction under s.12(1)(b), an
initial allowance equal to 60% of the expenditure will be allowed as a deduction (s.39B(1A)(c)).
In addition, an annual allowance calculated at the rate of depreciation prescribed in the Inland
Revenue Rules (IRR) Rule 2 on the reducing value of the asset will be deductible (ss.39B(2)
and (3)). Note that the initial allowance is claimable when the taxpayer ‘incurs’ the capital
expenditure in the year of assessment, while annual allowance is only available as a deduction
if the taxpayer ‘uses’ the asset that is essential to the production of his or her assessable
income during the relevant year. Generally, for a salaries tax payer where single capital
expenditure is involved, the reducing value of the asset is the capital expenditure incurred less
the initial allowance and any annual allowances claimed in respect of the asset (s.39B(4)).

If the taxpayer ceased to use or disposed of an asset a deduction on which was claimed
under s.12(1)(b), a balancing charge being the open market value or sale proceeds less
the reducing value of the asset would be added to the assessable income of the taxpayer
accordingly (s.12(5)).

Illustrative Example 25 – Computation of Initial and Annual Allowances

Danny Yue works in the same school as Lisa on a casual basis. For security reasons,
casual staff does not have access to the desktop computers provided to permanent
staff. Instead, casual staff is expected to prepare its work using its own computers. When
Danny started with the school in January 2019, he borrowed a laptop from his brother
occasionally to prepare the schoolwork. After teaching for three months, he realised he
needed a laptop if he planned to continue teaching at the school. He eventually bought
the cheapest laptop available that suited his school needs for HK$5,000 on 2 April 2019.
Danny started using the laptop the following day at school. Can Danny claim depreciation
allowances in respect of the laptop? What allowances are available to him for the year of
assessment 2019/20?

 nlike Lisa, where the school provides desktop computers for the teaching staff,
U
Danny has no choice but to get a laptop that is essential for his teaching use. It would
not be realistic for him to use his brother’s laptop on an ongoing basis. Thus, he
can claim depreciation allowances under s.12(1)(b) as the laptop is essential in the
performance of his duties. Given that Danny bought and used the laptop in the year
of assessment 2019/20, he can claim the following allowances in the same year:

% HK$ Allowances
A B HK$
(A × B)
Cost: laptop 5,000
Less: Initial allowance (s.39B(1A)(c)) 60 (3,000) 3,000
Reducing value 2,000
Less: Annual allowance (s.39B(2), IRR Rule 2) 30 (600) 600
Reducing value carried forward to YA2020/21 1,400
Depreciation allowances (s.12(1)(b)) 3,600

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Illustrative Example 25 (continued)

Danny can claim HK$3,600 being the depreciation allowances under s.12(1)(b) for
the year of assessment 2019/20. The balance of HK$1,400 will be carried forward
to the year of assessment 2020/21. If Danny continues to use the laptop for his
casual teaching employment, an annual allowance of HK$420 (30% × HK$1,400)
will be claimable as a deduction, being the annual allowance, in the year of
assessment 2020/21.

Illustrative Example 26 – S.12(5) Computing Balancing Charge

After a year as a casual teacher at the school, Danny Yue left his casual employment
for a permanent position at another school. His new employer provides him with a
laptop solely for school use. Danny sold his laptop to his successor at the last school at
HK$2,200. Will Danny be taxed on the sale proceeds?

 nder s.12(5), the balancing charge in respect of the laptop will be included as
U
Danny’s assessable income for the year of assessment 2020/21. The balancing charge
is computed as follows:

HK$
Reducing value brought forward from YA2019/20 1,400
Less: Disposal value (2,200)
Balancing charge (s.39D(1)(a)) 800

Chapter 3, Section 3.7.1, contains detailed discussion on depreciation allowances on plant

and machinery.

4.6.3 Loss Brought Forward

The excess of outgoings, expenses and allowances deductible under ss.12(1)(a) and 12(1)(b)
over the amount of people’s assessable income is to be carried forward and set off against
their assessable income in subsequent years of assessment (s.12A(1)). It is unlikely that salaries
taxpayers will generate any loss, given the limited deductions available under s.12. In the
event a loss was generated, the loss brought forward would be set off first against taxpayers’
assessable income in the year immediately following the year the loss occurred (s.12A(3)).
Any remaining excess shall be set off against their assessable income for the next year of
assessment until the excess has been completely utilised.

Where a married taxpayer had elected for a joint assessment with his or her spouse, the
loss brought forward shall first be set off against the assessable income of the person who
incurred the loss. Any excess thereof shall be set off against the assessable income of the
spouse under s.12A(4) (Section 4.8). Should there still be any unutilised loss remaining, the loss
shall be carried forward to the following year of assessment for set-off against the assessable

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income of the taxpayers in the same manner as aforesaid if a joint assessment is elected. If no
joint assessment was elected, the remaining loss shall be set off against the assessable income
of the person who incurred the loss under s.12A(3) as described in the earlier paragraph.

4.6.4 Excess of Allowable Deductions of a Spouse under Joint Assessment

Where an election is made for a joint assessment, the excess of allowable deductions of a
spouse for the year of assessment is deducted from the assessable income of the other spouse
to arrive at the net assessable income of that other spouse for that year (ss.12(1)(d) and 12(3)).

4.6.5 Self-education Expenses

Under s.12(1)(e) of the IRO a taxpayer may claim a deduction for self-education expenses
paid in the year of assessment up to the capped amount prescribed in Schedule 3A if the
requirements under s.12(6) below are met.

• The expenses are of a category defined in s.12(6)(b);

• The course is a prescribed course of education under s.12(6)(c); and

• The education provider is an institution listed in s.12(6)(d) or an institution approved by

the commissioner (s.12(6)(e)).

The course of education or examination taken must be to gain or maintain qualifications for
use in any employment. General interest classes or courses will not be deductible (see IRBRD
D82/06 where the Board and the IRD disallowed a self-education expense deduction claimed
by a qualified solicitor taxpayer in respect of a course on a diploma in acupuncture). The Board
held that to meet the s.12(1)(e) deduction, the taxpayer must prove that:

• The taking of the course would enable him to gain or maintain some qualification or
qualifications; and

• The qualification or qualifications gained or maintained by taking the course would be

used by him for some prospective employment.

4.6.5.1 Expenses Must Be Paid in the Year of Assessment

The wordings of s.12(1)(e) provide that the claim for a deduction must be made in the year
of assessment that the self-education expenses are paid, that is, if the taxpayer paid for the
course fee in, say, January 2019 and the course only commences in April 2019, the expenses
must be claimed in the year of assessment 2018/19 (see IRBRD D88/99).

Where the taxpayer’s employer reimburses the taxpayer the self-education expenses,
a deduction will not be allowed. If the employer reimburses the taxpayer part of the
self-education expenses, the taxpayer may claim the balance of the expenses that is not
reimbursed.

The maximum amount prescribed in Schedule 3A is HK$100,000 for the years of

assessment 2019/20 and 2020/21.

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4.6.5.2 Expenses of Self-education – S.12(6)(b)
Expenses of self-education is defined to include:

• Fees, including tuition and examination fees in relation to a prescribed course of

education undertaken by the taxpayer.

• Fees in respect of an examination set by an education provider or a trade, professional

or business association, and undertaken by the taxpayer to gain or maintain
qualifications for use in any employment.

However, s.12(6)(b) specifically excludes the following from expenses of self-education:

• Expenses for which a deduction is allowable or has been allowed to the taxpayer in any
year of assessment under any other provision of this ordinance; or

• Expenses to the extent to which they have been reimbursed or are reimbursable to the
taxpayer by his or her employer or any other person unless the reimbursement has
been or will be included in the assessable income of the taxpayer.

4.6.5.3 Prescribed Course of Education – S.12(6)(c)

A prescribed course of education means a course undertaken to gain or maintain qualifications
for use in any employment and being a:

• Course of education provided by an education provider;

• Training or development course provided by a trade, professional or business

association; or

• Training or development course accredited or recognised by an institution specified in

Schedule 13 (Schedule 13 of the IRO contains a list of trade or professional institutions,
societies or associations).

4.6.5.4 Education Provider and Approved Institution – ss.12(6)(d) and 12(6)(e)

Generally, the term ‘education providers’ refers to universities, university colleges or technical
colleges, schools registered under the Education Ordinance or institutions approved by the
commissioner. Lists of the education providers can be found at:

https://www.gov.hk/en/residents/taxes/salaries/allowances/deductions/selfeducation.htm.

4.6.6 Concessionary Deductions

S.12B(1)(a) provides that in arriving at the net chargeable income of a taxpayer, concessionary
deductions under Part 4A are allowed as deductions. Unlike personal allowances that are
only allowed to taxpayers charged under the progressive tax rates, concessionary deductions
are also available to taxpayers who are subject to tax under the standard rate. Part 4A
concessionary deductions are:

• Approved charitable donations (s.26C);

• Elderly residential care expenses (s.26D and Schedule 3C);

• Home loan interest (s.26E and Schedule 3D);

• Contributions to recognised retirement schemes (s.26G and Schedule 3B);

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• Qualifying premiums paid under the Voluntary Health Insurance Scheme (VHIS) policy
(s.26K and Schedule 3E);

• Qualifying annuity premiums paid under a qualifying deferred annuity policy (s.26O and
Schedule 3F); and

• Tax deductible MPF voluntary contributions (s.26S and Schedule 3F).

The following sections discuss the circumstances under which the concessionary
deductions are allowed.

4.6.6.1 Approved Charitable Donations s.26C

Under s.26C(1), a deduction is allowed, subject to a cap, in respect of the aggregate amount of
donations made by a taxpayer or his or her spouse (not being a spouse living apart from the
taxpayer) if the donations are made:

• In money;

• To charitable institutions or trusts of a public character that are exempt from tax under
s.88 of the IRO or the government;

• For charitable purposes; and

• Of HK$100 and above in aggregate.

The amount of donations deductible is limited to 35% of:

• The assessable income of the taxpayer for the year of assessment after deducting
outgoings or expenses allowed under s.12(1)(a) and capital allowances under
s.12(1)(b); or

• The aggregate assessable income of the taxpayer and his or her spouse where an
election for joint assessment has been made (Section 4.8), after deducting outgoings
and expenses allowed under s.12(1)(a) and capital allowances under s.12(1)(b) (ss.26C(2)
(a)(ii) and (2A)(c)).

Note that the capping is not on the net assessable income of the taxpayer, but the
assessable income after deducting outgoings or expenses permissible under s.12(1)(a) and
capital allowances under s.12(1)(b). Carried forward losses and self-education expenses
deductions are not taken into account.

Illustrative Example 27 – Approved Charitable Donations

Let’s have a look at Danny Yue from Illustrative Example 25. In April 2019, he enrolled for
a part-time study in a Bachelor of Education (Honours) in Early Childhood Education at
Yew Chung College of Early Childhood Education, an education provider under s.12(6)(d).
He paid a tuition fee of HK$42,500 for the first year. Danny’s teaching salary for the year
of assessment 2019/20 was HK$384,000. Besides the laptop he bought for his teaching
use, Danny made a cash donation of HK$50,000 to F.O.C.U.S. (Focus on Children’s
Understanding in School), a charitable institution that is exempt from tax under s.88 of
the Ordinance. Can Danny claim a deduction for the donation of HK$50,000?

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Illustrative Example 27 (continued)

 nder s.26C, Danny can claim a deduction for the cash donation subject to a cap
U
at 35% of his assessable income less expenses allowed under s.12(1)(a) and capital
allowances allowed under s.12(1)(b). The cap amount in Danny’s case is:

HK$
Salary 384,000
Less:
Depreciation allowance (s.12(1)(b)) (3,600) Illustrative Example 18
(A) 380,400
s.26C(2A)(c) cap amount: 35% × A 133,140

Danny can claim a deduction for the full amount of the donation made of
HK$50,000 since the amount is below the cap amount of HK$133,140 for the year of
assessment 2019/20.

Under s.26C(3)(a), the same approved charitable donation will not be allowed as a
deduction to more than one person. Thus, a married taxpayer who has not elected for
a joint assessment must decide who of the couple will make the claim for an approved
charitable donation.

What Constitutes an Approved Charitable Donation?

S.2(1) of the IRO defines ‘approved charitable donation’ to mean a donation of money to any
charitable institution or trust of a public character that is exempt from tax under s.88 or to the
government, for charitable purposes. The list of approved charities can be found at
https://www.ird.gov.hk/eng/tax/ach_index.htm.

The IRO does not define the term ‘donation’. DIPN No. 37 (Revised), paragraph 3, describes
what constitutes a donation. In brief, a donation is a gift or a voluntary transfer of property
for no valuable consideration, that is, no material benefit in return. The IRD has provided
examples of items that would fall outside ‘donations’, including payments for grave spaces (see
IRBRD D54/11), purchases of raffle tickets, admission fees to charity film shows (see Sanford
Yung-tao Yung v CIR (1979) 1 HKTC 1081), the cost of tickets for charity balls and concerts
and so on. Alternatively, receipts by the donors of badges, flags and other similar token
acknowledgements are minute and do not breach the materiality requirement to preclude the
payments from being a donation.

In DIPN No. 37 (Revised), paragraph 8, the IRD quotes the decision of Lord MacNaghten in
Income Tax Special Commissioners v Pemsel (1891) AC 531 on objectives which are charitable as:

• The relief of poverty;

• The advancement of education;

• The advancement of religion; and

• Any other purposes of a charitable nature beneficial to the community and not coming
within the scope of the preceding three categories.

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For the purposes of the IRO, the approved charitable donation must be a donation of
money. Donations made in any form other than money would not be deductible for tax
purposes. Further, the total amount of all approved charitable donations made in a year of
assessment must be at least HK$100 when added together.

4.6.6.2 Elderly Residential Care Expenses s.26D

If a taxpayer or his or her spouse paid for the residential care expenses of the taxpayer’s or
his or her spouse’s parent or grandparent, the taxpayer would be entitled to claim a deduction
up to the prescribed maximum amount, in respect of the residential care expenses paid in the
year of assessment (s.26D(1)).

Eligibility
The elderly residential care expenses are deductible if the following conditions are met:

• The parent or grandparent is the parent or grandparent of the taxpayer or his or

her spouse;

• The parent or grandparent was aged 60 or above at any time during the year of
assessment in question or if under 60, was eligible to claim an allowance under the
government’s Disability Allowance Scheme;

• The parent or grandparent lived in a residential care home; and

• The residential care home is situated in Hong Kong and licensed or exempted from
licensing under the Residential Care Homes (Elderly Persons) Ordinance or is a
nursing home registered under the Hospitals, Nursing Homes and Maternity Homes
Registration Ordinance or the Private Healthcare Facilities Ordinance (Cap. 633) from
1 January 2021.

Parent and grandparent are defined in s.26D(5) and s.2(1) to include the taxpayer’s or his or
her spouse’s or deceased spouse’s natural, legally adopted or step-parents/grandparents.

The maximum deduction available is prescribed in Schedule 3C (s.26D(3)). This amount

is set at HK$92,000 for the year of assessment 2017/18 and HK$100,000 for the year of
assessment 2018/19 onwards.

Expenses Allowable
The residential care expenses must have been paid in the year of assessment in order to
qualify for a deduction in that year of assessment. The deduction is allowed for the cost of
residential care expenses, for example, accommodation, food, nursing care and other sundry
expenses, actually paid to the residential care home, subject to the capped amount, for each
parent or grandparent (s.26D(2)). In DIPN No. 36 (Revised), paragraphs 3 and 4 the IRD stresses
tressesthat this concessionary deduction is only available for the cost of care provided to a
parent or grandparent who is a resident in a residential care home to satisfy the ‘residential’
requirement. Further, private or personal expenses paid by the residential care home on the
resident’s behalf and subsequently recovered from the taxpayer or his or her spouse are not
deductible residential care home expenses.

How the Deduction Operates

The deduction for the same parent or grandparent can only be granted to one taxpayer (s.26D(4)
(a)). Thus, the taxpayer must agree among his or her family members, who may also have

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contributed to the residential care expenses, on who will claim for the deduction. The taxpayer
who will be claiming the deduction can only claim the residential care expenses he or she (and his
or her spouse if not living apart) have actually paid up to the capped amount. The person named
in the invoice or account will be deemed to be the person who has made the payment even
though different family members may have contributed for the residential care expenses.

If a married couple, both with income, has more than one parent or grandparent living
in a residential care home, the taxpayer may claim a deduction for the residential care home
expenses paid for one of the parents or grandparents and his/her spouse may also claim a
deduction for the expenses paid for the other parent or grandparent. The deductions are
permissible whether the married couple is assessed separately or elected for a joint assessment.

Once a taxpayer claimed the deduction for residential care expenses in respect of a parent
or grandparent, no one would be entitled to claim dependent parent/grandparent or additional
dependent parent/grandparent allowances in respect of the same parent or grandparent
(ss.30(5) and 30A(5)). DIPN No. 36 (Revised), paragraph 24, explains how the commissioner
would resolve a situation where two or more taxpayers (other than a married couple not living
apart from each other) had claimed and were allowed the deduction. The commissioner can
withdraw the deduction previously granted as in the case of personal allowances (s.26D(4)(b))
when such scenario occurred (see IRBRD D31/05).

Illustrative Example 28 – Elderly Residential Care Expenses

Roger, an accountant, is married to Yan Yan. Both Roger’s 78-year old parents live in
a residential care home in Hong Kong. Yan Yan’s 90-year old grandfather also lives in
the same residential care home. For the year of assessment 2019/20, Roger, being the
only child, paid HK$105,000 for each of his parent’s monthly home expenses. Yan Yan’s
grandfather’s expenses were fully met by the Comprehensive Social Security Assistance
Scheme Allowance but Yan Yan paid HK$12,000 for other maintenance needs of her
grandfather in the same year.

 nder s.26D(1), Roger can claim the elderly residential care expenses he paid in
U
respect of his parents. The amount claimable by Roger is HK$200,000 (HK$100,000
× 2) under s.26D(3) and Schedule 3C. Yan Yan did not pay for the elderly residential
care expenses that were fully met by the government. However, she can claim
dependent grandparent allowance in respect of her grandfather (see Section 4.7.5).

4.6.6.3 Home Loan Interest – s.26E

Under s.26E(1), a taxpayer who paid interest on a mortgage obtained to acquire a dwelling
that is used exclusively or partly as his place of residence can claim a deduction for the loan
interest paid during the year of assessment up to the capped amount prescribed in Schedule
3D (s.26E(2)(a)(ii)). DIPN No. 35 (Revised) provides the details of the deduction and the
following summarise the key elements of s.26E. The maximum home loan interest deduction
prescribed in Schedule 3D is HK$100,000. This capped amount has not changed since year of
assessment 2003/04.

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Eligibility
To be eligible for home loan interest deduction, the taxpayer must satisfy the following
conditions:

• The taxpayer must be the sole or part owner of the dwelling;

• The dwelling is situated in Hong Kong as a separate rateable unit under the Rating
Ordinance (s.26E(9));

• The dwelling is used wholly or partly as the taxpayer’s residence (s.26E(9));

• The taxpayer paid interest on the loan obtained to finance the purchase of the dwelling;

• The loan is secured by a mortgage or a charge over a property in Hong Kong (s.26E(9));

• The lender is an approved institution listed in s.26E(9); and

• The taxpayer has not been granted home loan interest deduction for 20 years of
assessment (s.26E(4)(c)). Note: the number of entitlement years for home loan interest
deduction was 15 years prior to year of assessment 2017/18.

Definition of Home Loan Interest and Approved Lenders

S.26E(9) defines home loan interest as ‘interest paid by the person as a sole owner, or as a joint
tenant or tenant in common of the dwelling for the purposes of a home loan to:

• The government;

• A financial institution;

• A credit union registered under the Credit Unions Ordinance (Cap.119);

• A money lender licensed under the Money Lenders Ordinance (Cap.163);

• The Hong Kong Housing Society;

• An employer of the person; or

• Any recognised organisation or association’.

‘Home loan’ is defined as a loan of money that is

a. Applied wholly or partly for the acquisition of a dwelling that:

(i) During any period of time in that year of assessment is held by the person as a sole
owner, or as a joint tenant or tenant in common; and

(ii) During that period of time is used by the person exclusively or partly as his place of
residence; and

b. Secured during that period of time by a mortgage or charge over that dwelling or any
other property in Hong Kong (s.26E(9)) – see IRBRD D11/07.

Qualifying Dwelling
Where the taxpayer paid interest in respect of a loan obtained to acquire a dwelling that is
used exclusively or partly as his or her place of residence and the loan was also applied for the
acquisition of a car parking space, located in the same development as the dwelling, the car
parking space is deemed to be part of the dwelling (s.26E(8)). Interest paid on that part of the
loan in respect of the car parking space qualifies as home loan interest.

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A taxpayer can only claim home loan interest in respect of his or her principal place of
residence. If the taxpayer owned more than one property and used different properties as his
or her place of residence at distinct periods during a year, the taxpayer can claim home loan
interest for each dwelling for the respective periods where the dwelling was used as his or her
principal place of residence (s.26E(3)(b)). However, the IRD would not accept an alternating use
dwelling at regular intervals, for example, weekdays at one dwelling and weekends at another.
In such scenario, the dwelling where the taxpayer and his or her family spent most of their time
would be considered the principal place of residence (see DIPN No. 35 (Revised), paragraph 18).

Illustrative Example 29 – More than One Principal Place of Residence

Pei Lin’s parents lives in Guangzhou. In 2016, she took a mortgage to finance the
purchase of a small residence near her office in Causeway Bay. On 1 December 2019,
Pei Lin obtained another loan to finance the purchase of a three-bedroom apartment
in Mid-Levels as her parents would be moving back to Hong Kong when her dad retired
in December 2020. Pei Lin moved into the new apartment on 15 February 2020. She
renovated the Causeway Bay apartment after vacating it and eventually sold it in April
2020. During the year of assessment, 2019/20, she paid interest of HK$90,000 on the
loa9 for her Causeway Bay apartment and HK$40,000 for the Mid-Levels apartment’s
mortgage. What home loan interest can Pei Lin claim as a deduction for the year of
assessment 2019/20?

 rom 1 April 2019 to 14 February 2020 the Causeway Bay apartment was Pei Lin’s
F
primary place of residence. The Mid-Levels apartment became her main place of
residence from 15 February 2020. Under s.26E(2), Pei Lin will be able to claim home
loan interest for the loan interest paid on the. Causeway Bay apartment for the
period 1 April 2019 to 14 February 2020 (10.5 months). The interest paid on the
Mid-Levels apartment’s mortgage from 15 February to 31 March 2020 (1.5 months)
will also qualify for home loan interest deduction. Thus, the total home loan interest
deductible to her is HK$76,250 computed as follows:

10.5 1.5
HK$70, 000 HK$40, 000 HK$76, 250 .
12 41
1
  The loan interest was for the period 1 December 2019 to 31 March 2020 and only the portion
applicable to the period that the Mid-Levels apartment became Pei Lin’s place of residence would
qualify as home loan interest. From the period 1 December 2019 to 14 February 2020, Pei Lin’s
primary place of residence was her Causeway Bay apartment.

Dwelling Wholly Used as Residence for Part of the Year or Used Partly as Principal Residence
If during the year of assessment, a taxpayer paid interest on a mortgage in respect of his or
her residence, home loan interest deduction up to the maximum prescribed amount would be
available to the taxpayer regardless of the months he or she lived in the property. However,
where a dwelling was used partly as the taxpayer’s principal residence, home loan interest
deduction allowable would be based on an amount that was reasonable in the circumstances
of the case (s.26E(2)(a)(i)(B)).

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Illustrative Example 30 – Dwelling Wholly used as Residence for Part

of the Year
Elise (Illustrative Example 15) took a mortgage from a Hong Kong bank to acquire
her residence in August 2014. She moved into the apartment in September 2014 and
paid mortgage interest on the residence of HK$90,000 for the year of assessment
2014/15. Even though Elise only used the place as her primary residence from
September 2014 to March 2015 (7 months), she would be entitled to home loan interest
deduction of HK$80,000 (the maximum prescribed in Schedule 3D) for the year of
assessment 2014/15.

Home Loan Used Partly for Dwelling

Where home loan interest was paid in respect of a dwelling that the taxpayer used exclusively
or partly as his or her place of residence, but the loan was not applied wholly for the acquisition
of the dwelling, the home loan interest deduction allowable would be such part of the home
loan interest paid as was reasonable in the circumstances of the case (s.26E(3)(a)).

Illustrative Example 31 – Loan not Applied Wholly on Residence

After a year with GBank Hong Kong, Elise (Illustrative Example 30) was able to apply for
a staff loan under GBank Hong Kong employee home loan scheme. The staff loan was
provided at a substantially lower interest rate. Elise refinanced her home loan on 1 April
2019. At the time of refinancing, her outstanding principal with the Hong Kong bank was
HK$830,000. Elise applied for the maximum home loan that she was entitled to under her
staff grade, that is, HK$1 million. She repaid the mortgage with the Hong Kong bank and
used the remaining amount to finance the purchase of a used car. Elise paid HK$85,000
interest to GBank Hong Kong from 1 April 2019 to 31 March 2020. Advise Elise on the
amount of home loan interest she can claim for the year of assessment 2019/20.

 trictly, when a person substitutes an original mortgage of his or her home by a

S
subsequent mortgage in order to obtain a more favourable rate of interest, the person
will not be entitled to home loan interest deduction as the loan will not fall within the
definition of ‘home loan’ under s.26E(9). This is because the loan is not applied for the
acquisition of the dwelling used as the person’s primary place of residence. However,
as a matter of policy and practice, the commissioner still grants home loan interest
deduction as a concession under such scenario (see IRBRD D123/01).

In the case of Elise, the interest would only be deductible to the extent of the
repayment of the original mortgage, that is, sum applied on the home loan. Thus, she
could only claim the interest computed as follows (see IRBRD D22/01):.

830, 000
HK$85, 000 HK$70, 550.
1, 000, 000

The remaining amount of HK$14,450 related to interest on the portion of loan used
to finance the purchase of her car would not be deductible as home loan interest.

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In the case of a home loan account that allows flexibility in repayments and permits
subsequent withdrawals, any interest incurred on subsequent withdrawals would not qualify as
home loan interest – see IRBRD D40/12.

Shared Ownership
Where the taxpayer is the sole owner of the dwelling, he or she is entitled to claim home loan
interest paid subject to the cap amount of HK$100,000. Where the property is jointly owned or
owned by multiple persons as tenants in common, interest is deemed to be paid in accordance
with the ownership ratio (ss.26E(2)(b) and 26E(2)(c)). Thus, each owner can claim home loan
interest deduction in proportion to his or her share of ownership as long as home loan interest
has been paid.

In IRBRD D5/02, the taxpayer had to purchase her residence under a joint ownership
with her mother as part of the condition of the home loan scheme from the government.
She paid for all the mortgage instalments and claimed the full home loan interest deduction
of HK$100,000. The Board upheld the commissioner’s position that under s.26E(2)(b)(i),
the taxpayer can only claim a deduction to the extent of 50% because there was another
joint tenant.

Period of Deduction
Home loan interest deductions are granted to each taxpayer for a maximum period of 20 years
of assessment under s.26E(4)(c). The home loan interest claim does not have to be continuous
and is not limited to one dwelling. A taxpayer can claim home loan interest in respect of any
dwelling in any year as long as the requirements under s.26E are met.
Deduction for Married Taxpayers
For a married couple not living apart, there can only be a single principal place of residence at
any one point in time. A married couple not living apart from each other cannot each claim a
different principal place of residence and seek home loan interest deductions in respect of the
properties owned.

In the case of a separately assessed married couple, home loan interest deduction will be
allowed based on each spouse ownership of the dwelling subject to a total maximum amount
of HK$100,000.

Nomination for Spouse to Claim s.26E Deduction (s.26F)

A taxpayer who is entitled to claim home loan interest deduction may nominate for his or her
spouse to claim the deduction if the taxpayer has no income chargeable to tax for the year of
assessment (s.26F(1)). Once a nomination is made, the taxpayer’s entitlement to home loan
interest deduction ceases and the spouse assumes the deduction allowable (s.26F(2)(a)). The
taxpayer is regarded as having been granted the s.26E home loan interest deduction for the
purposes of determining the remaining number of years that the taxpayer is entitled to home
loan interest – see Deduction for Married Taxpayers in this section (s.26F(2)(b)).

Upon allowance of home loan interest deduction to the taxpayer’s spouse, the
commissioner will send a written notification to the taxpayer of the allowance under s.26F(3).
The taxpayer has up to six months from the date of this notification to revoke his or her
nomination. If a revocation is submitted, the nomination is deemed not to have been made
(s.26F(4)).

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4.6.6.4 Contributions to Recognised Retirement Schemes s.26G

Under s.26G, mandatory contributions made by an employee to an MPF scheme are deductible
in the year of assessment that the contributions are made subject to a cap of HK$18,000. This
amount is prescribed in Schedule 3B. In the case of a recognised occupational retirement
scheme, the deduction allowable under s.26G is the lower of:

• The contributions paid by the employee; and

• The amount of mandatory contributions the employee would have been required to
pay had the scheme been an MPF scheme (s.26G(3)(a)),

up to the maximum amount prescribed in Schedule 3B of the IRO.

4.6.6.5 Qualifying Premiums Paid under the Voluntary Health Insurance Scheme

Policy s.26K
Qualifying premiums paid by a taxpayer and/or the taxpayer’s spouse, not being a spouse
living apart from the taxpayer as policy holder(s) of a voluntary health insurance scheme (VHIS)
policy, are deductible up to a maximum amount of HK$8,000 (s.26K and Schedule 3E of the
IRO). This deduction is effective from the year of assessment 2019/20. In order to claim the
deduction, certain conditions must be met (see Eligibility for Deduction in this section). A VHIS
policy is defined under s.26I(1) of the IRO to mean an insurance policy that is in whole or in
part issued under an insurance plan certified by the Secretary for Food and Health to be in
compliance with the VHIS. A policy holder means a legal holder of the policy (s.26I(1)).

What Constitutes Qualifying Premiums Paid Under a Voluntary Health Insurance

Scheme Policy?
S.26I(1) of the IRO defines ‘qualifying premiums’ to mean the net sum of money that is payable
under a VHIS policy to the insurer for writing or renewing the policy being an insurance plan
certified by the Secretary for Food and Health to be in compliance with the government’s VHIS.

If the insurance policy covers both VHIS and other components, for example, a life
insurance, only the net premium relating to VHIS is eligible for a deduction.

Eligibility for Deduction
To be eligible for the deduction:

• The qualifying premiums must be paid by the taxpayer and/or the taxpayer’s spouse,
not being a spouse living apart from the taxpayer;

• The insured person is either the taxpayer or a specified relative of the taxpayer in the
year of assessment; and

• The insured person is either:

°° A holder of a HKID card at any time during the year of assessment; or

°° Under the age of 11 and not an HKID card holder at any time during the year of
assessment, but his or her natural parent or adoptive parent must be a HKID card
holder when the insured person was born or adopted (s.26K(1)).

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Specified Relatives
An individual is a specified relative of a taxpayer if the individual at any time during the year of
assessment is:

• The taxpayer’s spouse;

• A parent or grandparent of the taxpayer or his or her spouse who is at any time during
the year of assessment:

°° Aged 55 or more; or

°° Under 55 but eligible to claim an allowance under the government’s Disability

Allowance Scheme;

• A child or sibling of the taxpayer or his or her spouse who is at any time during the year
of assessment unmarried and:

°° Under the age of 18; or

°° Aged 18 or more but under 25 years of age and receiving full-time education at a
university, college, school or other similar educational establishment; or

°° Aged 18 or more but, by reason of physical or mental disability, incapacitated for

work (s.26J).

How the Deduction Operates

The amount of qualifying premiums deductible to the taxpayer for each insured person is
the actual net qualifying premium paid in the year of assessment or HK$8,000, whichever is
lower. Qualifying premiums payable but not paid within the relevant year of assessment would
only be taken into consideration in the year of assessment when such premiums are actually
paid – see DIPN No. 56 (Revised), paragraph 11.

If there is more than one policy holder for a VHIS policy, the qualifying premiums paid are
deemed as paid by all the policy holders in equal share (s.26K(2)).

There is no cap on:

• The number of VHIS policy holders; and

• The number of specified relatives

claimable by a taxpayer. A deduction can be made in respect of the same insured person under
more than one VHIS policy.

More than one taxpayer can claim for a deduction of qualifying premiums paid in respect of
the same insured person subject to:

• The capped deductible amount of HK$8,000 for each insured person in a year of
assessment (s.26K(3), Schedule 3E); and

• The total deduction claimed by the taxpayers does not exceed the qualifying premiums
paid in respect of the insured person in the relevant year of assessment.

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Illustrative Example 32 – Voluntary Health Insurance Scheme Policy

with More than One Policy Holder
Bob and his brother Billy purchased a VHIS policy for their 80-year-old father, a HKID
holder. Bob paid HK$15,000 and Billy paid HK$4,000 in respect of the VHIS policy in the
year of assessment 2019/20. Both Bob and Billy are the named policy holders. What
VHIS qualifying premium deduction, if any, is available to Bob and Billy in the year of
assessment 2019/20?

 nder s.26K(2), the total net premium of HK$19,000 is deemed to have been paid by
U
Bob and Billy in equal share. Thus, Bob can claim a deduction of HK$8,000 and Billy
can also claim a deduction of HK$8,000 in respect of the VHIS policy, irrespective
of the actual amount paid by Bob and Billy. Note that the amount of deduction
claimable is capped at HK$8,000. The total amount claimable by Bob and Billy is
HK$16,000, which does not exceed the actual premium paid of HK$19,000.

Note that s.26K(1) specifies that qualifying premiums paid during a year of
assessment is deductible for the year of assessment. Thus, the excess premium paid
by Bob and Billy of HK$3,000 would not be available for a deduction in the following
or future years of assessment.

Married Taxpayers
S.26K(1)(a) provides that the qualifying premiums must be paid by the taxpayer or his or her
spouse, not being a spouse living apart from the taxpayer, as a policy holder of the VHIS.
This means that in the case of a married taxpayer not living apart from his or her spouse, the
qualifying premiums are deductible to either the married taxpayer or the taxpayer’s spouse
or to both in so far as one of them is the VHIS policy holder and the other prerequisites of
a deduction (see Eligibility for Deduction under Section 4.6.6.5) are met. The deduction is
available as long as:

• The deduction allowed to each of the married couple in respect of the insured person
does not exceed HK$8,000 in the year of assessment; and

• The total amount deductible does not exceed the qualifying premiums paid (s.26L(2)).

Illustrative Example 33 – Qualified Voluntary Health Insurance Scheme

Premiums Paid by a Married Taxpayer or Spouse, not Being a Spouse
Living Apart from the Taxpayer
Jim is married to Julia. For the year 2019/20, Jim and Julia paid the following VHIS
qualifying premiums:

Specified relative Policy holder(s) Premium paid in HK$

Jim’s father (age 65) Jim 12,000
Jim’s mother (age 66) Jim 10,000
Julia’s father (age 60) Julia 9,000
Julia’s mother (age 60) Julia 8,000

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Illustrative Example 33 (continued)

Jim, Julia and their parents are HKID holders. Given that Jim earned significantly more
than Julia, Jim and Julia agreed that Jim should claim the maximum deductions available in
respect of the VHIS premiums paid for their parents. Let us now compute the amount of
qualifying premiums deductions available to Jim and Julia.

Qualifying premiums claimable (HK$) by

Specified relative Jim (s.26L(2)(a)) Julia (s.26L(2)(b)) Total
Jim’s father (age 65) 8,000 4,000 12,000
Jim’s mother (age 66) 8,000 2,000 10,000
Julia’s father (age 60) 8,000 1,000 9,000
Julia’s mother (age 60) 8,000 0 8,000
32,000 7,000 39,000

For the year of assessment 2019/20, Jim can claim the maximum deduction of
HK$8,000 per insured person (a total of HK$32,000), and Julia would claim a deduction
of HK$7,000. The amounts claimed by Jim and Julia in respect of each insured parent
do not exceed the cap of HK$8,000 and the total deductions claimed by Jim and Julia
do not exceed the actual premiums paid in respect of each insured parent (s.26L(2)).

A married taxpayer and his/her spouse must agree on how to divide the amount of
deduction to be claimed by each. If there is no agreement, the IRD would not consider any claim
made if the total claim exceeded the amount of qualifying premiums paid (s.26L(3)). If excessive
claims were made by married couples, additional assessment would be raised by the IRD to
withdraw a deduction previously allowed to reflect an agreement reached, or failure to reach an
agreement by the married taxpayer and his or her spouse within a reasonable time (s.26L(5)).
Refund of Qualifying Premiums Paid
Under s.26M(2), the qualifying premiums paid are reduced by any premium refunded. If the
refund is made after a claim has been made by the taxpayer, the taxpayer must notify the
commissioner in writing within three months after the date of refund. Failure to do so without
reasonable excuse constitutes an offence under s.80(2) of the IRO – see Chapter 2, Section 2.5.
Additional assessment may be made despite any time limit under s.60 on making additional
assessment (s.26M(3)).

4.6.6.6 Qualifying Annuity Premiums and Mandatory Provident Fund Voluntary

Contributions
From the year of assessment 2019/20, a taxpayer is allowed to claim a concessionary deduction
in respect of qualifying annuity premiums paid during the year of assessment under a qualified
deferred annuity policy and tax-deductible MPF voluntary contributions (TVC).

Qualifying Annuity Premiums

S.26N(1) defines qualifying annuity premiums to mean the net sum of money that is payable
under a Qualifying Deferred Annuity Policy (QDAP) to the insurer for writing or renewing the
policy in so far as it relates to the provision of annuity payments. A QDAP, in turn, is defined as
an insurance policy:

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• Under which a regular payment is receivable by an annuitant during an annuity

period; and

• That is certified by the Insurance Authority to meet the criteria specified in the
guidelines published by the Insurance Authority under s.133 of the Insurance
Ordinance. See DIPN No. 57 (Revised), paragraph 10, for the criteria and features that a
deferred annuity insurance policy must have for certification.

Only premiums relating to the deferred annuity payment under a QDAP qualify for a tax
deduction. Premiums paid and attributable to riders in the same QDAP must be separated
from qualifying annuity premiums as the former is not tax deductible.

Conditions for Deduction
Under s.26O(1), the following conditions must be met to be eligible for a deduction:

• The qualifying annuity premiums must be paid by the taxpayer and/or the taxpayer’s
spouse, not being a spouse living apart from the taxpayer;

• The policy holder must be:

°° The taxpayer; or

°° The taxpayer’s spouse as sole policy holder; or

°° The taxpayer and his or her spouse in the case of joint policy holders;

• The annuitant(s) must be:

°° The taxpayer and/or the taxpayer’s spouse at any time during the year of
assessment; and

°° A HKID card holder.

Illustrative Example 34 – Deduction for Qualifying Annuity Premiums I

Suzy and Sam were planning to get married and they bought a QDAP on 1 April 2019 as joint
policy holders and annuitants. Suzy and Sam married on 1 May 2019. Sam paid qualifying
annuity premiums of HK$4,000 per month for a QDAP. Can Sam claim a deduction for the
qualifying annuity premiums paid of HK$48,000 in year of assessment 2019/20?

 or Sam to claim a deduction in respect of the qualifying annuity premiums, all the
F
conditions under s.26O(1) must be met. Let us analyse these conditions:

• Sam paid for the qualifying annuity premiums from 1 April 2019.

• The policy holders are Suzy and Sam. Suzy is Sam’s spouse effective 1 May 2019.
Prior to 1 May 2019, the condition requiring the policy holder(s) to be Sam and his
spouse is not satisfied.

• Suzy and Sam are the annuitants and as Suzy is required to be Sam’s spouse at
any time during the year of assessment, this condition is met.

Given that not all the conditions are met in the month of April, the qualifying annuity
premiums paid of HK$4,000 (for the month of April 2019) would not be eligible for a
deduction. However, the qualifying annuity premiums paid from May 2019 to March
2020 are eligible for a deduction as all the conditions of s.26O(1) are met.

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Illustrative Example 35 – Deduction for Qualifying Annuity Premiums II

In the case of Sam in Illustrative Example 34, the qualifying annuity premiums are due
payable on the first day of each month. Sam was admitted to the hospital for a major
operation while travelling in Malaysia. As such, he did not pay the March 2020 qualifying
annuity premium until 15 April 2020. Can Sam claim a deduction for the March 2020
qualifying annuity premium?

 he provision of s.26O(1) refers to qualifying annuity premiums paid during a year

T
of assessment. Given that the March 2020 premium was only paid in April 2020, the
amount would only be eligible for a deduction in the year of assessment 2020/21.

Where the taxpayer and his or her spouse are joint policy holders, the qualifying annuity
premiums paid by either or both of them during the year of assessment are deemed as paid
by them in equal share (s.26O(3)). A taxpayer may claim a deduction for qualifying annuity
premiums on multiple QDAPs as long as the total amount claimed does not exceed the
maximum amount prescribed – see Maximum Allowable Deduction Under ss.26O and 26S
under Section 4.6.6.6.

Married Taxpayers
A deduction may be claimed by the taxpayer and/or the taxpayer’s spouse in respect of
qualifying annuity premiums paid by either or both of them as long as:

• The total deductions allowed to each of them under s.26O and s.26S do not exceed the
amount specified in Schedule 3F in relation to the year of assessment; and

• The total deductions allowed to them under s.26O do not exceed the qualifying annuity
premiums paid (s.26P(2)).

Similar to the provisions governing VHIS premiums claimable by a married couple, a

married taxpayer and his/her spouse must agree on how to divide the amount of deduction
to be claimed by each of them. If there is no agreement, the IRD would not consider any claim
made if the total claim exceeded the amount of qualifying annuity premiums paid (s.26P(3)). If
excessive claims were made by married couples, additional assessment would be raised by the
IRD to withdraw a deduction previously allowed to reflect an agreement reached, or failure to
reach an agreement by the married taxpayer and his or her spouse within a reasonable time
(s.26P(5)).

Refund of Qualifying Annuity Premiums Paid

Under s.26Q(2), the qualifying annuity premiums paid are reduced by any qualifying annuity
premium refunded. If the refund is made after a claim has been made by the taxpayer, the
taxpayer has the obligation to notify the commissioner in writing within three months after the
date of refund. Failure to do so without reasonable excuse constitutes an offence under s.80(2)
of the IRO – see Chapter 2, Section 2.5. Additional assessment may be made despite any time
limit under s.60 on making additional assessment (s.26Q(3)).

Tax-deductible Mandatory Provident Fund Voluntary Contributions

S.26S(2) defines TVC to mean tax-deductible voluntary contributions as defined by s.2(1) of
the Mandatory Provident Fund Schemes Ordinance (Cap.485). TVC is a separate and distinct
account that has no relation to the mandatory or voluntary contributions made to MPF under

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an employment. However, TVC is subject to the same preservation requirements as mandatory

MPF contributions in that withdrawal is only allowed upon retirement or on statutory grounds.

Taxpayers may open a TVC account of their own choice in an MPF scheme and
contributions can be made at any time and in any amount. A taxpayer does not have to be
employed or self-employed when making contributions to the TVC account. Such TVC when
paid during a year of assessment is allowed as a deduction to the taxpayer under s.26S with
effect from the year of assessment 2019/20. Unlike qualifying annuity premiums, a taxpayer
can only claim a TVC deduction in respect of his or her own contributions. TVC paid by a
taxpayer cannot be claimed by his or her spouse.

Maximum Allowable Deduction under ss.26O and 26S

A taxpayer can claim a deduction for qualifying premiums paid in respect of multiple QDAPs.
However, s.26U(1) provides that the maximum deduction allowable to a taxpayer in respect
of qualifying annuity premiums and TVC is HK$60,000 in a year of assessment, effective
from the year of assessment 2019/20 (s.26T and Schedule 3F). Note that the capped amount
of HK$60,000 is the aggregate amount claimable by a taxpayer for both qualifying annuity
premiums paid and TVC.

S.26U(2) sets out the deduction order if a taxpayer is eligible to claim deductions under
both qualifying annuity premiums and TVC. TVC deduction shall first be allowed before
qualifying annuity premiums. This deduction order ensures that any excess qualifying annuity
premiums (excess of qualifying annuity premiums over the reduced cap (i.e. $60,000 reduced
by TVC) can be claimed by the taxpayer’s spouse.

Illustrative Example 36 – Maximum Tax-deductible Voluntary

Contributions and Qualifying Annuity Premiums Deduction Allowable
Mr. and Mrs. Yue, HKID holders, purchased a QDAP as joint policy holders and
annuitants. Mr. Yue paid HK$50,000 qualifying annuity premiums during the year of
assessment 2019/20. In addition, Mr. Yue paid HK$55,000 into his TVC account. What
deductions are allowable to Mr. and Mrs. Yue under ss.26O and 26S?

 nder s.26U, the capped aggregate deductions allowable to Mr. Yue is HK$60,000
U
comprising HK$55,000 TVC and HK$5,000 qualifying annuity premiums paid.
Mrs. Yue would be able to claim a deduction for the qualifying annuity premiums
of HK$45,000. This amount is within the capped amount claimable by Mrs. Yue
(HK$60,000) and the total qualifying annuity premiums deductible to Mr. and Mrs.
Yue does not exceed the qualifying annuity premium paid by Mr. Yue of HK$50,000
(s.26P(2)).

Key Learning Point

There are two main categories of deductions available under salaries tax, namely, s.12
deductions and the concessionary deductions under Part 4A.

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Knowledge Check Questions

Question 9
Identify which of the following is a deductible expense for the year of assessment 2019/20.
(I) Richard Wong paid HK$50,000 to Hong Kong University when he was successful in his
application for the MBA course in February 2020. His course starts in August 2020. He
claimed self-education expenses of HK$50,000 in the year of assessment 2019/20.

(II) Mr. Lim made a mandatory contribution of HK$18,000 to his employer’s MPF scheme.

(III) Leslie contributed HK$98,000 toward his 88-year old mum’s Hong Kong residential
care home fees. His sister also paid HK$98,000 and the invoices were issued
under her name.

(IV) Nick is a senior manager at an auditing firm and he paid A$645 annual subscription to
the Chartered Accountants Australia and New Zealand.

(V) Madam Chan is a policewoman. She kept the receipts totalling HK$2,000 that she paid
to have her uniform dry-cleaned.

A I, II and III
B I, III and IV
C I, II, IV and V
D I, IV and V

Question 10
Identify which of the following can be deducted as home loan interest.
A Mr. Li paid home loan interest of HK$100,000 on the loan he applied for to pay the
premium levied by the Hong Kong Housing Authority for the purpose of removing
the restriction on alienation in respect of the flat he acquired under the home
ownership scheme.
B Liz Cheong lives with her mother in an apartment registered under both Liz and her
mother’s names. Liz’s mother used her savings to pay for the deposit and Liz took a loan
to finance the remaining purchase price. The interest paid during the year of assessment
2019/20 was HK$140,000.
C Teng Teng took a mortgage to buy an apartment in Diamond Hill. Her mum and her
ten-year old brother live in the apartment. Due to her work schedules, Teng Teng
stayed with her boyfriend in Stanley and returned to Diamond Hill once a month during
weekends. She paid HK$110,000 home loan interest in 2019/20.
D In 2007, Mr. Leung borrowed from the bank and bought his residence at Mid-Levels.
The loan was fully repaid in January 2020. In June 2020, he re-mortgaged his Mid-Levels
apartment to secure a loan for the purchase of an investment property in Wan Chai. In
2019/20, Mr. Leung paid HK$150,000 interest on the mortgage.

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Knowledge Check Questions (continued)

Question 11
Hock Leong and Janet are married. Both Hock Leong and Janet are HKID holders. They
lived in Toronto for three years and Hock Leong returned to Hong Kong with their 7-year-
old daughter on 1 June 2019. Due to work, Janet remained in Toronto and only joined her
family in Hong Kong on 1 April 2020. Janet’s parents (both 70 years of age) are Hong Kong
residents and HKID holders. Identify which of the following are deductible to Hock Leong,
HKID cardholder in the year of assessment 2019/20.
(I) Qualifying premiums of HK$6,000 paid by Hock Leong in June 2019 for a VHIS policy
purchased for his 7-year-old daughter.

(II) Qualifying annuity premiums of HK$24,000 paid by Hock Leong in June 2019 for a
QDAP purchased for Janet. Janet is both the policy holder and annuitant.

(III) Qualifying premiums of HK$8,000 and HK$7,000 paid by Hock Leong in the year
of assessment 2019/20 in respect of VHIS policies for Janet’s father and mother,
respectively.

(IV) Qualifying annuity premiums of HK$36,000 paid by Hock Leong for a QDAP purchase
in June 2019. Hock Leong is the policy holder and annuitant.

A I, II and III
B I, III and IV
C I, II, III and IV
D I and IV

4 . 7
PERSONAL ALLOWANCES

There are two major differences between personal allowances and concessionary deductions:

1. Concessionary deductions are limited to the actual amount that the taxpayer has paid
in the year of assessment whereas personal allowances are granted at fixed amounts if
the taxpayer meets the conditions for the claim of the allowances.

2. Concessionary deductions are available to taxpayers who are assessed under both
the standard rate as well as progressive rates of tax, but personal allowances are only
granted to taxpayers who are assessed under the progressive tax rates.

Appendix 4.C summarises the allowances available under Part 5 and the amounts
prescribed in Schedule 4 of the IRO.

Taxpayers who are eligible can claim the personal allowances under Part 5 in their current
year tax return. If they have omitted a claim, they can make the claim in writing no later than six
years after the end of the year of assessment to which it relates. An allowance shall be granted
only if the claim contains such particulars and is supported by such proof as the commissioner
may require (s.27(2)). The following sections discuss the conditions that must be met for the
allowance to be granted.

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Exhibit 4.13 summarises the personal allowances under Hong Kong salaries tax.
Personal allowances are granted in full as long as the requirements for the claim of the
allowances are met.

Type of allowances IRO provisions Eligible person(s) and requirements

Basic allowance s.28 All taxpayers
If married and taxpayer’s spouse is not claiming
married person’s allowance (see below)
Personal s.28A Taxpayers who are eligible to claim allowances under
disability allowance the government’s Disability Allowance Scheme
(with effect from
YA 2018/19)
Married s.29 A married taxpayer and:
person’sa allowance • his or her spouse has no assessable income; or
(in year of marriage, • joint assessment has been elected; or
separation,
divorce or death) • personal assessment has been elected jointly by
the couple
s.29(4) A taxpayer who is married but living apart from but
continue to maintain and support his or her spouse
A taxpayer will not be eligible effective the year he or
she is legally divorced (see Sit Kwok Keung v CIR (2002),
5 HKTC 647 and IRBRD D22/11).
s.29(6) A taxpayer may revoke the claim within the YA where
the claim was made or within six years after the
expiration of the relevant YA
Dependent parent ss.30(1), 30(1A) Taxpayer and/or spouse not living apart maintains
allowance (DPA) in taxpayer’s or spouse’s parent at any time during the
respect of each parentb YA; and the parent
maintained • Is an ordinary resident in Hong Kong; and
s.30(1) • Was aged 60 or more; or
• Was below 60 and was eligible to claim an
allowance under the government’s Disability
Allowance Scheme; or
s.30(1A) • Aged between 55 to below 60 and was throughout
the year not eligible to claim an allowance under
the government’s Disability Allowance Scheme
s.30(5) Not eligible if elderly residential care expense
deduction has been granted in respect of that same
parent under s.26D
s.33(1) Grantable to only one taxpayer in respect of a
parent for a YA
s.33(1A)(a) No DGA has been claimed in respect of the same
person by any taxpayer
Additional DPA ss.30(3)(b), In addition to the above conditions, the parent
30(3A)(b) resided with the taxpayer for less than full valuable
consideration continuously throughout the YA

EXHIBIT 4.13 Personal allowances under Hong Kong salaries tax

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Type of allowances IRO provisions Eligible person(s) and requirements

Dependent grandparent ss.30A(1), 30A(1A) Taxpayer and/or spouse not living apart maintains
allowance (DGA)c taxpayer’s or spouse’s grandparent at any time during
in respect of each the YA; and
grandparentb maintained • The same age and residency requirements for DPA
are met in respect of the grandparent
s.30A(5) Not eligible if elderly residential care expense
deduction has been granted in respect of that same
grandparent under s.26D
s.33(1) Grantable to only one taxpayer in respect of a
grandparent for a YA
s. 33(1A)(a) No DPA has been claimed in respect of the same
person by any taxpayer
Additional DGA s.30A(3)(b), In addition to the preceding conditions, the
30A(3A)(b) grandparent resided with the taxpayer for less
than full valuable consideration continuously
throughout the YA
Dependent brother ss.30B, 30B(3)(a) Taxpayer and/or spouse not living apart has sole or
or dependent sister predominant care of the taxpayer’s or spouse’s brother
allowance for each brother or sister at any time during the YAd, and the brother or
or sister maintained, sister must be
including an adopted or a • Unmarried;
stepbrother or stepsister
• <18 years old; or
• ≥ 18 but under 25 years of age and was receiving
full-time education at a university, college, school or
other similar educational establishment; or
• ≥ 18 years of age and was, by reason of physical or
mental disability, incapacitated for work
s.33(1) Grantable to only one taxpayer in respect of a brother
or sister for a YA
s.33(1A)(b) No child allowance has been claimed by a taxpayer in
respect of the same brother or sister
Child allowance applies to s.31(1) Taxpayer who at any time during the YA, had a
own child (legitimate or child living with him or her and was maintaining a
otherwise), legally adopted child who was:
or stepchild of taxpayer • Unmarried;
or spousee (capped at
nine children) • < 18 years old; or
• ≥ 18 but under 25 years of age and was receiving
full-time education at a university, college, school or
other similar educational establishment; or
• ≥ 18 years of age and was, by reason of physical or
mental disability, incapacitated for work
s.31(3) For married couple not living apart, all child
allowances grantable shall be claimed by one spouse
only as nominated by the couplef
s.31(2) Where more than one taxpayer is entitled to claim
a child allowance in respect of the same child,
the allowance will be apportioned based on the
contributions made by each to the maintenance and
education of the child during the YA

EXHIBIT 4.13 (Continued)

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Type of allowances IRO provisions Eligible person(s) and requirements

Additional child allowance s.31(1A) Taxpayer who is eligible for the child allowance is
granted an additional child allowance of the same
prescribed amount in the year the child was born
Disabled ss.31A(1), 31A(4) Taxpayer is eligible for married person’s, child,
dependent allowance dependent brother or sister allowances or DPA, DGA
or a deduction under s.26D elderly residential care
expenses in respect of a dependent who:
• Is eligible for an allowance under the government’s
Disability Allowance Scheme
s.33(1) Grantable to only one taxpayer in respect of the
dependent family member in a YA
s.31A(3) Granted to the spouse nominated for the child
allowance in the case of a disabled child of a married
couple not living apart
s.31A(2) Disabled child where the child allowance was
apportioned between taxpayers will be apportioned
on the same basis as that used for the child allowance
Single parent allowance ss.32(1), 32(2)(a) Taxpayer is not married at any time during the YA and
in respect of the first • Had sole and predominant care of a child in respect
child only of whom he/she was entitled to the grant of a
child allowance
s.32(2)(c) Granted in respect of first child only
s.32(3) Where more than one taxpayer is entitled to claim
the allowance in respect of the same child in a YA,
apportionment can be made based on the period each
taxpayer has sole and predominant care of the child or
as the commissioner deems justg – see IRBRD D140/01.
a
In DIPN No. 18 (Revised), paragraphs 4 – 8, the IRD clarifies that besides legally recognised marriages (except
polygamous marriages), Chinese customary marriages prior to 7 October 1971 and same-sex marriages (see Section
4.1) are recognised.
b
‘Parent’ or ‘grandparent’ refers to the same person as those defined in ss.26D(5) and 2(1) for elderly residential care
expense deduction (see Eligibility under Section 4.6.6.2).
c
The operation of dependent grandparent allowance (DGA) mirrors that of dependent parent allowance (DPA), except
DGA is in relation to a grandparent and DPA is in respect of a parent.
d
The provision of s.30B(1) is drafted such that the dependent brother or dependent sister allowance is granted to a
taxpayer even if the maintained sibling did not meet the requirement during part of the year. For example, the taxpayer
maintained his sister, who was receiving full-time education at the university. In the year of assessment 2017/18, the
taxpayer’s sister turned 26 years of age. The full amount of dependent sister allowance of HK$37,500 would still be
granted to the taxpayer in that year of assessment.
e
A ‘child’ is defined in s.27(3) to mean any child of a person chargeable to tax or of his or her spouse or former spouse,
whether or not born in wedlock, and includes the adopted or stepchild of either or both of them. In the case of an
adopted child, the adoption must be done in a manner recognised by the laws in Hong Kong.
f
The nomination once made in relation to any year of assessment is not revocable unless with the consent of the
commissioner whose decision in the matter shall be final and not subject to objection or appeal (s.31(4)). In DIPN No. 18
(Revised), paragraph 61, the IRD indicates that the variation of a nomination will be considered favourably, where the
change will result in an overall reduction in the tax liability for the married couple. In general, it is more advantageous for
the spouse with a higher net income to claim the child allowance unless they are assessed under the standard rate of tax.
g
If custody of a child changes at some point during the year, the allowance will normally be apportioned on a time basis
(DIPN No. 18 (Revised), para. 65).

EXHIBIT 4.13 (Continued )

The following sections discuss some of the pertinent issues relating to the claim of specific
personal allowances.

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4.7.1 Full Valuable Consideration

The term ‘full valuable consideration’ under ss. 30(3)(b), 30(3A)(b), 30A(3)(b) and 30A(3A)(b)
means the benefit that the parent (or grandparent) obtains in being able to share the taxpayer’s
residence, that is, to use the taxpayer’s residence also as his or her own residence. This is a
tangible benefit that can be easily valued and capable of being paid for by the giving of full
valuable consideration. The value is represented by the market rental value of the premises,
with an appropriate discount to allow for the fact that the parent (or grandparent) would have
to share the same with the taxpayer and his or her family. Intangible benefits such as love and
care, or the spiritual satisfaction of togetherness, and so on, are excluded (IRBRD D30/07).

4.7.2 Maintained or Treated as Being Maintained

Under s.30(4)(or s.30A(4)), a parent (or grandparent) is treated as being maintained by a
taxpayer if the following are met:

• That parent (or grandparent) resides, other than for full valuable consideration, with the
taxpayer and the taxpayer’s spouse for a continuous period of not less than six months
in the year of assessment; or

• The taxpayer or the taxpayer’s spouse contributes not less than the prescribed amount
of HK$12,000 (Schedule 4 Item 4(e)) in money toward the maintenance of that parent
(or grandparent) in the year of assessment.

It was held in IRBRD D20/10 that a taxpayer residing at his or her parents’ property does
not amount to ‘maintaining a parent’.

4.7.3 Ordinary Resident in Hong Kong

The term ‘ordinarily resident in Hong Kong’, though not defined in the IRO, is extensively looked
at in case law. The IRD clarifies this in DIPN No. 18 (Revised), paragraph 52, to mean one who
has his or her normal and usual place of residence in Hong Kong. Merely holding a Hong Kong
permanent identity card is insufficient.

Briefly, a person is ordinarily resident in Hong Kong if he or she:

• Habitually and normally resides, apart from temporary or occasional absences of long
or short duration; or

• Lawfully, voluntarily and for a settled purpose, as part of the regular order of life, lives

in Hong Kong (see Reg v Barnet London Borough Council ex parte Shah (1983) 2 AC 309 and
Vallejos Evangeline B. v Commissioner of Registration and Another (2013) 2 HKLRD 533).

4.7.4 Sole or Predominant Care

Under s.30B(3)(a), the taxpayer or his or her spouse has ‘maintained’ the taxpayer’s brother
or sister or the brother or sister of the taxpayer’s spouse if, at any time during the year
of assessment, the taxpayer or the taxpayer’s spouse had sole or predominant care of the
brother or sister or of the brother or sister of the spouse. Sole or predominant care is also
a requirement for single parent allowance under s.32(1). The provision of money was not
completely irrelevant to maintenance, but this alone could not be enough to show sole or
predominant care of the dependent (IRBRD D3/14 and D10/11).

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The Court of Appeal in Sit Kwok Keung v CIR (2002) 5 HKTC 647 addressed the term ‘sole and
predominant care’ for the purpose of s.32(1). In this case, the taxpayer’s marriage was dissolved
by a court decree and the man was ordered to pay periodical payments to his ex-wife for her
and their two sons. Custody of the children was given to her. The taxpayer claimed the single
parent allowance in his tax return for the following year.

The Board opined that the concept of ‘predominant care’ involves a comparison of the
respective roles played by the taxpayer and his ex-wife as a parent and held that he did not
have sole care of his sons. The court upheld the Board’s decision on the basis that the taxpayer
had failed to discharge the burden of proof that his care for the sons in all aspects of the
day-to-day living is predominating and supreme over that of the mother’s.

Whether a taxpayer or the taxpayer’s spouse meets the requirement under s.30B(3)(a) was
analysed by the Board in IRBRD D10/11. The case involved a taxpayer who claimed that his wife
maintained her 37-year old sister. The taxpayer’s sister-in-law suffered from polio shortly after
birth, which caused deformity in her lower limbs. She was wheelchair bound and lived with her
retired parents in mainland China. The taxpayer and his spouse provided financial support to
cover the daily and medical expenses of his sister-in-law and parents-in-law. His wife visited
her sister and parents several times a year, bringing them their daily needs. She talked weekly
to her sister on the phone. The Board upheld the decision of the commissioner and denied
the taxpayer’s claim for a dependent sister allowance. The Board cited the Court of Appeal’s
opinion on ‘sole and predominant care’ in Sit Kwok Keung v CIR (2002) 5 HKTC 647 and concluded
that the amount of care provided by the taxpayer toward the dependent sibling must have
supremacy or ascendancy over others, that is, his parents-in-law. Despite the taxpayer and
his wife’s effort and resources provided to his sister-in-law, given the distance between the
taxpayer and his wife’s sister, the latter’s daily needs could only be taken care of, and were
indeed so, by the taxpayer’s parents-in-law.

4.7.5 Claims by More than One Taxpayer

S.33 deals with the claim of allowances and how the commissioner will resolve a situation
where more than one taxpayer is entitled to an allowance that can only be claimed by one
taxpayer, or duplicate claims.

For all allowances except for a child, disabled dependent (child) and single parent
allowances where apportionments are permitted under certain circumstances, only one
taxpayer is permitted to claim all other types of allowances in respect of the same person of
whom the allowances are granted. If, besides the taxpayer, another taxpayer is also entitled to
claim the allowance for the same parent, grandparent, brother or sister, and so on, in the same
year of assessment, the taxpayers must agree among themselves on who will be claiming the
allowance. If there is no agreement, the IRD is likely not to grant the allowance to any of the
taxpayers – see IRBRD D15/15.

The commissioner is entitled not to consider any claim until he or she is satisfied that the
eligible taxpayers have agreed on which of them would claim the allowance. In the event that
the taxpayers eligible for the allowance were unable to decide who would have the allowance
within a reasonable time, the commissioner would raise additional assessments to disallow
all taxpayers who were granted the allowance previously. The commissioner can raise such
additional assessment within the year of assessment or within six years after the expiration
thereof (ss.33(3), 33(3B), 33(3D)).

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Illustrative Example 37 – S.31 Child Allowance

Jane Sum, divorced, has custody of her twins who live with her. Her twins turned
19 in February 2019 and both finished school in June 2018. Her daughter Ling Ling
commenced a two-year full-time diploma in the Bakery, Pastry and Confectionary course
with the Vocational Training Council (VTC) in September 2019. Her son, Mun Ho, started
his technician apprentice with MTR in the same month. Can Jane claim child allowance2
in respect of her twins for the years of assessment 2018/19 and 2019/20?

 nder s.31(1), Jane is eligible to claim child allowances of HK$200,000 each in

U
respect of her twins for the year of assessment 2018/19 if her unmarried twins,
though above 18 years of age, were attending school full-time for part of the year of
assessment 2018/19.

Her daughter Ling Ling started a two-year full-time course with VTC and was
therefore receiving full-time education at VTC. Jane can therefore claim a child
allowance of HK$120,000 in respect of her for the year of assessment 2019/20.
However, her son Mun Ho is doing his apprenticeship under a contract of
employment with MTR. Thus, he is working and not receiving full-time education, and
the requirement of s.31(1)(b) was not met for the year of assessment 2019/20.

Key Learning Point

In the case of taxpayers who are assessed under the progressive rates of tax, personal
allowances are only granted to them if the prerequisites of the grant of allowances are
met.

Knowledge Check Question

Question 12
Identify which of the following is eligible to claim the relevant personal allowances.
(I) Jim and John both contributed HK$13,000 each to their mother and father who live in
Hong Kong. Their parents turned 60 in June 2020. They agreed Jim will claim DPA in
respect of their mother and John will claim in respect of their father.

(II) Mr. Huang’s 90-year old mother lives with Mr. and Mrs. Huang, both retired. Their
youngest son who lives two blocks from them claims dependent grandparent
allowance and additional dependent grandparent allowance.

(III) Jess Mok is separated from her husband. She works part-time and has no net
chargeable income due to basic allowance. Her husband claimed married person’s
allowance as he is supporting her.

(IV) Mr. Tang claimed dependent brother allowance. He is supporting his 20-year old
brother who studies full-time at HKU. His brother lives with him since their retired
parents moved to China a few years ago.

439

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Knowledge Check Questions (continued)

(V) Simon and Simone have two children both aged under ten. Given that only one of
them can claim child allowance in respect of the same child, Simon and Simone agree
that each will claim the child allowance in respect of one child.

A I and II
B II and III
C I and IV
D I and V

4 . 8
JOINT ASSESSMENT OF SPOUSES

Under salaries tax, a married couple is separately assessed unless they elect for a joint
assessment (s.10(1)). An election under s.10(2) may be made if the married couple not living
apart have assessable income and:

• Either of the spouses’ claimable concessionary deductions and/or allowances exceed

his or her assessable income; or

• Both have net chargeable income and the total salaries tax liability when jointly
assessed is lower than when separately assessed.

The assessable income and deductions of the married couple will be aggregated and
married person’s allowance as well as other eligible allowances will be deducted against
the income to arrive at the total net chargeable income under a joint assessment (s.12B(2)).
Tax is then computed accordingly. See Section 4.10.2 on the tax computation under a joint
assessment for a married taxpayer.

A joint assessment is generally beneficial if one spouse’s net assessable income is below
the basic allowance grantable. If a taxpayer’s spouse has no assessable income under salaries
tax, the taxpayer does not have to elect for a joint assessment, and would be able to claim
the applicable concessionary deductions, the married person’s allowance as well as other
allowances where applicable.

4.8.1 Joint Assessment Election

Joint assessment election is made on a yearly basis. If an election is made by a married couple
that married each other in the year of assessment to which the election relates, the couple is
deemed to be married at the commencement of the year (s.10(5)).

Where a joint assessment is made in a situation where one spouse has excess
concessionary deductions and/or allowances (Spouse A), salaries tax on the aggregated
net chargeable income is payable by the spouse (Spouse B) who is liable to tax absent the
joint assessment (s.10(3)(a)). In the case of an objection to an assessment made under this
scenario, Spouse A will have the same right to object as Spouse B who is assessed, but any such
objection is only limited to the determination of Spouse A’s net assessable income, and Spouse

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A’s entitlement to any concessionary deductions or allowance, or other matters to which

Spouse A could have objected had he/she been the person so charged (s.64(9)).

If a joint assessment is elected because both of the spouses have a net chargeable income
and an election results in an overall lower tax liability, the married couple must nominate the
spouse who will be liable for the salaries tax liability (ss.10(3)(b), 11(5)).

If a taxpayer’s spouse a tax is deceased, an executor will have the same right to make an
election for a joint assessment as the deceased would have had if the deceased had not died
(s.10(4)).

See Illustrative Example 44 for an example of salaries tax computation under a joint
assessment.

4.8.2 Time and Manner a Joint Election May be Made

Under a joint assessment, both the married taxpayer and his/her spouse must each file a tax
return, that is, BIR60, and both must elect for a joint assessment. The married couple may
withdraw the election made by giving the notice jointly in writing to the commissioner (s.11(1)).
The election and withdrawal may be made any time:

• Within that year of assessment or the following year of assessment; or

• Before the expiration of one month following the time when the assessment for the
year of assessment becomes final and conclusive under s.70,

whichever is the later, or within such further time that the commissioner considers reasonable.

The IRD gives examples, in DIPN No. 18 (Revised), paragraph 15, of circumstances where
an extension of time may be granted, for example, when a spouse was absent from Hong Kong
for an extended period or a spouse has the unabsorbed deductions or allowances agreed only
after the expiration of the election period.

If a withdrawal is made in respect of a year of assessment, the election is deemed never

to have been made and assessments will be made separately for each spouse (s.11(3)). Once
a withdrawal is made in respect of a year of assessment, the married couple is not eligible to
re-elect for that year (s.11(4)).

Key Learning Point

A married couple not living apart and both with assessable income may elect for a joint
assessment if:

• Either of the spouses has excess claimable concessionary deductions and/or

allowances over assessable income; or

• Both have a net chargeable income and the total salaries tax liability when jointly
assessed is lower than when separately assessed.

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Knowledge Check Question

Question 13
Evaluate which of the following statements are accurate.
A As long as a taxpayer and his/her spouse are not living apart, they can elect for a joint
assessment.
B Under a joint assessment, the assessable income of the taxpayer and his/her spouse is
aggregated.
C An election for a joint assessment must be made each year.
D The approved charitable donation made by one spouse can only be claimed by the other
spouse under a joint assessment.

4 . 9
ASCERTAINMENT OF ASSESSABLE INCOME

Before diving into the tax computations, we need to understand which taxable income is
brought into assessment in the relevant year of assessment. The provisions of ss.11B, 11C
and 11D are relevant in determining the assessable income to be brought to tax in a year of
assessment. Under s.11B, the assessable income of a taxpayer in any year of assessment is the
aggregate amount of income accruing to them from all sources in that year of assessment. As
we have learned at the beginning of this chapter, Hong Kong tax is territorial and only income
arising in or derived from Hong Kong falls within the salaries tax net (see Section 4.1.1). In view
of this, the income accruing to a taxpayer from all sources is subject to the income caught
under s.8 as discussed under Section 4.1.1.

4.9.1 Income Accrued and Received

Let us have a look at the provisions of ss.11B, 11C and 11D as these provisions are important
in computing the assessable income of taxpayers for a year of assessment. For income to
be included as assessable income in a year of assessment, s.11B requires the income to be
accrued to taxpayers. Income accrues to taxpayers when they are entitled to claim a payment
of it (s.11D(b)).

4.9.1.1 Income Accrued but Not Received

S.11D(a) provides that income accrued, but not received by taxpayers during the basis period
for a year of assessment shall not be included in their assessable income for that year of
assessment. Such income is only assessed at the time when the taxpayer received it by
way of an additional assessment in respect of the year of assessment in which the income
was accrued.

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Illustrative Example 38 – Income Accrued and Received – ss.11B

and 11D(a)
Casey is a sales executive at SureSell. Based on his sales for the months of February
and March 2020, the accounting department of SureSell has computed his commission
income to be HK$40,000. Under SureSell’s internal control, the sales executive’s manager
as well as the finance manager must approve all commissions before payment can
be made. Casey’s manager was admitted to the hospital unexpectedly at the end of
February and was away until 1 April 2020. He signed off Casey’s commissions on his
return. Casey was subsequently paid on 15 April 2020.

 lthough Casey’s commission income was accrued, s.11D(a) provides that income
A
accrued, but not received by Casey during the basis period for a year of assessment,
shall not be included in his assessable income for that year of assessment. The
commission income would only be assessed at the time when Casey received it, that
is, 15 April 2020 but in respect of the year of assessment in which the income was
accrued, that is, year of assessment 2019/20.

If the commission income were only paid to Casey at a time after the 2019/20 notice
of assessment has been issued, Casey would be assessed on the commission by way
of an additional assessment for the year of assessment 2019/20.

Contrast this Illustrative Example with the following Illustrative Example.

Illustrative Example 39 – Income Accrued but not Received – s.11D(b)

(Adapted from IRBRD D78/88)
Joyce signed a contract of employment with a Hong Kong company on 1 May 2019. Her
employment contract has a clause ‘You will not be entitled to receive payment of salary
for any month until the 5th day of the following month’. Joyce received her March 2020
salary amounting to HK$80,000 on 5 April 2020. In which year of assessment will Joyce’s
March 2020 salary be assessed?

 nder s.11D(b), the salary only accrues to Joyce when she becomes entitled to claim
U
payment thereof, that is, on 5 April 2020. Thus, the March salary of HK$80,000 would
only be assessable in the year of assessment 2020/21 as Joyce is only entitled to
claim the March 2020 salary on 5 April 2020.

4.9.1.2 Income Deemed Received

Under s.11D(a), people are deemed to have received the accrued income:

• When it has been made available to them; or

• When the income has been dealt with on their behalf or as directed by them.

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In IRBRD D17/12, the taxpayer joined his company’s benefit scheme whereby he was
entitled to the benefit amount that included the employer’s contribution to the Fidelity Fund.
Under the benefit scheme, withdrawals from the Fidelity Fund were subject to a vesting
condition. On expiry of the vesting period of 2.5 years, the taxpayer could either cash out and
withdraw the remaining benefit amount or instruct his employer’s parent company to invest,
on his behalf, in the Fidelity Fund. After over four years with the company, the taxpayer left his
employment. The IRD assessed the benefit amounts based on vesting. The taxpayer argued
that tax should only be levied at the time of withdrawal. The Board upheld the commissioner’s
assessments on the ground that s.11B provided that a taxpayer is subject to salaries tax on
income that accrued to him during the relevant year of assessment. S.11D(a) provides that
income that has either been made available to a person or has been dealt with on his behalf
or according to his directions shall be deemed to have been received by him. In this case, the
taxpayer’s right to claim payment of the benefit has materialised on expiry of the vesting period
and he was deemed to have received the benefit.

4.9.1.3 Deemed Commencement and Cessation of an Employment

In determining the assessable income of a person under s.11B, a person is deemed to
commence or cease, as the case may be, to derive income from a source whenever and as
often as he or she commences or ceases:

• To hold any office or employment of profit; or

• To become entitled to a pension (s.11C).

Whether a person has commenced or ceased his or her employment is often a question
of fact and ascertainable given the obligations imposed under the IRO. We have learned in
Chapter 2 that an employer has the obligation to notify the IRD when an employee commences
and ceases an employment with the employer (ss.52(4) and 52(5)).

4.9.1.4 Income Deemed Accrued

S.11D(b)(i) deals with lump sum payment upon cessation of an employment or deferred pay
that is addressed in Section 4.9.2. S.11D(b)(ii) provides that any payment made by an employer
to a person after he or she has ceased or been deemed to cease to derive income that:

• If it had been made on the last day of the period during which he or she
derived income;

• Would have been included in that person’s assessable income for the year of
assessment in which he or she ceased or is deemed to cease to derive income from
that employment;

shall be deemed to have accrued to that person on the last day of the employment.

4.9.1.5 Income Received but Not Accrued

We have seen how income accrued but not received is not brought to tax until the time when
the income is received or deemed received by a person under s.11D(a). By the same token,
income received but not accrued is not taxable to an individual until such time when the
income is accrued.

In IRBRD D26/07, the taxpayer joined a bank on 21 February 2005. His contract of
employment provided for a sign-on bonus of HK$390,000 and a settling-in allowance of

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HK$66,000 payable with his first month’s pay. Under the employment terms, the taxpayer
would be required to repay these two payments on a pro-rata basis if he resigned within the
first 12 months of employment. The taxpayer included these payments in his tax return for the
year of assessment 2004/05 and he was assessed accordingly.

The taxpayer terminated his employment on 5 September 2005 and refunded his
employer a pro-rata portion of the sign-on bonus and the settling-in allowance. He wrote to
the IRD asking for an amendment to his year of assessment 2004/05 assessment and the IRD
disagreed. The taxpayer appealed to the Board.

The Board allowed the appeal on the basis that a person cannot be taxed for money that he
has not received under s.8 of the IRO. The taxpayer was only entitled to receive the full sign-on
bonus and settling-in allowance contingent on his having served the full 12 months from the
date of employment. He did not and was thus not entitled to the full sign-on bonus or the full
settling-in allowance.

Apply and Analyse 4
Let us have a look at how this affects Elise Wong of GBank (Illustrative Example 30) based on
the additional information provided here. Under GBank’s policy, the bank would reimburse
a course fee of an employee for a relevant course on the condition that the incumbent
remained in the employment of the bank for at least one year upon completion of the
course. Elise is doing the course part-time; she will only complete the postgraduate course
in June 2020. Elise paid her course fees of HK$77,100 in March 2018 and March 2019 and
the bank reimbursed her the full amount for each claim shortly after. Jane Sum reminded
Elise that should she leave the employment of the bank within a year from the completion
of the course, she would be required to repay the bank the reimbursed course fee.

Analysied

 e have learned from Section 4.4.1 and the Glynn case, that the reimbursement of
W
course fee is a perquisite assessable to tax because money was paid to reimburse
Elise her liability to pay the course fee to the university. Based on IRBRD D26/07
and D55/12, Elise will only be entitled to the sum of HK$154,200 if she stays with
GBank at least a year after the completion of her course, that is, in June 2020. For the
purpose of s.11B, the income will only accrue to her in YA 2020/21. Thus, the course
fee reimbursement will only be included as assessable income to Elise in the year of
assessment 2020/21.

We have addressed the ‘income’ aspect; let’s look at the deductions available to
Elise. Elise will not be able to successfully claim a deduction for the course fee
under s.12(1)(a) as the course is not wholly, exclusively and necessarily incurred
in the production of her income (see Section 4.6.1). However, we have learned in
Section 4.6.5.1 that a deduction for self-education expenses under s.12(1)(e) may be
claimed. Under s.12(1)(e), the claim for self-education expenses must be made in the
year that the expenses are paid. Although DIPN No. 9 (Revised), paragraph 25, states:
‘Fees that have been reimbursed or are reimbursable by an employer or any other
person are not allowable’, Elise should make a claim for the self-education expenses
in the years of assessment 2017/18 and 2018/19, the years she paid for the tuition
fees (see IRBRD D55/12).

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4.9.2 Lump Sum Payment on Cessation of Employment or Deferred Pay

An employee may apply to have a gratuity or lump sum payment related back to the year of
assessment in respect of which the payment was made under s.11D(b)(i), if relating back would
reduce his or her tax liability, where:

• Lump sum payments were made upon the retirement from or termination of any
office or employment or any contract of employment of an employee, for example,
gratuities; or

• Lump sum payment of deferred pay or arrears of pay arising from an award of salary
or wages, paid by an employer during employment or post cessation.

For the purpose of s.11D(b)(i), a lump sum payment may be paid by the employer while
the taxpayer is still under the employer’s employment or after they have left the employment.
Note, however, that s.11D(b)(i) does not apply to:

• Leave payments (IRBRD D21/84); or

• Lump sum payments not being a lump sum payment of deferred pay or arrears of pay
arising from an award of salary or wages, received not upon termination or retirement
(IRBRD D39/94).

4.9.2.1 Time and Manner an Application May be Made

An application must be made in writing within two years after the end of the year of
assessment in which the payment is made. The payment is then treated as income accruing:

• During the periods in which the services were performed or the employment was
exercised; or

• If the service or employment period exceeded three years, at a constant rate over the
three years ending on the last day of employment or the date of entitlement of the
payment thereof, whichever is the earlier.

We have learned in earlier chapters that an assessment becomes final and conclusive if
no objection was made within one month from the date of the notice of assessment under
the provisions of the IRO (ss.64 and 70). However, an application made by any person under
s.11D(b)(i) for the adjustment of an assessment is to be regarded as a valid objection to the
assessment even though the one-month time limit stipulated has lapsed.

Illustrative Example 40 – Relating Back Gratuity for a Service Period

Less than Three Years
Sisi Cheung had a two-year contract (1 January 2018 to 31 December 2019) as an English
tutor at a reputable tuition centre in Kowloon. Under the contract, she was entitled to an
end of contract gratuity amounting to HK$90,000. If Sisi were to apply to have the lump
sum payments related back to the service period for which they were made, how would
the gratuity be assessed?

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Illustrative Example 40 (continued)

Based on s.11D(b)(i), Sisi could have her gratuity related back as follows:

Total no. of months (A) 24

Gratuity assessable No. of months
Tax year B ÷ A × HK$90,000 (B) Period
YA 2017/18 11,250 3 1/1/2018–31/3/2018
YA 2018/19 45,000 12 1/4/2018–31/3/2019
YA 2019/20 33,750 9 1/4/2019–31/12/2019
Total HK$ 90,000

Illustrative Example 41 – Relating Back Gratuity to Service Period

in Excess of Three Years
Eddie was entitled to a contract gratuity of HK$140,400 when he was made redundant
after 7 years and 11 months of service. Given that the total service period exceeded
three years, the amount would be related back evenly over 36 months ending on the
date of payment or the last date of employment, whichever is the earlier.

Total no. of months (A) 36a

Gratuity assessable No. of months
Tax year B ÷ A × HK$140,400 (B) Period
YA 2016/17 31,200 8 1/8/2016–31/3/2017
YA 2017/18 46,800 12 1/4/2017–31/3/2018
YA 2018/19 46,800 12 1/4/2018–31/3/2019
YA 2019/20 15,600 4 1/4/2019–31/7/2019
Total HK$ 140,400
a
Deemed to be accruing at a constant rate over 36 months under s.11D(b)(i).

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Key Learning Point

The assessable income of a taxpayer in any year of assessment is arrived at following the
provisions of ss.9, 11B, 11C, 11D and 12.

Knowledge Check Question

Question 14
Identify which of the following adjustments must be made to the total income in
computing a Hong Kong taxpayer’s assessable income for the year of assessment 2019/20.
(I) Discretionary bonus accrued in the books of the employer as of 31 March 2020 but
not paid until June 2020.

(II) Gratuities paid to a taxpayer upon completion of a two-year project.

(III) Payouts from an MPF scheme which is attributable to the mandatory contributions
upon the person’s permanent departure from Hong Kong.

(IV) Donations made to an approved charitable organisation in Hong Kong.

(V) Balancing charge upon the disposal of an asset used in the production of
assessable income.

A I and II
B I, II and III
C II and IV
D II, IV and V

4 . 1 0
COMPUTATION OF SALARIES TAX

By now, we are familiar with what income is assessable and the expenses deductible under
salaries tax, when such income is brought to tax and the timing of deductions as well as
the eligibilities for allowances. We shall, in this section, learn how to compute the salaries
tax payable by an individual taxpayer, a married taxpayer when assessed separately as
well as under a joint assessment. Exhibit 4.14 provides an overview of how salaries tax
is computed.

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Income (office/employment/pension) – ss.9, 9A

Step 1
Compute – Non-assessable Income – ss.8(1A)(b), (1A)(c), (1B),(2), (2A)
assessable
income
= Assessable income (A)

Step 2
Compute net
– Less: Allowable deductions – s.12
assessable
income–
s.12 = Net assessable income

– Less: Concessionary deductions Part 4A – s.12B(1)(a)

Step 3
Compute
net
chargeable = Net income (B)
income

– Less: Allowances under Part 5 – s.12B(1)(b)

= Net chargeable income (C)

Step 4 Tax payable (D) – s.13: the lower of:

Apply the tax
(1) progressive tax rates applied on ‘C’ ; and
rates
(2) standard tax rate × ‘B’
applicable to
salaries tax

Step 5 Less: Tax reduction under s.100(1) that is, prescribed percentage × D
– or the maximum prescribed amount, whichever is lower
Less s.100(1)
tax reduction

= Tax payable

EXHIBIT 4.14 Salaries tax computation

The following are the steps involved in computing the salaries tax liability of a taxpayer
whether assessed separately or jointly.

Step 1: Applying the relevant IRO provisions, the assessable income of a taxpayer in a year
of assessment is computed as follows:

Salary, wages, bonus, allowances, commission, leave pay – Section 4.4.1

Taxable perquisites, including share award gains – Sections 4.4.2 to 4.4.6
Taxable termination pay, including payment in lieu of notice – Sections 4.4.8 and 4.9.1.4
Add: Taxable sum from retirement schemes – Section 4.4.7
Income deemed received – Section 4.9.1.2
Income from an office – Section 4.2.1
Pension – Section 4.2.3

Add/Less: Lump sum payment on cessation of employment, deferred payment – Section 4.9.2

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Income accrued but not received – Section 4.9.1.1

Less: Income received but not accrued – Section 4.9.1.5
Income specifically excluded – Sections 4.1.2, 4.3.1, 4.5.1 and 4.5.2
= Assessable income (AI)

Step 2: From the preceding assessable income of an individual, we make the adjustments
for deductible expenses and any balancing charge to arrive at the net assessable income (s.12):

Assessable income (AI)

Deductions under s.12 (nexus to assessable income)
• Outgoings and expenses wholly, exclusively and necessarily incurred in the production
of assessable income – Section 4.6.1
• Depreciation allowances and balancing allowance – Section 4.6.2
Less:
• Loss brought forward – Section 4.6.3
• Self-education expenses – Section 4.6.5
• Excess of spouse’s allowable deductions – Section 4.6.4 (if joint assessment is elected)

Add: Balancing charge – Section 4.6.2.1

= Net assessable income (NAI)(1A)

Step 3: Next, we calculate the net chargeable income in accordance with s.12B:

Net assessable income (NAI)

Concessionary deductions under Part 4A
• Approved charitable donations – Section 4.6.6.1
• Elderly residential care expenses – Section 4.6.6.2
• Home loan interest – Section 4.6.6.3
Less:
• Contributions to recognised retirement schemes – Section 4.6.6.4
• Qualifying premiums paid under VHIS policy – Section 4.6.6.5
• Qualifying annuity premiums and TVC – Section 4.6.6.6
= Net income (NI)
Less: Personal allowances under Part 5 – Section 4.7
= Net chargeable income (NCI)

If a joint assessment were elected, the NCI would be the aggregated NAI of the taxpayer
and the taxpayer’s spouse less the concessionary deductions and personal allowances available
to the married couple.

Step 4 and 5: The last two steps involve applying the applicable tax rates to arrive at the
salaries tax liability and reducing that amount by the s.100(1) tax reduction (see Appendix
4.D), to determine the net tax payable. As we have learned by now, salaries tax payable is
the lower of:

• Progressive tax rates (Schedule 2) on net chargeable income; and

• Standard tax rate of 15% (Schedule 1) on net income.

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The tax payable and net tax payable are computed as below:

Net chargeable income (NCI) × progressive ratesa

The lower of OR
Net income (NI) × 15%
= Salaries tax payable (STP)
Less: Tax reduction
= Net salaries tax payable
a
See the progressive tax rates table at Schedule 2 of the IRO.

Let us now apply the preceding information and compute the salaries tax liabilities of the
taxpayers under various scenarios.

4.10.1 Separate Assessment

There is no specific format for salaries tax computations. The format used in this chapter takes
into consideration the computation of rental value of residence provided by the employer
under s.9(2) in the grouping of assessable income.

Illustrative Example 42 – Tax Computation: Individually Assessed

without Time Apportionment
Konrad Koenig joined GBank Hong Kong as a controller in April 2018. For the year
of assessment 2019/20, he received an annual salary of HK$800,000 and a bonus of
HK$200,000. GBank provided him with housing and paid a total of HK$490,000 for his
apartment plus associated costs (management fee and utilities, accounts that were in the
name of GBank Hong Kong). In addition, he did a cashless exercise of the stock option
vested on 2 January 2020, that is, 400 of the 1,600 units granted on 2 January 2019 (strike
price of €20.64 per share). GBank closed at €28 on 2 January 2020 on the Frankfurt
Stock Exchange.

Konrad is a member of the Institute for Practising Accountants (IPA) in Germany and
he paid an annual fee of €120 in June 2019. He is exempted from the bank’s MPF scheme
in Hong Kong. Konrad donated HK$50,000 to the Community Chest in 2019/20. Konrad
also enrolled in a Master of Applied Finance in Risk Management course part-time with
the Open University of Hong Kong in March 2019 and paid a tuition fee of HK$77,100
in April 2019. He did not seek a reimbursement from GBank due to the one-year
post-completion bond.

Konrad is divorced. He has custody of his 9-year-old daughter. His 63-year-old mother
moved to Hong Kong to live with them in June 2018 to help take care of his daughter while
he works. Konrad and his daughter are very fond of each other and he spends most of his
private time with her.

Let us now compute Konrad’s salaries tax liability for the year of assessment 2019/20.

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Illustrative Example 42 (continued)

Konrad Koenig
Salaries Tax Computation
Year of assessment 2019/20
HK$ HK$ HK$
Salary 800,000
Bonus 200,000 1,000,000

Less: ss.12(1)(a) and (1)(b) expenses

Professional subscription IPAa (1,062)

A 998,938
Rental value of housing (A × 10%) 99,894
Gain on stock option b
25,550 125,444
B 1,124,382
Less:

Self-education expenses (77,100) (77,100)

Net assessable income 1,047,282
Less: Concessionary deduction
Approved charitable donation (capped at 35% of B) (50,000) (50,000)
Net income C 997,282
Less: Personal allowances
Basic allowance (132,000)
Child allowance (120,000)
Parent allowancec (100,000)
Single parent allowance d
(132,000) (484,000)
Net chargeable income 513,282
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$313,282 17% 53,258
D 69,258
Tax at standard rate (C × 15%) E 149,592

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Illustrative Example 42 (continued)

Konrad Koenig
Salaries Tax Computation
Year of assessment 2019/20
HK$ HK$ HK$
Tax payable (lower of D and E) 69,258
c
Less: 100% tax reduction s.100(1) (20,000)
Net tax payable 49,258

a
€120 exchange based on IRD-published average selling rate of 8.8529.
b
The stock option gains under s.9(4)(a) are computed as below:
c
Capped at HK$20,000.

Assessable stock option gain €

OMV at time of exercised, that is, 2/1/2020 (€28 × 400) 11,200
Less: Consideration paid – strike price €20.64/share (€20.64 × 400) (8,256)
2,944
Converted to HK$ at 8.6788 (IRD-published buying rate for January 2020) HK$25,550

c
Parent and additional parent allowance of HK$50,000 each (s.30(3)).
d
Single parent allowance of HK$132,000 where sole and predominant condition is satisfied (s.32(1)).

Illustrative Example 43 – Tax Computation: Individual Assessed

with Time Apportionment
Sophie Chen is the Chief Legal Counsel, Asia Pacific, of an Australian pharmaceutical
company. She relocated to Hong Kong on 1 April 2019. Sophie relocated her 83-year-old
mother with her as she is the only child and did not want to leave her mother alone in
Sydney. Sophie provided her tax consultant with the following information pertaining to
the year of assessment 2019/20:

Income HK$ Expenses HK$

Salary 1,560,000 Donations to HK Red Cross 60,000
Bonus 390,000 Donation ticket to ACC’s charity balla 5,453
(December 17) – did not attend
Share award gains (300 vested 296,140 Subscription fee to Association of 1,964
30 June 2019 at A$168)b Corporate Counsel Australiac
Apartment, utilities and domestic 480,000 Deducted from salary for her share 48,000
helper provided of housingd
Relocation expenses paid by company 60,450 Contribution to MPF scheme 18,000

a
Based on the average selling rate published by IRD of 5.4532.
b
Share award granted on 30 June 2018 vested evenly over a four-year period. Closing price listed on ASX on 30 June 2019.
c
Based on the average selling rate published by IRD of 5.5317.
d
Her share for the total housing costs as agreed with her employer.

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Illustrative Example 43 (continued)

Sophie also provided her travel schedules:

Arrival date Departure Days Arrival date Departure Days in

date in HK date HK
31/3/2019 15/4/2019 15 23/9/2019 15/10/2019 22
21/4/2019 14/5/2019 23 21/10/2019 4/11/2019 14
20/5/2019 28/5/2019 8 11/11/2019 20/12/2019 39
3/6/2019 17/6/2019 14 2/1/2020 21/1/2018 19
23/6/2019 29/7/2019 36 1/2/2020 1/3/2020 29
3/8/2019 22/8/2019 19 9/3/2020 16/3/2020 7
28/8/2019 18/9/2019 21 23/3/2020 27/3/2020 4
Total 270
Leave days attributable to HK: 16

270 Total days chargeable to salaries tax 286

20 16
346

Let us compute Sophie’s salaries tax liability for the year of assessment 2019/20.

Sophie Chen
Salaries Tax Computation
Year of assessment 2019/20
HK$ HK$ HK$
Salary 1,560,000
Bonus 390,000
Share award gains a
67,823 2,023,019
Less: ss.12(1)(a) and (1)(b) expenses
Professional subscription (2,093) (2,093)
2,017,823
Assessable income under time apportionment:
(HK$2,017,823 × 286 ÷ 366) A 1,576,769
Rental value of housing (A × 10%) 157,677
Less: Rent paid by employee (48,000) 109,677
Net assessable income B 1,686,446

Less: Concessionary deduction

Approved charitable donation (capped at 35% of B) (60,000)b
Contributions to mandatory MPF (18,000) (78,000)
Net income C 1,608,446

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Illustrative Example 43 (continued)

Sophie Chen
Salaries Tax Computation
Year of assessment 2019/20
HK$ HK$ HK$
Less: Personal allowances
Basic allowance (132,000)
Parent allowance c
(100,000) (232,000)
Net chargeable income 1,376,446
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$1,176,446 17% 199,996
D 215,996
Tax at standard rate (C × 15%) E 241,267

Tax payable (lower of D and E) 215,996

Less: 100% tax reduction s.100(1)b (20,000)
Net tax payabled 195,996

a
Share awards attributable to vesting period in Hong Kong:
b
Capped at HK$20,000.

Closing price listed on ASX 30/6/2019 (B) A$168

Vesting period from transfer date: 1/4/2019–29/6/2019 (C) 90 days

Share Value No. of days Amount before time basis

awards A$ grant to vest apportionment A$

Period from grant to vest A D = (A × B) E C÷E×D

30/6/2018–29/6/2019 300 50,400 365 12,427

HK$ 67,823#

#
The average buying rate published by IRD of 5.4577.
b
 he donation ticket to ACC’s charity ball of A$1,000 (HK$5,453) is not a tax-deductible donation as ACC is not a
T
tax-exempt institution under s.88 of the IRO. Further, the donation is not a charitable donation but payment for
the ticket to a charity ball.
c
Parent and additional parent allowance of HK$50,000 each (s.30(3)).
d
The relocation paid by Sophie’s employer is not within the scope of salaries tax charge. See DIPN No. 41, paragraph 19.

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4.10.2 Joint Assessment

Under a joint assessment, the net assessable income of each spouse will be computed
separately before aggregation. In arriving at the net assessable income of each spouse, if
the aggregate of deductions claimed by either spouse exceeds the assessable income of that
spouse, the excess will be deducted from the assessable income of the other spouse in arriving
at the other spouse’s net assessable income.

Part 4A concessionary deductions and Part 5 allowances are deducted from the aggregated
net assessable income to arrive at one net chargeable income for the couple. The notice of
assessment and demand note for the tax payable under a joint assessment will be issued to
the nominated spouse or the spouse who will be liable to salaries tax in the absence of a joint
assessment (Section 4.8.1).

Illustrative Example 44 – Tax Computation: Joint Assessment

Joe Ho is the IT Manager at GBank. He is married to Peggy, a part-time kindergarten
teacher. Peggy completed a part-time course, Writing and Editing for Publication, with
the University of South Australia in May 2018 and started working part-time as an editor
of the children page for a local company upon completion of her course. She also bought
a laptop in April 2018 as it is essential for her to do remote access edits for the company
and Peggy had a new-born baby on 1 January 2019. Peggy took a year off teaching, but
continued with her part-time editing job. Joe took a staff loan from GBank to purchase
an apartment in Tsing Yi in October 2017. The apartment is registered in Peggy and Joe’s
names. They moved into the apartment shortly after. Joe also exercised 150 GBank stock
options vested on 2 January 2019 at a strike price of €20.64. GBank share price closed at
€28 on 2 January 2019. The following are the information required to assist with Joe and
Peggy’s salaries tax calculation for the year of assessment 2018/19:

Joe HK$ Peggy HK$

Income: Income:
Annual salary 580,000 Annual salary: teaching 90,000
Bonus 160,000 Annual salary: editing 90,000
Expenses: Expenses:
Home loan interest 120,000 Laptop 10,200
Contribution: MPF scheme 18,000 Contribution: MPF scheme 9,000
Donations to Community Chest 5,000 Donation to school, a tax-exempt 15,000
institution under IRO
Course fee paid on 1 April 2017 38,500
Contributions to grandmother 15,000
(80 years of age)

Let us help Joe and Peggy decide if they should elect for a joint assessment and
calculate their salaries tax liabilities for the year of assessment 2018/19 under separate
and joint assessments.

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Illustrative Example 44 (continued)

Joe and Peggy Ho

Salaries Tax Computations
Year of assessment 2018/19
Separate assessment Joint
assessment
Joe Peggy Total
HK$ HK$ HK$ HK$
Salary 580,000 180,000
Bonus 160,000
Less: ss.12(1)(a) and (1)(b) expenses
Depreciation allowancesa (7,344)
A 740,000 172,656
Gain on stock option b
10,025
B 750,025 172,656
Less:
Self-education expenses (38,500)
Net assessable income 750,025 134,156 884,181
Less: Concessionary deduction
Approved charitable donation (capped at (20,000) (20,000)
35% of B)c
Home loan interestd (50,000) (50,000) (100,000)
Contributions to mandatory MPF (18,000) (9,000) (27,000)
Net income C 662,025 75,156 737,181
Less: Personal allowances
Basic/married person’s allowance (132,000) (132,000) (264,000)
Child allowance c, e
(240,000) (240,000)
Grandparent allowance c, f
(50,000) (50,000)
Net chargeable income 240,025 – 183,181
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000 1,000
On next HK$50,000 6% 3,000 3,000
On next HK$50,000 10% 5,000 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000 9,000
Balance 17% 6,804 5,641
D 22,804 – 14,641

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Illustrative Example 44 (continued)

Joe and Peggy Ho

Salaries Tax Computations
Year of assessment 2018/19
Separate assessment Joint
assessment
Joe Peggy Total
HK$ HK$ HK$ HK$
Tax at standard rate E 99,304 11,273
(C × 15%)
Tax payable (lower of D and E) 22,804 – 14,641
Less: 100% tax reduction s.100(1) b
(20,000) (14,641)
Net tax payable g
2,804 – 2,804 –

a
The depreciation allowances are calculated as follows:
b
Capped at HK$20,000.

Year of assessment (YA) % HK$ Allowances

2018/19 A B HK$ (A × B)
Cost: Laptop 10,200
Less: Initial allowance (s.39B(1A)(c)) 60 (6,120) 6,120
Reducing value 4,080
Less: Annual allowance (s.39B(2), IRR Rule 2) 30 (1,224) 1,224
Reducing value carried forward to YA2019/20 2,856
Depreciation allowances (s.12(1)(b)) 7,344

b
The stock option gains under s.9(4)(a) are computed as below:

Assessable stock option gain: €

OMV at the time when shares were notionally acquired, that is 3/1/2019 (€28 × 150) 4,200

Less: Consideration – strike price €20.64/share (€20.64 × 150) 3,096

1,104

Converted to HK$ at 9.0806 (IRD-published buying rate for January 2019) HK$10,025

c
 eggy and Joe agreed that donations, child and grandparent allowances would be claimed under Joe’s
P
assessment as he has a much higher assessable income.
d
S.26E deduction restricted to 50% each up to the capped amount of HK$100,000.
e
 iven the child was born in the year of assessment 2018/19, the additional child allowance of HK$120,000
G
(s.31(1A)) can be claimed.
f
 eggy is eligible to claim dependent grandparent allowance as she contributed more than HK$12,000 to her
P
grandmother (ss.30A(3)(a) and (4)(a)(ii) and Schedule 5 Item 4(e)).
g
There will be no salaries tax payable under a joint assessment.

As we can see from this example, Joe and Peggy’s overall tax liability is lower
when they elect to be jointly assessed due to the excess basic allowance over Peggy’s
assessable income.

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4.10.3 Provisional Salaries Tax

Under s.63B(1), every person who is chargeable to salaries tax for a year of assessment is
liable to pay provisional salaries tax (PST) in respect of that year of assessment. Although PST is
calculated based on a taxpayer’s preceding year’s income, it is the salaries tax on the taxpayer’s
current year income.

If taxpayers expect their net chargeable income for the current year to be significantly
lower than the preceding year, they can request for a holdover of PST in writing:

• Within 28 days before PST payment is due; or

• 14 days after the date of payment notice

whichever is later (s.63E(1)). See Chapter 2, Section 2.4, on holdover of taxes.

Illustrative Example 45 – Due Date for Holdover of Provisional

Salaries Tax
Konrad (Illustrative Example 42) received a demand note on 6 August 2020. The first
instalment (typically including 75% of PST) is due on 7 January 2021 and the second
instalment (25% of PST) is due on 8 April 2021. Under s.63E(1), if Konrad were to request
for a holdover of PST in respect of the first instalment, he must lodge the holdover
application by the later date of:

• 20 August 2020, that is, 14 days after the issue of the demand note; or

• 10 December 2020, that is, 28 days before 7 January 2021.

So in this instance, 10 December 2020.

And the holdover application in respect of the second instalment must be made no
later than 11 March 2021, that is, 28 days before 8 April 2021.

The reasons for which taxpayers may request a holdover of PST are set out in s.63E(2).
These are:

• They will be entitled to deductions and/or allowances not available in the previous year,
for example, birth of child;

• Their net chargeable income is likely to be less than 90% of the net chargeable income
for the preceding year;

• They have ceased or will cease employment before the end of the basis period for the
year of assessment to derive income chargeable to salaries tax, for example, due to
retirement; or

• An objection was lodged and pending for the preceding year.

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Illustrative Example 46 – Provisional Tax Computation

We have assisted Konrad with his year of assessment 2019/20 salaries tax computation.
Let us now compute Konrad’s PST for the year of assessment 2020/21. For PST
purposes, Konrad’s net chargeable income is to be computed in accordance with
ss.63C(1) and 63CA.

Konrad Koenig
PST Computation
Year of assessment 2020/21
HK$ HK$ HK$
With reference from Illustrative Example 42:
Net income for 2019/20 A 997,282
Net chargeable income for 2019/20 B 513,282
a
PST at progressive rates (Schedule 2) :
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$313,282 17% 53,258
C 69,258
PST at standard rate (A × 15%) D 149,592

PS payable (lower of C and D) 69,258

PST payable 69,258

a
 o apply the prescribed capped amounts, personal allowances and progressive tax rates applicable to the year
T
of assessment 2020/21 (s.63CA).

PST will be used to offset the salaries tax payable by that person for that year of
assessment. Any excess thereof will then be applied to offset PST for the succeeding year
of assessment before a refund is made (s.63F). If a married couple were to elect for a joint
assessment, the spouse nominated would be liable for PST.

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Illustrative Example 47 – PST Applied against Salaries Tax

We have learned in Illustrative Example 42 that Konrad’s mother only moved in with
him in June 2018, when he became a single father. Thus, the dependent parent and
single parent allowances would not have been granted to him in the preceding year of
assessment. Assuming that Konrad did not request for a holdover and had paid a total PST
of HK$86,258 for the year of assessment 2019/20 in April 2020, the following shows his
tax payable, being salaries tax and PST for the years of assessment 2019/20 and 2020/21,
respectively:

Konrad Koenig
Final tax assessment for 2019/20 and provisional tax for 2020/21

HK$

Final tax payable 2017/18 (Illustrative Example 42) 49,258

PST paid (86,258)

Excess tax paid (37,000)

PST for year of assessment 2020/21 (Illustrative Example 46) 69,258

Total tax payable 32,258

Key Learning Point

Salaries tax is computed by:

• Ascertaining the taxpayer’s assessable income and net assessable income;

• Deducting from the above net assessable income concessionary deductions under
Part 4A, and personal allowances under Part 5 to arrive at the net chargeable
income (s.12B); and

• Applying the progressive tax rates in Schedule 2 on the net chargeable income
of the taxpayer (s.13(1)); or apply the standard tax rate in Schedule 1 on the
net assessable income as reduced by the concessionary deduction (s.13(2)(a)),
whichever is lower.

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Knowledge Check Question

Question 15
Identify which of the following are deductible in arriving at the net chargeable income of a
taxpayer for the year of assessment 2019/20?
A Fees paid in March 2019 by an auditor to HKICPA for the qualifying programme that only
commenced after March 2019.
B Payment of HK$92,000 to a nursing home in Macau for the care of the taxpayer’s
grandmother.
C Payment made for the Hong Kong Red Cross gala dinner tickets.
D Mortgage interest paid on a loan applied to acquire the residence/apartment and the
carpark lot of the taxpayer in the year of assessment 2019/20.

4 . 1 1
EMPLOYEES TAX PLANNING

By now, we should be familiar with the scope of charge for salaries tax, the timing of
taxation of an income, and the tax impact of different fringe benefits. We now turn to focus
on how similar benefits, if structured differently, can result in a different tax outcome as
well as how employment contract can be structured to benefit from a Hong Kong territorial
tax system.

4.11.1 Structuring Employment Arrangements

We have learned that a person is chargeable to salaries tax on all income from an employment
if that employment is located in Hong Kong, that is, Hong Kong sourced. There are two
exceptions to this rule. These are:

• If the person performs all services in relation to that employment outside Hong Kong,
save for the 60-day exemption rule discussed in Section 4.1.2.2; or

• When the person’s income is subject to tax substantially the same as salaries tax in the
foreign jurisdiction where the services are rendered and that jurisdiction does not have
a double taxation agreement with Hong Kong.

Alternatively, if a person’s employment is located outside Hong Kong, salaries tax is only
charged on that portion of the income that is attributable to services rendered in Hong Kong.

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The IRD uses the time apportionment basis to attribute income to services rendered in Hong
Kong, that is, allocating income based on the days including attributable leave days that the
person is in Hong Kong.

In determining if an employment is located in Hong Kong, the IRD relies on the principles
set out in the Goepfert case. To recap, the IRD is likely to accept that the employment is located
outside Hong Kong if all three of the following attributes are present:

• The employment contract is negotiated, executed and enforceable outside Hong Kong;

• The residency of the company/employer, that is, the location where the company has
its management and control, is not in Hong Kong; and

• The employee’s remuneration is paid outside Hong Kong.

Tax-efficient structuring of the employment arrangement in a situation where an employee

is required to perform services in multiple jurisdictions will ensure that they are not subject
to salaries tax on the income relating to services rendered outside Hong Kong. This will
eliminate the possibility of a double taxation on the same income given that income from
the performance of services is likely to be subject to tax in the country where the services are
performed.

Given that a non-Hong Kong employment involves a foreign employer, consideration

must also be given to potential tax implications in the employer’s jurisdiction and the overall
corporate tax structure. The remuneration of the employee may be required to be pushed out
via inter-company cross charges and this is likely to drive the overall employment structure of
international companies.

In the case of a Hong Kong company employee who is expected to provide services for
a prolonged duration in another country, it may be desirable to have a separate contract
of employment executed with the foreign affiliate for the duration of the assignment.
Further, care should be taken to ensure that the assignee’s visits to Hong Kong do not
exceed 60 days in a year of assessment, if work visits are envisaged (see Section 4.1.2.2).
As in the case of an inbound assignee or employee, proper assignment of an outbound
employee will address potential double taxation for the individual and at the corporate
level, permanent establishment, withholding tax and transfer pricing issues (see
Chapters 10 and 11).

Whether an employment is located in Hong Kong or outside Hong Kong is a question of

fact. An employee who is employed as part of a team in Hong Kong and reports to someone
who is based and belongs to a team in Hong Kong will have a Hong Kong employment.
Alternatively, a person may use the Hong Kong office as a base to perform his or her duties
for an employer outside of Hong Kong. Further, the residency of a company is factual.
While establishing that a company is resident in another jurisdiction is desirable from the
employment contract-sourcing angle, it may not be in the best interest of the company from

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a corporate tax perspective. The IRD will review each case based on all relevant facts and will
apply the substance over form principle if the arrangement makes no commercial or business
sense other than to avoid paying taxes in Hong Kong.

Illustrative Example 48 – Structuring of Employment Contract:

Non-resident Employer
GBank is now looking to hire a Regional Head of Wealth Management. As there was
no suitable candidate within GBank Hong Kong, Jane has requested Jenny to help with
the search. Jenny had earlier discussed the employment planning opportunities with
Jane and Helmut, Human Resources Director of GBank Germany on aligning the bank’s
executive remuneration structure as well as contract and remuneration structuring to
attract senior executives.

Jenny has shortlisted one candidate from Hong Kong and one from Singapore for
GBank and both were flown to GBank Frankfurt for interviews with various executives
and board members. GBank in Germany offered Kenny Lee the job right after the
interview. He was introduced to various GBank’s senior executives and after signing
the master contract of employment and the assignment letter, Kenny returned to
Singapore.

Kenny will be based in Hong Kong. As this position is responsible for GBank Asia Pacific
region, he is required to travel extensively in the region. Kenny will report to the Senior
Director of Private Wealth Management in Frankfurt. His remuneration is provided in
Euros. However, the bank will remit one-third of his monthly salary to his Hong Kong Dollar
account to meet his local expenses, and the balance of his remuneration will be paid into
his Singapore Dollar account in Singapore.

We have learned in Location of Remuneration Payment under Section 4.2.2.2 that

where an employee is paid plays a role, though not determinative in concluding the
location/source of an employment in Hong Kong (IRBRD D20/97 and Lee Hung Kwong v CIR
(2005) 4 HKLRD 80).

GBank Germany has structured Kenny’s employment contract to be located outside

Hong Kong given his role is regional and benefits all GBank entities in the region.
It is anticipated that Kenny will spend approximately 25% of his time in Hong Kong.
By structuring the contract in this manner, GBank also minimises the bank’s tax costs
as Kenny will be tax equalised; thus, he will only be responsible for the taxes that he
would have to pay had he performed the job out of Singapore. The salaries tax liability in
Hong Kong will be limited to the income attributable to the days Kenny renders services
in Hong Kong based on the time apportionment basis.

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Illustrative Example 49 – Assignment of an Employee from Hong Kong

Mr. Newton Wu, an Australian citizen, works for a Hong Kong company with sales and
marketing offices in different parts of China. The company has faced challenges in
penetrating the Chinese market for years. Newton speaks fluent Mandarin and is quite
knowledgeable about the company’s products. He was the top sales manager in Hong
Kong for the past three years. The general manager of the Beijing affiliate requested
for Newton’s assistance. The company has agreed to second and loan him to the
Chinese affiliate for a period of three years. Advise the company on how Newton’s loan/
secondment to China can be carried out tax efficiently.

If the Hong Kong employer were to second Newton to Beijing, he would continue to
have a Hong Kong employment. His remuneration for the period that he worked in
China will be subject to Hong Kong salaries tax unless he renders all services outside
Hong Kong during each year of assessment (considering also the 60-day exemption
rule, Section 4.1.2.2). As Newton will be subject to individual income tax in China,
Hong Kong will allow the taxes paid in China as a tax credit under s.50 if Newton is a
Hong Kong tax resident as defined under Article 4(1)(2) of the ‘Arrangement Between
the Mainland of China and the Hong Kong Special Administrative Region for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income’.

However, if the Chinese company were to offer Newton a separate contract

stipulating the terms of the secondment and the duration of the contract as agreed
with the Hong Kong company, the Chinese contract would be a separate contract
of service and a non-Hong Kong employment when properly executed (see IRBRD
D55/91). If Newton were to render services in Hong Kong during the period of
secondment and his visits to Hong Kong did not exceed 60 days, he would not have
any salaries tax liability. If his visits exceeded 60 days, the time apportionment basis
would apply in attributing the income chargeable to salaries tax. Newton would seek
to claim the foreign tax credit in China. He would be a China tax resident if his stay in
China in the tax year is more than 183 days.

Salaries tax aside, note that under the first arrangement, the Hong Kong company
would potentially have a permanent establishment (PE) in China under Article 5(3)(2) of the
double tax treaty. It is therefore beneficial for the arrangement to be structured such that
Newton would be an employee of the Chinese affiliate (the second alternative above) – see
Chapter 10 Section 10.5.3.2.

4.11.2 Structuring Remuneration Packages

Fringe benefits planning is often used by employers in Hong Kong and, when done properly, is
generally accepted by the IRD. As we have seen in Sections 4.4.2 and 4.4.6, the IRO has specific
provisions governing the taxation of perquisites or fringe benefits. In addition, the IRD has

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issued DIPN No. 16 (Revised) on its practice with regards to the taxation of fringe benefits.
These common fringe benefits are:

• Housing benefit (Section 4.4.2);

• Company-provided car or other company’s assets made available to employees for

private use (Section 4.4.6.1);

• Benefits relating to the employee’s residence, for example, utilities, telephone and
domestic help (Section 4.4.6.2);

• Interest-free loan (Section 4.4.6.3);

• Corporate club membership (Section 4.4.6.5);

• Retirement benefit (Sections 4.4.7 and 4.5.2); and

• Medical and other benefits (Section 4.4.1).

Rents including management fees and rates paid by an employer or reimbursement of

rents, management fees and rates by an employer to the employee under a housing benefit
scheme are not taxable to the employee (s.9(1A)(a)). Rather, the employee is taxed on the
rental value that is deemed to be 10% (or 8% or 4% depending on the type of residence) of the
assessable emoluments of the employee (excluding stock option gains or lump sum retirement
payment) from the employer less expenses and/or allowances deductible under ss.12(1)(a) and
(1)(b) (Section 4.4.2). As this benefit can result in significant tax savings, the IRD will review the
arrangement to ensure that the housing benefit is not a housing allowance.

To properly put in effect a housing benefit, there should be a properly executed and
stamped lease agreement, ideally between the company and the landlord such that the
company pays all rents directly to the landlord. This will avoid scrutiny by the IRD of the flow of
funds to the landlord and how the reimbursements were made, for example, classification in
accounts, timing of reimbursement, rent receipts and so on.

The use of company assets, for example, car, yacht, bungalow and so on by an
employee for private purposes is not taxable if the benefit is not in any way convertible into
money, that is, non-transferable and the employee cannot surrender the use for cash or
additional pay.

In general, an employer can provide a benefit to an employee tax-free if the payment

made by the employer is not a discharge of the employee’s liability and the employee cannot
convert the benefits into cash (Section 4.4.1). To effect this properly, the employer should be
the party under the contractual arrangements with the service providers, for example, utilities,
telephone, medical insurance, domestic help and so on, to ensure that payments made are as a
result of the employer’s own obligations to the service providers.

As we have learned in Sections 4.4.7 and 4.5.2, an employee may receive certain tax-free

sums from a recognised occupational retirement scheme or MPF scheme. The employment
contract may incorporate such retirement benefits into the remuneration package, although a
portion of the benefit may be taxed if the employment were to terminate prior to retirement
and below ten years of service with the company.

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Illustrative Example 50 – Tax-efficient Employment Package

As Hans will be retiring from GBank, the bank is looking for his successor. The bank
would like to offer tax-efficient compensation packages to its senior executives and this
is a good opportunity for the GBank to review the bank’s compensation packages. GBank
has budgeted HK$3.7 million (see below for a breakdown) excluding a discretionary stock
option grant for this position. Jenny presented GBank with the following, illustrating how
GBank can structure the employment package tax effectively, using the example of a
married individual with a child below 18 years of age.

All cash package

HK$
Salary and bonus and accommodation allowances 3,623,000 flexible
3,623,000
MPF mandatory contributions 18,000 fixed
Voluntary contributions 36,000
Company medical insurance 23,000
77,000

Salaries tax computation: All cash package

Year of assessment 2019/20
HK$ HK$ HK$
Salary, bonus and allowances 3,623,000
Net assessable income 3,623,000
Less: Concessionary deduction
 Contributions to mandatory MPF (18,000)
Net income C 3,605,000
Less: Personal allowances (384,000)
 Married person’s allowance (264,000)
 Child allowance (120,000)
Net chargeable income 3,221,000
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$3,021,000 17% 513,570
D 529,570

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Illustrative Example 50 (continued)

Salaries tax computation: All cash package

Year of assessment 2019/20
HK$ HK$ HK$
Tax at standard rate (C × 15%) E 540,750
Tax payable (lower of D and E) 529,570
Less: 100% tax reductiona
(20,000)
Net tax payable 509,570

a
Capped at HK$20,000.

Remuneration package with benefits in kind, that is,

company-provided housing (inclusive of utilities and domestic help)
and a fully maintained company car
HK$
Salary and bonus 1,623,000 flexible
Accommodation with utilities and telephone 1,500,000
Fully maintained company car (not assessable) 500,000
3,623,000
MPF mandatory contributions 18,000 fixed
Voluntary contributions 36,000
Company medical insurance 23,000
77,000

Salaries tax computation: Remuneration package with benefits in kind

Year of assessment 2019/20
HK$ HK$ HK$
Salary and bonus 1,623,000
A 1,623,000
Rental value of housing (A × 10%) 162,300
Net assessable income 1,785,300
Less: Concessionary deduction
Contributions to mandatory MPF (18,000)
Net income C 1,767,300
Less: Personal allowances (384,000)
Married person’s allowance (264,000)
Child allowance (120,000)
Net chargeable income 1,383,300

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Illustrative Example 50 (continued)

Salaries tax computation: Remuneration package with benefits in kind

Year of assessment 2019/20
HK$ HK$ HK$
Tax at progressive rates (Schedule 2)a:
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$1,183,300 17% 201,161
D 217,161
Tax at standard rate (C × 15%) E 265,095

Tax payable (lower of D and E) 217,161

Less: 100% tax reduction a
(20,000)
Net tax payable 197,161

a
Capped at HK$20,000.

From the this example, remuneration package with the housing and car benefits
resulted in a substantial salaries tax savings of HK$312,409.

Key Learning Point

Salaries tax savings can be generated through a proper structure and implementation of:

• An employment contract; and

• Remuneration and fringe benefits package.

Knowledge Check Questions

Question 16
Identify which of the following is a fringe benefit that can be properly used for
remuneration packaging purposes.
(I) Rent reimbursements made to an employee who has executed a lease agreement
with a third-party landlord.

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Knowledge Check Questions (continued)

(II) Staff morale holiday provided and paid by the company.

(III) A credit card provided and paid by the company where the use is strictly limited to
business only.

(IV) Medical insurance for staff contracted by the employer with the insurance
company directly.

(V) Accommodation, utilities and telephone provided to an employee where the company
contracted directly with the landlord and service providers.

A I and III
B II and IV
C I, III and V
D I, IV and V

Question 17
Identify which of the statements below are true.
(I) The IRD looks at the totality of facts in determining if an employment is a Hong Kong
employment.

(II) If an employee’s job does not require him to travel, there is no point in structuring his
contract as a non-Hong Kong employment.

(III) If the employing company is a Hong Kong resident company, the IRD will unlikely
accept that an employment with the company is located outside Hong Kong even
though the contract is negotiated and executed outside Hong Kong.

(IV) A Hong Kong company that assigns the employee to China to oversee the quality
of products manufactured by its fellow subsidiary in China has a Hong Kong
employment contract with the employee.

(V) Salaries tax savings can be achieved by timing the payment of a lump sum amount to
an employee.

A I, II, III and IV

B I, II, IV and V
C I, II, III, IV and V
D I, II, III and V

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SUMMARY

Salaries tax overview:

• Salaries tax is charged on pension, income from an employment or from an office arising in or
derived from Hong Kong.

• Income from a Hong Kong employment and income from services rendered in Hong Kong are
income arising in or derived from Hong Kong.

• An employment is a Hong Kong employment if the following conditions are met:

°° The employment contract is negotiated, executed and enforceable in Hong Kong;

°° The employer is resident in Hong Kong; and

°° The employee is paid in Hong Kong for his or her services.

• Certain specific receipts are exempt from salaries tax under s.8(2), for example, emoluments
of staff of consulates, certain payments from recognised retirement schemes, and so on.

Income chargeable to salaries tax:

• Income from a Hong Kong employment (except income of Hong Kong government employee
or a member of the crew of a ship or an aircraft) is fully taxable in Hong Kong except when:

°° All services are performed outside Hong Kong; or

°° When the services are rendered in a non-DTA jurisdiction and the income is subject to
tax of substantially the same nature as salaries tax and such foreign tax has been paid
(s.8(1A)(c)).

• All services are deemed rendered outside Hong Kong if services are rendered in Hong Kong
during visits for not more than 60 days in the year of assessment under s.8(1B).

• In the case of DTA jurisdiction, s.50 foreign tax credit will be allowed as a set-off against
salaries tax payable on the same income (s.8(1C)).

• All income of Hong Kong government employees is subject to salaries tax.

• The income of a member of the crew of an aircraft or a ship is exempt from Hong Kong
salaries tax if he or she is present in Hong Kong for not more than a total of:

°° 60 days in the year of assessment; and

°° 120 days over two consecutive years of assessment, one of which is the relevant year of
assessment (s.8(2)(j)).

• In computing the 60 or 120 days under s.8(2)(j), part of a day is counted as one day.

• In the case of a non-Hong Kong employment, salaries tax is chargeable on income derived
from services rendered in Hong Kong for visits in excess of 60 days (ss.8(1A)(a) and (1B)).

• The time basis of apportionment based on the days the employee stays in Hong Kong is used
to attribute the income subject to salaries tax for a non-Hong Kong employment.

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• Unlike the counting of days for the purpose of the 60-day exemption rule, the day of arrival
and the day of departure is counted as one day in total for the time apportionment basis of
salaries tax liability computation.

Office:
• The source of income of a director is where the company making the payment is managed
and controlled.

• The exemption provisions that apply to employment income do not apply to income from
an office.

Pension:
• Pensions are chargeable to salaries tax if the pension fund is managed and controlled in
Hong Kong.

• Non-government pensions attributable to services rendered outside Hong Kong are tax
exempt (s.8(2)(ca)).

Employment:
• Income from an employment includes perquisites whether from an employer or others
(s.9(1)(a)).

• Excluded from employment income are any amount paid to discharge the employer’s sole and
primary liability other than payment in connection with:

°° A holiday journey;

°° Employee’s child education; and

°° Any benefit that is in any way convertible into money (s.9(2A)).

• Accommodation provided or subsidised is taxed at the rental value of the residence or the
rental value less the employee’s contributions to rent (ss.9(1)(b) and (1)(c)).

• The actual rents paid or reimbursed by the employer or an associate is not taxable (s.9(1A)(a))
unless the reimbursements are allowances.

• The rental value of any residence provided is deemed to be 10% of the income under s.9(1)(a)
from the employer less deductions and/or allowances claimable under ss.12(1)(a) and
(1)(b), and any lump sum payment or gratuity received by the employee upon retirement or
termination of employment.

• Where the residence is a hotel, boarding house or hostel, the deemed rental value percentage
is 8% for a two-room or 4% for a one-room accommodation.

• A stock option granted to an employee is taxed on the notional gain when exercised, assigned
or released (s.9(1)(d)).

• The notional gain on exercise of a stock option is the difference between the open market
value of the shares acquired upon exercise of the option and the amount an employee is
required to pay for the shares or grant (s.9(4)(a)).

• The notional gain on assignment or release of a stock option is the difference between the
amount of the consideration and the amount that an employee is required to pay for the
grant of the right (s.9(4)(b)).

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• Unconditional stock awards granted to an employee are taxed based on the market value of
the shares at the time they are granted (upfront approach).

• Share awards that are vested over a period of time subject to an employee remaining in the
employment of the company (conditional share awards) are taxed at the time of vest.

• Conditional share awards are taxed based on the market value of the shares at the
time of vest.

Retirement benefits:
• Any sum received being commutation of pension under a recognised occupational retirement
scheme upon retirement, death, incapacity or terminal illness are salaries tax exempt
(s.8(2)(c)).

• A lump sum benefit attributable to voluntary contributions made by an employer, received

on termination of service is exempt if the service year with the employer is ten or more years
(ss.8(2)(c)(i), 8(4)(a) and (5)).

• The benefit attributable to the shortfall in ten years of service will be subject to salaries tax
(s.9(1)(ab)(ii)).

Termination payments:
• Termination payments made to abrogate the rights of an employee under the contract of
employment are not taxable.

• Termination payments made under a contract of employment or for past, present or future
services are chargeable to salaries tax.

• Restrictive covenant payments are generally not taxable.

• Severance or long service payments made in accordance with the provisions of the
Employment Ordinance, that is, the amount after offsetting gratuities and benefits paid to or
accrued benefits held in an MPF scheme, are not taxable.

Deemed income from an employment:

• The income paid to a service company for the services of an individual who controls, or whose
associate or associates control, the company is deemed income from an employment of the
individual and thus subject to salaries tax (s.9A).

• The same income from an employment deeming provision applies to a trust where the
individual or his or her associate is a beneficiary of the trust (s.9A).

• The tests to decide if an employment exists are:

Control;

Integration;

Economic reality;

Mutuality of obligation; and

Totality of facts.

• The deeming provision of s.9A does not apply if all of the six criteria set out in s.9A(3) (see
Section 4.4.1.1) are met.

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Allowable deductions:
• There are two categories of deductions under salaries tax, namely, deductions under s.12 and
concessionary deductions under Part 4A.

• Generally, an expense or outgoing, not being private, domestic or capital in nature, which
is wholly, exclusively and necessarily incurred in the production of an assessable income is
deductible under s.12(1)(a).

• S.12(1)(a) test is applied stringently and very few expenses meet all the requirements.

• The IRD allows certain expenses as extra-statutory concessions as a deduction under

s.12(1)(a).

• The extra-statutory concession deductions are professional subscription fees and laundry
expenses for a taxpayer who must work in a uniform.

• Certain flat rate deductions are also allowed for specified employment, for example,
commissions-based employments to cover entertainment or travel expenses incurred to earn
the commission income and laundry expenses of disciplined servicemen.

• Reasonable expense allowance, for example, per diem from an employer to cover
work-related travel expenses is generally not taxable.

• Depreciation allowances being initial allowance and annual allowance are granted in
respect of expenditure incurred on plant and machinery essential to the production of
assessable income.

• Self-education expenses paid in respect of a course undertaken is deductible up to the

prescribed amount if the course taken is to gain or maintain qualifications for use in an
employment.

• Concessionary deductions under Part 4A are deductible under salaries tax and personal
assessment.

• Cash donations to approved charitable institutions totalling HK$100 or more are deductible
up to 35% of the assessable income of the taxpayer less deductions under s.12(1)(a) and (1)
(b) (s.26C).

• Qualifying elderly residential care expenses paid to a residential care home in Hong Kong
in respect of each eligible parent or grandparent are deductible up to the prescribed
amount (s.26D).

• Home loan interest expense paid on loan used to acquire the taxpayer’s primary residence in
Hong Kong is deductible up to the prescribed capped amount of HK$100,000 (s.26E).

• A taxpayer with home loan interest expenses and no assessable income may nominate his or
her spouse to claim the deduction s.26(F).

• Contributions to a recognised retirement scheme up to HK$18,000 or mandatory

contributions to MPF scheme are deductible (s.26G).

• Qualifying premiums paid under VHIS policy are deductible up to a maximum amount of
HK$8,000 as prescribed for each insured person.

• The aggregate of qualifying annuity premiums paid under QDAP and TVC paid into a TVC
account are deductible up to a maximum of HK$60,000.

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Personal allowances:
• Personal allowances are prescribed sums allowable to a taxpayer in a year of
assessment (s.27).

• A taxpayer is entitled to a basic allowance and can claim other personal allowances if he or
she is eligible for the allowances (s.28(1)(a)).

• A married taxpayer is entitled to a basic allowance or can claim a married person’s allowance
if his or her spouse did not claim for both allowances (s.28(2)).

• All child allowance grantable to a married couple not living apart from each other must be
claimed by one nominated spouse only (s.31(3)(a)).

• If the child allowance is grantable to both parents not living together, disabled dependent
allowance in respect of the child will be grantable to both in the same ratio (s.31A(2)).

• If two or more persons are entitled to claim single parent allowance in respect of the same
child, the allowance shall be apportioned as determined by the commissioner (s.32(3)).

• All other personal allowances may be claimed by one taxpayer only in respect of the same
dependent.

• No taxpayer is eligible for DPA or DGA if a deduction is claimed under elderly residential care
expenses in respect of the same parent or grandparent (ss.30(5) and 30A(5)).

Joint assessment:
• A married couple is assessed separately unless a joint assessment will reduce the couple’s
overall tax liability and has been elected (s.10).

Computation of salaries tax and PST:

• If lump sum payments were made upon cessation of an employment or an employee received
a deferred payment, the employee may apply to have the payment related back to the years
of assessment in respect of which the services were rendered if doing so would reduce the
person’s tax liability (s.11D(b)(i)).

• In computing the salaries tax liability of a taxpayer, income accrued but not received or
deemed received shall be excluded from the person’s assessable income (s.11D(a)).

• Similarly, an income received but not accrued to a taxpayer may be excluded in computing the
person’s assessable income.

• A taxpayer who is chargeable to salaries tax in any year of assessment is required to pay
provisional tax in respect of that year of assessment (s.63B).

• Provisional tax is generally computed based on income less allowances of the preceding year
adjusted by using the current year’s prescribed amounts for concessionary deductions and
personal allowances (ss.63C and 63CA).

Employees tax planning:

• Salaries tax planning can be achieved by a proper structure of the employment contract as
well as remuneration package using tax effective benefits.

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MIND MAP

SCOPE OF TAX (ss.8(1), (1A) TO (1C) DEDUCTIONS (s.12)

SCOPE OF SALARIES TAX MIND MAP ALLOWABLE DEDUCTIONS AND PERSONAL
ALLOWANCES MIND MAP

INCOME AND EXEMPTIONS (s.8(2))

INCOME MIND MAP SALARIES TAX CONCESSIONARY DEDUCTIONS (PART 4A)
(PART 3) ALLOWABLE DEDUCTIONS AND PERSONAL
ALLOWANCES MIND MAP
INCOME FROM EMPLOYMENT (s.9) SEE ALSO
INCOME MIND MAP HOME LOAN INTEREST s.26E MIND MAP

COMPUTATION OF SALARIES TAX PERSONAL ALLOWANCES (PART 5)

ALLOWABLE DEDUCTIONS AND PERSONAL
Calculate the net assessable income, that is, assessable income ALLOWANCES MIND MAP
less s.12 deductions (ss.11B, 12)
Deduct eligible concessionary deductions and personal
allowances to arrive at net chargeable income (s.12B(1))
Tax payable is the lower of the two amounts below
• Applying the progressive tax rates to net chargeable income or
• Applying the standard tax rate to net chargeable income before
personal allowances (s.13)
A married couple may elect for joint assessment if beneficial (s.10).
• The net assessable income of each spouse is computed separately;
their net assessable income are aggregated and concessionary
deductions and personal allowances deducted to arrive at the
joint net chargeable income (s.12B(2))
• Tax is computed as for an individual above and an assessment
will be issued to the spouse with net chargeable income, if a joint
assessment had not been made, or to the nominated spouse (s.10(3))

EMPLOYMENT DEEMED INCOME FROM AN

EMPLOYMENT (s.9A)
Income arising in or derived from
HK (s.8(1)(a)) Totality of facts test applied (DIPN No. 25
Includes income derived from services (Revised)):
rendered in HK plus attributable leave • Control;
pay (s.8(1A)(a)) • Integration;
• Time apportionment basis • Economic reality; and
• Mutuality of obligation
Excludes employment income if
• All services rendered outside HK, taking into OFFICE s.8(1)(a)
account 60-day exemption rule (s.8(1A)(b)(ii),
(1B)); or Income from office, for example, director’s
• Service rendered outside HK and fee, is HK sourced if the company paying
substantially similar taxes charged and paid the fees is managed and controlled in HK
in that non-DTA country (s.8(1A)(c)) SCOPE OF PENSION S.8(1)(b)
Income from services rendered in DTA SALARIES TAX
countries taxable and tax credit claimed s.8(1), (1A) TO (1C) Income from pension is HK sourced if the
under s.50 of IRO (s.8(1C)) pension fund is managed and controlled in
HK; and the pension is attributable to
Income of all government employees even services rendered in Hong Kong
if they render all services outside HK
(s.8(1A)(b)(i)) All HK government pensions fully assessable
Income of an aircraft/ship crew member Exemption s.8(2):
unless he/she is present in HK for less than
See Income
a total of:
• 60 days in the YA and
• 120 days over 2 consecutive YAs, one of
which is the YA concerned (s.8(2)(j))
Income of visiting teachers/researchers who:
• Were HK residents prior to posting; and
• Are exempted from foreign taxes under
a DTA arrangement with HK (s.8(1AB))
SOURCE OF EMPLOYMENT INCOME
Goepfert case: place where the duties are
performed is not relevant for s.8(1) but
location of employment. Factors relevant
in deciding the location of employment:
• Place where the contract was negotiated
and concluded;
• Residence of the employer; and
• Place where the employee was paid
IRD will review each case based on all
relevant facts and apply substance over
form principle (DIPN No. 10 (Revised) para. 24)

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EMPLOYMENT INCOME s.9(1)(a) SPECIFICALLY EXCLUDED AS EMPLOYMENT

INCOME
Includes salary, wages, bonus, allowances,
perquisites, etc. whether from an employer Actual payment of rent or rent refund
or others (s.9(1)(a)) (s.9(1A)(a))
Amount received from non-recognised Receipt of stock option/right (s.9(5))
retirement schemes (s.9(1)(aa)) Liability test, that is, amount paid by
Payment from recognised retirement employer to, or for the credit of, a person
schemes or accrued benefit received or other than the employee in discharge of
taken to have received from MPF scheme, the employer’s sole and primary liability
other than on retirement, death, incapacity, (s.9(1)(a)(iv)) – see exclusions below
terminal illness or payment attributable to
the employer’s contributions that exceed SPECIFICALLY INCLUDED AS EMPLOYMENT
s.8(5) proportionate benefit on termination INCOME
INCOME
of service (s.9(1)(ab), (ad) and (ae)) Liability test exclusion:
Any payment received pursuant to a • Benefit convertible into money (s.9(2A)(a));
judgement given under s.57(3)(b) of ORSO • Employee’s child education (s.9(2A)(b));
as is attributable to the employer’s • Holiday journey (s.9(2A)(c)); and
contributions in respect of which the Deemed income from an employment for
judgement was given (s.9(1)(ac)) ‘Type I’ service company (s9A)
Notional stock option gains from exercise,
assignment or release (s.9(1)(d)) INCOME EXEMPTED FROM SALARY TAX s.8(2)
Rental value or the rental value less the Official emoluments of consuls, vice-consuls
employee’s contributions to rent of and staff of consulate (s.8(2)(b))
accommodation provided or subsidised Commutation of pension from recognised
(s.9(1)(b) and (1)(c)) schemes, Pension Ordinances (s.8(2)(c))
• The rental value is computed based on the
Non-government pension attributable to
following percentage of the income under
services rendered outside HK (s.8(2)(ca))
s.9(1)(a) from the employer less deductions/
allowances claimable under s.12(1)(a) and Accrued benefits attributable to mandatory
(1)(b) and lump sum payment and gratuity contributions received from MPF scheme
received; on retirement, death, permanent departure
- 10% for apartment or service apartment; or from HK, etc (s.8(2)(cb))
- 8% for a two-room hotel, boarding house Sums withdrawn from a recognised
or hostel; or retirement scheme or accrued benefits
- 4% for a one-room hotel, boarding house attributable to employer's voluntary
or hostel (s.9(2)(a)) contributions received from MPF scheme
on retirement, death, incapacity, terminal
COMMON LAW PRINCIPLE illness or termination after a service period
Beneficiary derived by the recipient. In FCT v of at least 10 years (s.8(2)(cb), (cc))
Cooke and Sherden (1980) 80 ATC 4140, the Certain Central People’s Government
receipt of an item that saved a taxpayer emoluments and certain Chinese People’s
from incurring expenditure was held not Liberation Army pensions and gratuities
to be income (s.8(2)(d), (e), (f), (h))
Real gain. In Hochstrasser v Mayes (1960) HK War Memorial pensions (s.8(2)(fa))
AC 376, compensation for work related Scholarship, exhibition, bursary or other
expenses was held not to be income similar educational endowment while the
Convertible to money or money’s worth. person is receiving full-time instructions at
Frequent flyer rewards were held not to an educational establishment (s8(2)(g))
be income on the basis that the points Periodic alimony/maintenance payments
were not convertible to cash in Payne v. FCT from former spouse (s.8(2)(i))
(1996) 66 FCR 299
Remunerations not deductible under s.17(2)
Reward for services rendered, for example, for profits tax (s.8(2)(k))
tips for good services in Calvert v Wainwright
(1947) 27 TC 475
Periodic, recurrent and regular are the
characteristic of income under common law

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DEDUCTIONS S.12 CONCESSIONARY DEDUCTIONS (PART 4A)

Outgoings and expenses: Allowable based on actual amount paid up
• Not private, domestic and capital in nature to the prescribed capped amounts
• Wholly; Approved charitable donations (s.26C)
• Exclusively; and • in money;
• Necessarily; • for charity;
• Incurred; • to institutions/trusts tax exempt under s88
• In the production of assessable income of IRO; and
(s.12(1)(a)) • ≥ HK$100
Depreciation allowances (s.12(1)(b)) ALLOWABLE Elderly residential care expenses (s.26D)
Loss brought forward from previous YA DEDUCTIONS • Deduction for the same parent or
(s.12(1)(c)) AND PERSONAL grandparent granted to one taxpayer only
Spouse excess deductions (s.12(1)(d)) ALLOWANCES (s.26D(4)(a))
• Once claimed, cannot claim dependent
Self-education expenses paid up to
parent or grandparent allowance in respect
prescribed amount (s.12(1)(e)
of the same parent/grandparent (ss.30(5)
Onerous record keeping and substantiations, and 30A(5))
for example for entertainment expenses,
Home loan interest (s.26e) (see home loan
taxpayer needs to keep records of the names
interest mind map).
of the people entertained, the nature of the
business in question and cost (DIPN No. 9) Contributions to recognised retirement
schemes (s.26G)
(Revised), para. 15, to show the
direct correlation with a business negotiation Qualifying premiums paid under VHIS
policy (s.26K)
Taxpayer to discharge the onus of proof
(s.64(2)) Qualifying annuity premiums and TVC
(ss.26O and 26S)
Stringent and restrictive
EXTRA-STATUTORY CONCESSION
PERSONAL ALLOWANCES (PART 5)
DEDUCTIONS
Fixed amounts granted if eligible for the
Subscription to professional bodies,
allowances:
for example, HKICPA
• Basic (s.28);
• Personal disability (s.28A); Flat rate deduction for laundry expenses
• Married person’s (s.29); of taxpayers who must work in uniform
• Dependent parent and grandparent (ss.30 A flat 10% of the commission income to
and 30A); cover allowable expenses incurred in
• Dependent brother or dependent sister earning the commission income of certain
(s.30B); commission-based employment
• Child – up to 9 children (s.31);
• Disabled dependent (s.31A); and
• Single parent (s.32)
Allowances are only relevant if assessed
under the progressive rates of tax
Not eligible for DPA and DGA if elderly
residential care expenses claimed (ss.30(5)
and 30A(5))

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ELIGIBILITY CRITERIA QUALIFYING DWELLING

Taxpayer is owner or part owner of the Including car parking space located in the
dwelling same development
Dwelling is residential and a rateable unit Only one principal residence at any one
in Hong Kong point in time
Taxpayer used dwelling wholly or partly as Includes dwelling used:
his/her residence • As principal residence for part of YA; or
Taxpayer paid interest on the loan used • Partly as residence during the YA
to acquire the dwelling during the YA The principal place of residence for a
The loan is secured by a mortgage over taxpayer who owns and used more than
a property in Hong Kong one property as residence is:
• That dwelling used as the principal
The lender is an approved institution listed
residence at each distinct period during
in s.26E(9)
the year for each respective period; or
HOME LOAN
HOME LOAN INTEREST DEDUCTION • If there was an alternating use of dwelling
INTEREST s.26E
at regular interval, the dwelling where the
Taxpayer who is sole owner is entitled to taxpayer and his/her family spent majority
claim the interest paid up to HK$100,000 of time
for the YA
Interest claimable for jointly owned MARRIED COUPLE
dwelling follows the taxpayer’s share of the Only one principal residence at any point
ownership, capped at the proportionately in time for married couple not living apart
reduced maximum amount deductible
(ss.26E(2)(b)) and 2(c)) A married taxpayer and his/her spouse
should claim each share of the home loan
Proportionate adjustment is made to interest: interest (based on ownership) in the
• On loan applied partly for the purchase of respective returns, subject to a maximum
the dwelling; amount of HK$100,000
• Dwelling used partly as a residence
The respective periods within the YA
Granted to each taxpayer for a maximum where the taxpayers were single, married,
period of 20 YAs (s.26E(4)(c)) or married but living apart are treated
Interest on loan applied to replace original separately in determining the deductibility
mortgage secured to acquire the residence claimable (see DIPN No. 35 (Revised)
due to more favourable interest is examples 13–15)
deductible up to the maximum capped A taxpayer who is entitled to claim home
amount as a concession from the IRD loan interest deduction may nominate for
A taxpayer entitled to home loan interest his/her spouse to claim the deduction (s.26F).
deduction may nominate for his/her • Once nominated, the taxpayer’s entitlement
spouse to claim the deduction (s26F) ceases and the spouse assumes the
deduction allowable
• Revocation should be made in writing within
six months from the date of the IRD’s
notification of the allowance of the home
loan deduction to the nominated spouse

APPENDIX

4.A Counting Days in Hong Kong

Day of arrival Day of departure Total number

of day(s)
60-day exemption rule 1 day 1 day 2 days
Time apportionment: 1 day 1 day
midnight rule

4.B Taxation of Accrued Benefits Received from ROR Schemes (adapted from IRD’s Pamphlet
‘Employer’s Tax Obligation under MPF Schemes and ROR Schemes’)

Accrued benefits attributable to: Circumstances received Salaries tax status

• Employee’s contributions and Any circumstance Exempt
investment return thereof
• Employer’s contributions and Retirement, death, incapacity Exempt (s.8(2)(cc)(i))
investment return thereof or terminal illness

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Accrued benefits attributable to: Circumstances received Salaries tax status

Termination of services
where service year(s):
• ≥ 10 years Exempt (s.8(2)(c)(i))
• < 10 years • Amount not exceeding
proportionate
benefit: Exempt
• Amount in excess of
proportionate benefit:
Taxable (s.9(1)(ab)(ii))
Other circumstances • Taxable (s.9(1)(ab)(i))

4.C Personal Allowances

Year of assessment
2017/18 2018/19
onwards
(until
superseded)
Type of allowance HK$ HK$ Provision in IRO
Basic 132,000 132,000 s.28, Schedule 4, item 1
Personal disability N/A 75,000 s.28A, Schedule 4, item 2
Married person 264,000 264,000 s.29, Schedule 4, item 3
Dependent parent (DPA): age s.30
≥ 60 years of age 46,000 50,000 ss.30(1), 30(3)(a), Schedule 4, item 4(a)
55 or more but < 60 23,000 25,000 ss.30(1A), 30(3A)(a), Schedule 4,
item 4(c)
Additional DPA: age
• ≥ 60 years of age 46,000 50,000 ss.30(1), 30(3)(b), Schedule 4, item 4(b)
• 55 or more but < 60 23,000 25,000 ss.30(1A), 30(3A)(b), Schedule 4, item 4(d)
Dependent grandparent s.30A
(DGA): age
• ≥ 60 years of age 46,000 50,000 ss.30A(1), 30A(3)(a), Schedule 4, item 5(a)
• 55 or more but < 60 23,000 25,000 ss.30A(1A), 30A(3A)(a), Schedule 4, item5(c)
Additional DGA: age
• ≥ 60 years of age 46,000 50,000 ss.30A(1), 30A(3)(b), Schedule 4, item 5(b)
• 55 or more but < 60 23,000 25,000 ss.30A(1A), 30A(3A)(b), Schedule 4,
item 5(d)
Dependent brother/ 37,500 37,500 s.30B, Schedule 4, item 6
dependent sister
Child 100,000 120,000 s.31, Schedule 4, item 7(a)
Additional child – year of birth 100,000 120,000 s.31(1A), Schedule 4, item 7(b)
Disabled dependent 75,000 75,000 s.31A, Schedule 4, item 8
Single parent 132,000 132,000 s.32, Schedule 4, item 9

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4.D Reduction of Taxes – s.100(1)

Year of assessment Percentage of tax reduction Maximum amount of

tax reduction (HK$)
2016/17 75% 20,000
2017/18 75% 30,000
2018/19 100% 20,000
2019/20 100% 20,000

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Option II will not be charged salaries tax.
Answer B is incorrect. Option IV will not be charged salaries tax.
Answer C is correct. Only options I and III will be charged salaries tax.
Answer D is incorrect. Options II, IV and V will not be charged salaries tax.

Question 2
Answer A is correct. As Miss Chen has a Hong Kong employment, her employment income
is fully chargeable to salaries tax under s.8(1)(a) unless the income falls within the scope
of s.8(2)(j) exemption. For the year of assessment 2016/17, Miss Chen was in Hong Kong
for more than 60 days, thus, her income is fully assessable. In the following year of
assessment, although she was in Hong Kong for less than 60 days during the relevant
year, her presence in Hong Kong for the years of assessment 2016/17 and 2017/18 was
more than 120 days. Thus, her income is taxable for the year of assessment 2017/18 as
well. For the year of assessment 2018/19, her presence in Hong Kong was not more than
60 days for the year, and her presence in Hong Kong for the two consecutive years of
assessment 2017/18 and 2018/19 and years of assessment 2018/19 and 2019/20 totalled
less than 120 days. Her income for the year 2017/18 qualifies for the tax exemption under
s.8(2)(j). In the case of year of assessment 2018/19, she will not qualify for the exemption
given that her presence in Hong Kong exceeded the 60 days.
Answer B is incorrect. As stated above, in the year of assessment 2017/18, although she
was in Hong Kong for less than 60 days during the relevant year, her presence in Hong
Kong for the years of assessment 2016/17 and 2017/18 was more than 120 days. Thus, her
income is taxable for the year of assessment 2017/18 as well.
Answer C is incorrect. As stated above, Miss Chen’s employment income is fully chargeable
to salaries tax except for the year of assessment 2018/19.
Answer D is incorrect. As stated above, Miss Chen’s employment is fully chargeable to
salaries tax except for the year of assessment 2018/19.

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Question 3
Answer A is incorrect. Option I does not describe a case with Hong Kong employment.
Answer B is correct. Only options II, III and IV describe cases with Hong Kong employment.
Answer C is incorrect. Option I does not describe a case with Hong Kong employment.
Answer D is incorrect. Options III and IV are not the only cases that describe Hong Kong
employment.

Question 4
Answer A is correct. Only options I, II and IV describe income chargeable to salaries tax.
Answer B is incorrect. Option III does not describe income chargeable to salaries tax.
Answer C is incorrect. Options II and IV are not the only cases that describe income
chargeable to salaries tax.
Answer D is incorrect. Option III does not describe income chargeable to salaries tax.

Question 5
Answer A is incorrect. Option II is not subject to the time-in-time-out basis of
apportionment for ascertaining the salaries tax liability in Hong Kong.
Answer B is incorrect. Options II and III are not subject to the time-in-time-out basis of
apportionment for ascertaining the salaries tax liability in Hong Kong.
Answer C is correct. Only options I and IV are subject to the time-in-time-out basis of
apportionment for ascertaining the salaries tax liability in Hong Kong.
Answer D is incorrect. Option III is not subject to the time-in-time-out basis of
apportionment for ascertaining the salaries tax liability in Hong Kong.

Question 6
Answer A is correct. See D46/87 – the Board held that if an employee only made use of
the accommodation for the purpose of eating, sleeping and relaxing when performing his
or her duties, he received no personal benefit. Gabriel’s family lives in its Kowloon Tong
home. As a head chef, he is required to also work at odd hours as and when his employer
requires. The room is used for days when he needed to rest in between and is not his
residence.
Answer B is incorrect. Home-office travel expenses are private expenses. The reimbursements
are thus chargeable to salaries tax being money in value.
Answer C is incorrect. The car benefit is convertible into money by other means, that is,
opting for a monthly transport allowance. The taxable value is the amount of monthly
transport allowance paid to employees who opt out of the car benefit (s.9(2A)(a)).
Answer D is incorrect. Reimbursement of monthly subscription fees to a private health club
is a discharge by the employer of the managing director’s private liability and is therefore
assessable. See D37/09.

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Question 7
Answer A is incorrect. The gains from an exercise of the stock option is the notional gain
computed based on the OMV of the shares less the strike price. The IRD confirms in DIPN
No. 38 (Revised), paragraph 17, that the gain is required to be calculated by reference
to the open market value on the day of exercise and any other date is generally not
appropriate. Since Tim exercised the options on 31 August and the closing price at Nasdaq
was US$32, the OMV for notional gains purposes is US$32. Thus, for the purpose of ss.9(1)
(d) and (4)(a), the notional gain is the difference in the open market value of the shares,
that is, US$3,200 (US$32 × 100) less the considerations paid by Tim of US$2,000. The
assessable amount is US$1,200 and not US$1,300.
Answer B is incorrect. Mr. Park is provided a serviced apartment and the IRD does not treat
a serviced apartment as a hotel or boarding houses. Also, the rental value is 10% on the
income net of ss.12(1)(a) and (1)(b) deductions, that is, assessable income less outgoings
and expenses and depreciation allowances. Self-education expenses are not deducted in
computing the rental value.
Answer C is incorrect. Given that the award is otherwise convertible to a HK$4,000
Starbucks card that operates more like a pre-loaded cash card, the award is assessable.
Answer D is correct. Mandatory contributions to MPF are not regarded as income to an
employee under s.9(1)(ad).

Question 8
Answer A is incorrect. Options I and II are not exempt from tax.
Answer B is incorrect. Option I is not exempt from tax.
Answer C is incorrect. Option II is not exempt from tax.
Answer D is correct. Only options III, IV and V describe cases that are exempt from tax.
Answer – D (III, IV, V).
I. As the occupational retirement scheme is not a recognised scheme, the lump sum
paid to Pete is assessable under s.9(1)(aa).

II. Pension is chargeable to salaries tax under s.8(1)(b).

III. A sum received being the employer’s mandatory contribution to MPF scheme on
permanent departure from Hong Kong is exempt under s.8(2)(cb).

IV. Payouts from an MPF scheme to Jane who was diagnosed with terminal illness
is exempt under ss.8(2)(cb) and (cc)(ii).

V. Mrs. Li was with her employer for more than 10 years of service, thus the accrued
benefits deemed to be received by her is tax exempt (s.8(2)(cc)(ii)).

Question 9
Answer A is incorrect. Option III is not a deductible expense for the year of
assessment 2019/20.
Answer B is incorrect. Option III is not a deductible expense for the year of
assessment 2019/20.
Answer C is correct. Only options I, II, IV and V are deductible expenses for the year of
assessment 2019/20.

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Answer D is incorrect. Options I, IV and V are not the only deductible expenses for the year
of assessment 2019/20
Answer – C (I, II, IV and V).
I. S.12 (1)(e) provides that the claim for a deduction must be made in the year of
assessment the self-education expenses are paid.

II. Under s.26G(3)(b) and schedule 3B, the mandatory contribution to MPF scheme up

to HK$18,000 is deductible.

III. Under s.26D(4)(a), the deduction will only be granted to one taxpayer. As his sister
was named in the invoices, she is deemed to be the party who has paid for the
expenses – see DIPN No. 36, paragraph 19.

IV. Nick is a senior audit manager and being a member of an institution like the CAANZ
is a prerequisite of his employment and helps keep him abreast with current
developments which are key to the performance of his duties. The IRD’s policy
allows a deduction for such subscription fee paid to one professional association
as an extra-statutory concession – DIPN No. 9 (Revised), paragraph 17.

V. The IRD applied as a matter of discretion a flat standard deduction of HK$2,400

given to certain categories of employment, including uniformed member of the
Hong Kong Police Force.

Question 10
Answer A is incorrect. What Mr. Li acquired via the premium was the right to alienate a flat
that has always been his dwelling. The premium was the consideration for removal of the
restriction over his subsisting dwelling. He was not entitled to deduct interest on the loan
as home loan interest (D139/01).
Answer B is correct. Liz can claim home loan interest under s.26E(2)(c)(i) up to her 50%
ownership ratio, that is, HK$70,000 in year of assessment 2019/20.
Answer C in incorrect. To claim a deduction under s.26E(1), the Diamond Hill apartment
must be Teng Teng’s principal place of residence and used by her as such. Teng Teng’s
principal place of residence is in Stanley; she is not entitled to claim home loan interest
deduction (D62/09).
Answer D is incorrect. The loan obtained in June 2019 was not applied for the
acquisition of the Mid-Levels apartment. Thus, the claim for home loan interest is not
allowable – ss.26E(1), 26E(3)(a) and 26E(9).

Question 11
Answer A is incorrect. Option IV is also deductible to Hock Leong in the year of
assessment 2019/20.
Answer B is incorrect. Option II is also deductible to Hock Leong in the year of
assessment 2019/20.
Answer C is correct. Options I, II, III and IV are all deductible to Hock Leong in the year of
assessment 2019/20.
Answer D is incorrect. Options II and III are also deductible to Hock Leong in the year of
assessment 2019/20.

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Answer – C (I, II, III and IV).

I. Hock Leong can claim the qualifying premiums paid for his 7-year old daughter, the
qualifying premium paid meets the conditions under s. 26K(1) – his daughter
is a specified relative under s.26J(1)(c) and Hock Leong and Janet are HKID
cardholders. The qualifying premium paid in respect of his daughter is below the
capped amount of HK$8,000 (s.26K(3) and schedule 3E).

II. The conditions for a deduction of the qualifying annuity premiums under s26O are
met: Hock Leong paid for the QDAP premiums, the policy holder and annuitant
is his spouse. Further, the total amount paid (HK$24,000 and HK$36,000 as
mentioned in IV) and deductible to Hock Leong for the year of assessment
2019/20 under ss.26O and 26S totalled HK$60,000 (the capped amount allowable
under s.26U(1) and schedule 3F).

Note that If Janet were to pay for the qualifying annuity premium, condition
under s.26O(1)(b) would not be satisfied since Janet and Hock Leong lived apart
from each other in the year of assessment 2019/20. However, this is not the
case here.
III. The qualifying premiums paid in respect of VHIS policy purchased for Janet’s
parents met the conditions of s.26K(1): premiums paid by Hock Leong, the insured
persons are his specific relatives (s.26J(1)(b) & (2)(a)) and HKID cardholders (s.26K(1)
(c)(i)), the qualifying premiums paid were within the capped limit of HK$8,000 per
insured person (s.26K(3), schedule 3E).

IV. The conditions for a deduction of the qualifying annuity premiums under s26O
are met: Hock Leong paid for the QDAP premiums, he is the policy holder and
annuitant. The total amount paid (HK$36,000 and HK$24,000 as mentioned in II)
and deductible to Hock Leong for the year of assessment 2019/20 under ss.26O
and 26S totalled HK$60,000 (the capped amount allowable under s.26U(1) and
schedule 3F).

Question 12
Answer A is incorrect. Option II is not eligible to claim personal allowances.
Answer B is incorrect. Options II and III are not eligible to claim personal allowances.
Answer C is correct. Only options I and IV are eligible to claim personal allowances.
Answer D is incorrect. Option V is not eligible to claim personal allowances.
Answer – C (I and IV).
I. Jim and John can claim DPA as they maintained their parents; i.e. contributed
at least HK$12,000 each (s.30(4)(a)(ii)/schedule 4) and their parents are ordinarily
resident in Hong Kong, and aged 60 for part of the year (s.30(1AA)(1)).

II. Mr Huang (junior) is not eligible for dependent grandparent allowances as he did
not maintain his grandmother. His parents did.

III. Jess Mok and her husband cannot, and did not, elect a joint assessment under
s.10(2) and personal assessment under Part 7. Therefore, her husband cannot
claim a married person’s allowance as Jess has assessable income in the relevant
year (s.29(1)(a)).

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IV. Mr Tang’s brother meets the requirement of s.30B(1)(b). Since Mr. Tang’s
parents no longer live in Hong Kong, Mr. Tang is supporting his brother who lives
and depends on him, being his brother’s only family in Hong Kong. He is likely to
have sole and predominant care of his brother (s.30B(3)(a)).

V. Under s.31(3)(a), all child allowance must be claimed by one spouse only.
Simon and Simone are required to nominate the person who will claim for all
child allowances (s.31(3)(b)).

Question 13
Answer A is incorrect. Under s.10(2), a married couple not living apart may elect for a joint
assessment if either one spouse has more concessionary deductions and allowances
than the spouse’s net assessable income or if both have net chargeable income, the total
salaries tax liability of the couple is lower when assessed jointly as compared to separately.
Answer B is incorrect. The net assessable incomes of the taxpayer and his/her spouse
are aggregated and deductions made for Part 4A concessionary deductions and Part 5
allowances to arrive at a single net chargeable income (s.12B(2)).
Answer C is correct. S.10(1) stipulates that a married couple will be assessed separately
unless an election is made for a joint assessment for the year of assessment under s.10(2).
Answer D is incorrect. The approved charitable donation made by one spouse (not living
apart from the other) can be claimed by the other spouse under a separate assessment
as long as the same donation is not also claimed by the spouse himself/herself
(ss.26C(1), (3)(a)).

Question 14
Answer A is incorrect. Options I and II are not the only adjustments that must be made to
the total income in computing a Hong Kong taxpayer’s assessable income.
Answer B is correct. Only options I, II and III are adjustments that must be made to the
total income in computing a Hong Kong taxpayer’s assessable income.
Answer C is incorrect. Option IV is not an adjustment that must be made to the total
income in computing a Hong Kong taxpayer’s assessable income.
Answer D is incorrect. Options IV and V are not adjustments that must be made to the total
income in computing a Hong Kong taxpayer’s assessable income.

Question 15
Answer A is incorrect. Self-education expenses are only deductible in the year the expenses
are paid and not when the course commenced (s.12(1)(e)).
Answer B is incorrect. The nursing home in Macau is not licensed under the Residential
Care Homes (Elderly Persons) Ordinance (Cap.459) and does not fall within the definition of
residential care homes under s.26D(5). Thus, no deductions will be allowable.
Answer C is incorrect. Payment made for the Hong Kong Red Cross gala dinner tickets are
not donations of a charitable nature (DIPN No. 37 (Revised), para. 3).
Answer D is correct. Mortgage interest paid on the loan applied to acquire the residence/
apartment of the taxpayer, including a carpark lot is deductible up to the maximum
amount of HK$100,000 in the year of assessment 2019/20 (s.26E(8)(a)).

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Question 16
Answer A is incorrect. Option III is not a fringe benefit that can be properly used for
remuneration packaging purposes.
Answer B is incorrect. Option II is not a fringe benefit that can be properly used for
remuneration packaging purposes.
Answer C is incorrect. Option III is not a fringe benefit that can be properly used for
remuneration packaging purposes.
Answer D is correct. Only options I, IV and V are fringe benefits that can be properly used
for remuneration packaging purposes.

Question 17
Answer A is incorrect. Option V is also true.
Answer B is incorrect. Option III is also true.
Answer C is correct. All statements are true.
Answer D is incorrect. Option IV is also true.

EXAM PRACTICE

QUESTION 1
Miki Kasai is an air stewardess with a Japanese airline company. She is based in Tokyo and
is often in Hong Kong either as a final destination or on transit. Besides salary and hotel
accommodation that is provided by the airline, Miki is paid a daily travel allowance to cover
her meals and other miscellaneous expenses while she is travelling for work. The daily rate
varies depending on the city visited. Miki did not fly to Hong Kong for work prior to her
promotion to fly international routes in March 2016:

Basis period Days in HK No. of transit in HK

1/4/2016–31/3/2017 37 12
1/4/2017–31/3/2018 48 13
1/4/2018–31/3/2019 56 15
1/4/2019–31/3/2020 38 12

Required:

(a) Advise Miki if she is liable to Hong Kong salaries tax.

(b) Explain which part of Miki’s remuneration is taxable in Hong Kong.

Answer with reference to the IRO and the IRD practices.

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QUESTION 2
Eric Ang is married with two teenage sons. His wife Erica is a housewife. He works as the
regional product manager for a US IT company and is based out of Singapore. He is paid
in Singapore Dollar in Singapore although Eric has a foreign employment for Singapore
tax purposes. His family lives in Kuala Lumpur and he travels extensively in the Asia Pacific
region for work. Eric has been to Hong Kong a lot since he took over the responsibility for
North Asia in June 2019. The following is the schedule of his visits to Hong Kong for the year
of assessment 2019/20:

Dates Purpose of visit

1/4/2019–8/4/2019 Business
6/5/2019–10/5/2019 Business
18/5/2019–28/5/2019 Business
2/6/2019–9/6/2019 Business
15/6/2019–20/6/2019 Business
2/7/2019–14/7/2019 Holiday – annual leave
12/8/2019–18/8/2019 Business
8/12/2019–12/12/2019 Business
19/12/2019–26/12/2019 Holiday – annual leave
10/1/2020–15/1/2020 Business
20/1/2020–21/1/2020 Business
1/3/2020–6/3/2020 Business
15/3/2020–18/3/2020 Business
23/3/2020–26/3/2020 Business

The following is additional information relevant to the year of assessment 2019/20:

(iii) Salary (13-month basis) of S$273,477, that is, HK$1,472,400 (based the average
exchange rate of 5.3840 as of 31 March 2020).

(iv) Bonus of S$53,603 paid in February 2018, that is, HK$296,317 (28 February 2020
average exchange rate of 5.5280).

(v) His company paid MYR150,000 rent for the house his family occupied in Kuala Lumpur.

(vi) He was granted share awards since his first anniversary with the company (see the
following). The closing price of the company’s share on 2 January 2020 was US$50.

Grant date 2 Shares – vest equally over a four-year period on 2 January

January
2019 2020 2021 2022
2018 100 100 100 –
2019 150 150 150 150

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(vii) Eric stayed at the Mandarin Oriental hotel each time he was in Hong Kong for
business. In addition, the company paid a per diem of HK$600 to employees for visit to
Hong Kong.

(viii) Eric was named top product manager in the region and the company paid for
his family’s four return air tickets to Hong Kong of S$3,001.85 (HK$17,091 based
on the average exchange rate for July 2019 of 5.6935) and two-bedroom Airbnb
accommodation of HK$40,000 in July 2017.

(ix) Both Eric’s sons are attending full-time school in Kuala Lumpur.

(x) He is entitled to 18 days annual leave.

(xi) He was in Singapore for a total of 28 days and is therefore exempt from tax in
Singapore.

Required:

(a) Based on the preceding information and with reference to the IRO and the IRD
practices, determine if Eric Ang is subject to Hong Kong salaries tax.

(b) If he were chargeable to salaries tax, calculate Eric’s assessable income for the year of
assessment 2019/20.

(c) Calculate Eric’s salaries tax liability for the year of assessment 2019/20.

QUESTION 3
Jon Lum works as a senior marketing executive for a Hong Kong company. From 1 April
2019 to 31 March 2020, he earned HK$630,000 in base salary and HK$80,000 bonus. Jon is
married with a 5-year old daughter and a 3-year old son. His wife, Stephy, works part-time
as a legal assistant. She earned HK$100,000 for the same period. She enrolled in a part-time
Certificate in Law with the Hong Kong Open University and paid HK$13,650 in February 2020.
Stephy contributed HK$12,000 to her 63-year-old stepmother during the year. She also paid
her sister HK$30,000 being her share of their father’s elderly care home expenses. The home
is registered under her sister’s name. Stephy and her sister agreed that Stephy would claim
DPA in respect of their stepmother and her sister would claim eligible deduction in respect
of their father.

Jon and family live with his retired parents (both aged above 60) in a two-bedroom
apartment. He contributed HK$15,000 to each parent. In November 2019, Jon’s parents sold
their investment in shares and paid the deposit for the apartment next door that was for
sale. Jon took up a mortgage to pay for the balance of the purchase price. The apartment
was registered in Stephy and his name. Jon moved his family to its new apartment shortly
after they received the keys. He paid HK$80,000 interest on the mortgage for the year of
assessment 2019/20.

Required:

(a) Assuming Jon and Stephy did not pay any provisional taxes for the year of assessment
2019/20, compute the following:

• Jon and Stephy’s net assessable income;

• Jon and Stephy’s net chargeable income; and

• Jon and Stephy’s tax payable.

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(b) Explain whether Jon and Stephy should elect for a joint assessment. If so, explain who is
liable to pay the tax.

(c) Advise if Jon and Stephy will be liable to pay provisional salaries taxes for the year of
assessment 2020/21.

QUESTION 4
Wendy Tang was the Chief Executive Officer (CEO) of a Hong Kong company. She also sits on
the board of directors of a company in Singapore and another in Hong Kong. On 1 July 2020,
due to health reasons, Wendy cut down her work commitments and stepped down as the
CEO of the company. Instead, she works part-time as a consultant and continues to sit on
the company’s board of directors.

Wendy is divorced and maintained a 20-year old daughter who is attending college
full-time in the UK. Wendy lives with her 83-year old mother. For the year of assessment
2019/20, Wendy received and incurred the following income and expenses, respectively:

(i) Monthly salary of HK$165,000.

(ii) Monthly housing allowance of HK$56,000 with effect from 1 July 2019.

(iii) Discretionary bonus for the year ended December 2019 of Singapore (S)$900,000 paid
in December 2020 after the company’s accounts being audited and finalised.

(iv) S$10,000 director’s fee from a Singapore company. She attended two board meetings,
including the annual general meeting in Singapore. The Singapore company paid for
her air tickets and hotel accommodation. Singapore tax of S$2,200 was withheld from
the director’s fee.

(v) HK$60,000 director’s fee from the Hong Kong company.

(vi) A fully maintained company car and a driver provided by her employer. The driver is
on the company’s payroll.

(vii) Medical and health insurance premium of HK$28,000 paid by the company under its
Bupa insurance policy.

(viii) A domestic helper hired by the company, HK$90,000.

(ix) Utilities and mobile phone were provided under the company’s corporate accounts.

(x) The following is a summary of the stock options granted, vested and unvested from
her Hong Kong employer. The company share price closed at HK$520 on 2 January
2020 and Wendy exercised all her vested options on 2 January 2020.

Grant date Strike Option – vest equally over a four-year period on 2 January

2 January price HK$
2020 2021 2022 2023 2024
2017 450 4,800 4,800
2018 440 5,000 5,000 5,000
2019 465 10,000 10,000 10,000 10,000
2020 480 12,000 12,000 12,000 12,000

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(xi) Contributions to MPF scheme HK$18,000.

(xii) Home loan interest on the mortgage she took to acquire her residence with effect from
1 July 2019 of HK$180,000. Prior to that, Wendy and her mum lived in an apartment
rented by her employer. The rent was HK$80,000 per month, of which Wendy paid
30%, that is, HK$24,000 was deducted from her payroll each month.

(xiii) HK$60,000 paid for home care of her bed-bound mother.

(xiv) Approved charitable donations of HK$90,000 to the Community Chest and another
donation of £5,000 to the Manchester University JustGiving.

(xv) Annual subscription to the Hong Kong Institute of Directors HK$2,100.

(xvi) HK$480,000 PST for year of assessment 2019/20.

Required:

(a) Comment on whether the director’s fees received are chargeable to salaries tax.

(b) Compute the assessable stock option gain under s.9(4)(a).

(c) Compute Wendy’s salaries tax payable for the year of assessment 2019/20 and her PST
liability for the year of assessment 2020/21. Illustrate how the PST paid for 2019/20 is
applied to the total tax payment.

QUESTION 5
Rich Wong was married and took a loan (L1) to acquire a property in Stanley in 2016. The
property was registered under both Rich and his wife Rachel. Rachel and Rich decided to
separate in June 2019. Both Rich and Rachel continued to live in the Stanley property. On
1 October 2019, Rich stayed over at his friend’s in Central to reduce his commute to work.
Rachel changed the lock of the Stanley property and Rich was not able to return to the
property since, although he continued to pay the interest on the mortgage. For the year
of assessment 2019/20, Rich paid HK$120,000 interest on the loan. In January 2020, Rich
borrowed from his uncle another loan (L2) to finance the purchase of an apartment in
Central. He moved into the apartment shortly. He paid his uncle HK$30,000 interest on the
loan for the three months from January to March 2020. Rich and Rachel sold their Stanley
property in May 2020. Rich paid a further interest on L1 of HK$20,000 up until the sale of the
property. After the divorce settlement, Rich used his Central property to secure a loan from
the bank (L3) and the loan was used to repay his uncle.

Required:

(a) On the basis that Rich has not been granted home loan interest deduction in the
previous 20 years of assessment, explain whether Rich can claim any of the loan
interest expense relating to L1, L2 and L3 for the years of assessment 2019/20 and
2020/21 given that the interest related to Rich’s primary residences.

(b) Compute the home loan interest allowable to Rich under s.26E of the IRO for the year of
assessment 2019/20.

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QUESTION 6
Mr. Alex Kim worked as a senior marketing executive for a big Korean corporation (KC1)
Hong Kong office. Prior to Hong Kong, Mr. Kim was working in Singapore for the Singapore
subsidiary of KC1. In March 2020, his employer terminated Mr. Kim’s employment. The Hong
Kong company paid him a long service payment amounting to HK$250,000 in July 2020 in
recognition of his five years of service with the company. In September 2020, Mr. Kim joined
the Hong Kong subsidiary of another Korean corporation (KC2). To induce him to start earlier
with it, the company paid him an incentive amount of HK$300,000 upfront. The payment
is conditional upon him being with the company for at least 12 months. Mr. Kim is married
with a teenage boy and a little girl (born June 2019).

The relevant information in relation to Mr. Kim’s employment with KC1 for the period
from 1 April 2019 to March 2020 is listed below.

(i) Salary from of HK$760,000.

(ii) Bonus of HK$150,000.

(iii) Accommodation provided by the employer. Rent paid by the employer HK$480,000.

(iv) Transport allowance HK$96,000.

(v) Korean International school fees of HK$112,00 for Alex’s 16-year old son paid by
the company.

(vi) Contributions to MPF scheme HK$18,000.

(vii) Donations to Red Cross Hong Kong HK$10,000.

(viii) The accrued benefits attributable to his employer’s voluntary contributions held in his
MPF scheme account as at 31 March 2020 HK$100,000.

Required:

(i) Explain if the incentive amount of HK$300,000 is taxable to Mr. Kim. If so, explain in
which year of assessment will the amount be included as assessable income.

(ii) Compute Mr. Kim’s salary tax liability for the year of assessment 2019/20. Explain
briefly the treatment of each assessable amount and deduction.

QUESTION 7
Henry Heinz is the Chief Technology Officer at a Hong Kong company. He is married and
has twin daughters, both 20 years old and attending full-time college in the UK. His wife
Hanna teaches at the German-Swiss International School, and earned HK$480,000 in the
year of assessment 2019/20. She also donated HK$300,000 to the school association, which
is a tax-exempt institution under the IRO. Henry’s salary and bonus was HK$2.3 million
and HK$1 million, respectively. His employer provided his housing, utilities, telephone
and a domestic helper. Henry’s company reimbursed his medical insurance premium
of HK$90,000. The company paid HK$84,500 for Hanna’s and his air tickets to visit their
daughters who are attending universities in the UK. They also reimbursed the two-week
hotel accommodation of HK$28,000 and HK$48,000 for his two daughters’ return air tickets
from the UK to Hong Kong. Both Henry and Hanna contributed to the MPF schemes.

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The following are Henry’s stock options grant and vest dates:

Strike price (HK$): 148 151 191 206

Vest date Option granted and unit
2/1/2016 2/1/2017 2/1/2018 2/1/2019
2/1/2020 250 280 320 1,000
2/1/2021 280 320 1,000
2/1/2022 320 1,000
2/1/2023 1,000

Every year, Henry receives phantom shares equivalent to 10% of his salary. These phantom
shares vest upon the expiry of seven years. 15,000 phantom shares granted in January 2013
vested on 2 January 2020. The share price of the company was HK$122 at grant. Given the
price at the time of vest (closing price on 2 January 2020) was HK$280, Henry received a
payment of HK$2.37 million. Henry has been advised by his tax adviser who prepared and
filed his past years tax returns that it is beneficial for the phantom shares to be taxed in the
years they related to as his overall tax liability would be lower.

Required:

(a) Calculate the stock option notional gains assessable to salaries tax for the year of
assessment 2019/20.

(b) Explain whether the phantom shares are assessable to salaries tax and whether Henry
can minimise the tax on them.

(c) Compute Henry and Hanna’s salaries tax liabilities under separate assessments and a
joint assessment for the year of assessment 2019/20. Comment on the items of claims
when appropriate.

QUESTION 8
Mr. Calvin Curtis, married with five young children, is a sous chef with an international
hotel chain based out of the US. His employer offers to assign him as an executive chef
in the company’s chain of newly acquired boutique hotels in Asia. Calvin is required to
travel around the region and work with the local chefs to create new menu for the hotel
restaurants. However, it is anticipated that he will spend at least 30% of his time in Hong
Kong. He has heard about employment contract structuring and remuneration packaging
from his peers in Hong Kong. The employer is flexible in the compensation components if
the cost to the company is the same.

Required:

Advise Curtis and his employer the planning opportunities available under Hong Kong
salaries tax.

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ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) S.8(2)(j) provides that the income of a member of the crew of a ship or an aircraft shall
be exempt from salaries tax if he or she was present in Hong Kong on not more than:

(i) a total of 60 days in the basis period for that year of assessment; and

(ii) a total of 120 days falling partly within each of the basis periods for two consecutive
years of assessment, one of which is that year of assessment.

For the purpose of determining the days in Hong Kong under s.8(2)(j), part
of a day in Hong Kong is counted as one day. In D40/07, and D20/00 the Board
held that part of a day should be counted as a day. Further, transit days are also
counted as days present in Hong Kong as upheld in D11/13. Thus, Miki was in Hong
Kong for the following number of days and her tax positions for the years are as
shown below:

Basis period Days in No. of transit Total days S.8(2)(j) exemption

HK in HK in HK
1/4/2016–31/3/2017 37 12 49 Exempt
1/4/2017–31/3/2018 48 13 61 No exemption – exceed 60
1/4/2018–31/3/2019 56 15 71 days, thus did not meet
s.8(2)(j)(i)
1/4/2019–31/3/2020 38 12 50 No exemption – exceed 120
days for YA2018/19 and
2019/20, thus did not meet
s.8(j)(ii)

Based on the above, Miki is chargeable to salaries for the years of assessment 2017/18,
2018/19 and 2019/20.

(b) Miki has a non-Hong Kong employment as she works for a Japanese airline. Under
s.8(1A)(a), her income attributable to the services rendered in Hong Kong is chargeable
to salaries tax. The IRD uses the time basis apportionment rule, that is, days she was in
Hong Kong plus leave days attributable to attribute her income to services rendered in
Hong Kong.

The daily allowance paid by her employer to cover her meals and living expenses
are assessable income (DIPN No. 10, para. 29). In addition, the hotel accommodation
provided to her by the airline in Hong Kong is assessable based on the rental value
(deemed 4% of the income attributable to services rendered in Hong Kong – ss.9(1)(b)
and 9(2)(a)). The actual expenses incurred by her on meals and other similar expenses
are not deductible being expenses of a private nature and not wholly, exclusively and
necessarily incurred in the production of income (D54/94).

QUESTION 2
(a) From the information provided, Eric has a non-Hong Kong employment. As Eric’s
visits to Hong Kong for the year of assessment 2019/20 were more than 60 days,
he would not qualify for the exemption under s.8(1B). Eric’s income from his
employment will be chargeable to salaries tax under s.8(1A)(a) and the IRD would apply
the time-in-time-out, that is, time basis apportionment rule to attribute his income to
services rendered in Hong Kong.

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(b) Based on Eric’s schedule, his visits to Hong Kong totalled 81 days, 63 workdays and 18
non-work day in the year of assessment 2019/20 as computed below.

Dates Days in HK Purpose of visit

1/4/2019–8/4/2019 7 Business
6/5/2019–10/5/2019 4 Business
18/5/2019–28/5/2019 10 Business
2/6/2019–9/6/2019 7 Business
15/6/2019–20/6/2019 5 Business
2/7/2019–14/7/2019 12 Holiday – annual leave
12/8/2019–18/8/2019 6 Business
8/12/2019–12/12/2019 4 Business
19/12/2019–25/12/2019 6 Holiday – annual leave
10/1/2020–15/1/2020 5 Business
20/1/2020–21/1/2020 1 Business
1/3/2020–6/3/2020 5 Business
15/3/2020–18/3/2020 3 Business
23/3/2020–26/3/2020 3 Business
Leave days 3
attributable to HKa
81

 Leave days attributable to services rendered in Hong Kong is computed as follows:

a

(78 18)
18 3
348
(ii) and (iii). Thus, Eric’s assessable income and tax payable for the year of assessment 2019/20 would be:

Eric Ang
Salaries tax computation
Year of assessment 2019/20
HK$ HK$ HK$
Salary 1,472,400
Bonus 296,317
Holiday journey a
57,091 ss.9(1)
(a), (2A)(c)
Share award gainsb 58,950 1,884,758 s.9(1)(a)
Assessable income under time
apportionment:
(HK$1,884,758 × 63 ÷ 366) 324,426
Daily allowance (HK$600 × 60) c
36,000 s.9(1)(a)
A 360,426
Rental value of housing 36,043 s.9(1)(b), (2)(a)
(A × 10%)d
Net assessable income 396,469
Less: Concessionary deduction –
Net income B 396,469
Less: Personal allowances
Married person’s allowance (264,000)
Child allowance e
(240,000) (504,000)

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Net chargeable income –

Net tax payable –

a
The award, including the accommodation being holiday journey benefits are assessable under s.9(1)(a) (s.9(2A)(c)).
b
Under ss.11D(b) and 9(1)(a), the share award would only be assessable at the time it is vested to Eric free of condi-
tions. As the share awards are subject to vesting of four years, the back-end approach applies. Further, they were
granted to Eric outside of Hong Kong, thus the IRD expresses in DIPN No. No. 38 (Revised), paragraph 66, that the
share award gains applicable to vesting period outside of Hong Kong may be excluded from assessable income.
Eric’s share award gain attributable to vesting from the day he was in Hong Kong would be calculated as follows:

Closing share price as at 2/1/2019: A US$50

Vesting days Amount
No. of from assessable
days to 1/4/2019 US$
Share awards Value US$ vest to 1/1/2020
Period from
grant to vest (B) C = (A × B) (D) (E) (E ÷ D × C)
2/1/2018–1/1/2020 100 5,000 730 276 1,890.41
2/1/2019–1/1/2020 150 7,500 365 276 5,671.23
7,561.64
Using IRD’s average buying rate for January 2020 of 7.7959 HK$ 58,950
c
Eric was working in Hong Kong for 60 days. No apportionment should be made on the allowances
that clearly referred to the services performed in Hong Kong (see D106/89).
d
The assessable value of the housing provided is equal to 10% of the income from employment
less expenses deductible under s.12(1)(a) and (1)(b) during the period where the accommodation
was provided. Eric is not assessed on the actual rent in Kuala Lumpur (s.9(1A)) and the cost of hotel
accommodation paid by the company in Hong Kong.
e
He is eligible for child allowances of HK$120,000 for each child as his two teenage sons are
attending full-time school in Kuala Lumpur.

QUESTION 3
(a) and (b) The following are the tax liabilities of Jon and Stephy under separate and joint
assessments. Based on the computations, it is beneficial for Jon and Stephy to elect for a
joint assessment. Given that Stephy would have an excess of deductions and allowances
over her income, Jon would be liable for the salaries tax payable (s.10(3)(a)).
Jon and Stephy Lum Salaries tax
computations
Year of assessment 2019/21
Separate assessment Joint
assessment
Jon Stephy Total
HK$ HK$ HK$ HK$
Salary 630,000 100,000
Bonus 80,000
710,000 100,000
Less:
Self-education expenses 13,650
Net assessable income 710,000 86,350 796,350
Less: Concessionary deduction
Home loan interesta (40,000) (40,000) (80,000)
Contributions to mandatory MPF (18,000) (5,000) (23,000)
Net income A 652,000 41,350 693,350

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Less: Personal allowances

Basic/married person’s allowance (132,000) (132,000) (264,000)
Child allowance b
(240,000) (240,000)
Dependent parents’ allowance c
(150,000) (150,000)
Net chargeable income 130,000 (90,650) 39,350
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000 787
On next HK$50,000 6% 3,000
Balance HK$30,000 10% 3,000
B 7,000 – 787
Tax at standard C 97,800 6,202 104,002
rate (A × 15%)

Tax payable (lower of B and C) 7,000 787

Less: 100% tax reduction s.100(1) (7,000) (787)
Net tax payable – – – –

a
The home loan interest will be allowed based on each person’s ownership of the property. S.26E(2)(b)(i) deemed
both Jon and Stephy to have paid equal share of the interest.
b
Given that Jon can better use the child allowances, Jon can claim the eligible child allowances under s.31(3).
c
Same as child allowance, Jon can better apply the dependent parent allowances including the DPA in respect of
Stephy’s stepmother. Thus, Jon is able to claim three dependent parent allowances totalling HK$150,000 as follows:

• Jon’s retired parent of HK$50,000 per parent, that is, total of HK$100,000

• Stephy’s stepmother of HK$50,000.

Jon cannot claim the additional dependent parent allowance in respect of his retired parents as the prerequisite
that his parents lived with him for less than full valuable consideration continuously throughout the year of
assessment was not met. Although Jon and family were living with his parents, they were living at his parent’s
apartment.(c) Given that Stephy has no net chargeable income, she will not be liable to pay provisional tax for the
year of assessment 2020/21. As for Jon, he will be liable to pay provisional salaries taxes for the year of assessment
2020/21 under s.63B of the IRO.

QUESTION 4
(a) Wendy Tang received director’s fees from a Singapore company and a Hong Kong
company. S.8(1)(a) brings within salaries tax income from an office arising in or derived
from Hong Kong. The source of director’s fee is determined by the location where the
company making the payment is resident, that is, where its central management and
control are exercised (McMillan v Guest (1942) 24 TC 190). In this case, the director’s
fees Wendy received are sourced from Singapore and Hong Kong, respectively. Thus,
the Singapore director’s fee would not be chargeable to salaries tax. Note that if
the Singapore director’s fee were to be Hong Kong sourced, the exemption under
s.8(1A)(c) would not apply as the provision of s.8(1A) is applicable to income from an
employment only.

The Hong Kong director’s fee of HK$60,000 being income arising in or derived
from Hong Kong would be subject to salaries tax.

(b) The stock options vested on 2 January 2020 would be relevant for the year of
assessment 2019/20. The assessable stock option gains (notional gains) are computed
as follows:

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Price at 2 January 2020 (A) HK$520

Strike price HK$ (B): 450 440 465 Total
Option Granted 2 January (C)
2017 2018 2019
Vest date
2/1/2020 4,800 5,000 10,000
Gains HK$ ((A − B) × C) 336,000 400,000 550,000
Stock option notional gains 1,286,000
(c)

Wendy Tang Salaries tax

computation
Year of assessment 2019/20
HK$ HK$ HK$
Salary (HK$165,000 ×12) 1,980,000
Bonus a
–
Less: ss.12(1)(a) and (1)(b) expenses
Subscription to the HKIoDb (2,100)
A 1,977,900
Rental value for 3 months (A × 10% × 3 ÷ 12) 49,448
Less: Rent paid by employee (HK$24,000 × 3) (72,000) –
Housing allowance (HK$56,000 × 9) c
504,000
Gain on stock option (see answer to part ii) 1,286,000
Director’s fee 60,000
B 3,827,900
Net assessable incomed 3,827,900
Less: Concessionary deduction
Approved charitable donation (capped at (90,000)
35% of B)e
Home loan interestf (100,000)
Contributions to mandatory MPF (18,000) (208,000)

Net income C 3,619,900

Less: Personal allowances
Basic allowance (132,000)
Child allowanceg (120,000)
Parent allowanceh (100,000) (352,000)
Net chargeable income 3,267,900
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$3,067,900 17% 521,543

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D 537,543
Tax at standard rate (C × 15%) E 542,985

Tax payable (lower of D and E) 537,543

Less: 100% tax reduction s.100(1) i
(20,000)
Net tax payable 517,543

a
Under s.11D(a), the bonus paid to Wendy in December 2020 is assessable in year of assessment 2020/21.
Although Wendy may apply to have the bonus related back to the year when services were rendered, that is,
year of assessment 2019/20, it would not be beneficial for her to do so given that her assessable income would
be significantly lower as she worked part-time effective July 2020.
b
The subscriptions paid to HKIoD being professional membership fee paid to an institution that is essential
in keeping abreast of current developments in the profession and are of regular use and benefit in the
performance of her duties as a director is deductible as an extra-statutory concession.
c
The housing allowance is fully taxable under s.9(1)(a).
d
Other benefits from the company, including the fully maintained car with a driver, medical and health
insurance, domestic helper, utilities and mobile phone provided by the company are not assessable as these
were payments made by the company to discharge its liabilities and not convertible to cash.
e
The £5,000 donations made to Manchester University Just Giving is not deductible as the donation is not to an
approved charitable institution in Hong Kong.
f
The s.26E home loan interest is deductible up to the maximum amount prescribed of HK$100,000 even
though Wendy only lived in the dwelling for part of the year.
g
Wendy is maintaining her daughter who is attending full-time education at a university; thus, she is eligible to
claim the child allowance.
h
Wendy maintained and cared for her mother who lives with her. She is eligible to claim DPA and additional
DPA under ss.30(1) and (2).
i
Capped at HK$20,000.

Wendy Tang
PST computation
Year of assessment 2020/21
HK$ HK$ HK$
Net assessable income (from preceding information) 3,827,900
Less: Concessionary deduction
Approved charitable donation (capped at 35% of B) (90,000)
Home loan interest (100,000)
Contributions to mandatory MPF (18,000) (208,000)
Net income C 3,619,900
Less: Personal allowances
Basic allowance (132,000)
Child allowance a
(120,000)
Parent allowance a
(100,000) (352,000)
Net chargeable income 3,267,900
PST at progressive rates (Schedule 2)a:
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000

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On next HK$50,000 14% 7,000

HK$200,000 16,000
Balance HK$3,067,900 17% 521,543
D 537,543
PST at standard rate (C × 15%) E 542,985

PST payable (lower of D and E) 537,543

a
Under s.63C(1), the provisional tax shall be calculated based on the 2020/21:

• progressive tax rates on Wendy’s 2020/21 net assessable income less the concessionary deductions and
allowances; or

• standard tax rate on her net income,

whichever is lower.

Wendy Tang
Final tax assessment for 2019/20 and provisional
tax for 2020/21
HK$
Final tax payable 2019/20 517,543
PST paid (480,000)
Final tax payable 37,543
PST for year of assessment 2020/21 537,543
Total tax payable 575,086

QUESTION 5
(a) Home loan expense is deductible if a taxpayer paid interest on a loan obtained to
acquire a property used as his or her primary residence (s.26E(9)). With regards to
L1, Rich can claim the home loan interest deduction for the period he lived in the
residence, that is, up to 30 September 2019. When he moved into his friend’s place, the
Stanley property was no longer his primary residence. Thus, interest paid thereafter on
L1 would no longer satisfy the criteria for a home loan deduction.

To be deductible under s.26E, the lender must be an approved institution listed

in s.26E(9). His uncle is not an approved lender and, thus, the interest on L2 is not
deductible as a home loan interest.

L3 was not applied for the acquisition of his Central apartment. It was used
to repay his uncle. As such the interest paid on L3 would not be deductible under
s.26E. S.26E(9), which defines home loan to mean ‘a loan of money which is applied
wholly or partly for the acquisition of a dwelling....’

(b) As the Stanley property was jointly held by Rich and Rachel, the interest of HK$120,000
is deemed to be paid in accordance with the ownership ratio (ss.26E(2)(b)). Thus, Rich
can only claim 50% of the home loan interest pertaining to the period from 1 April 2019
to 30 September 2019 for the year of assessment 2019/20 computed as follows:

6 1
HK$120, 000 HK$30, 000.
12 2

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QUESTION 6
(a) The ince.ntive payment of HK$300,000 is taxable to Mr. Kim as it related to a payment
made to him to induce him to provide services to KC2 – Fuchs, Walter Alfred Heinz v CIR
(2011) HKCFAR 74. However, the amount of HK$300,000 would only be assessable to
Mr. Kim after the 12-month bond period, that is, October 2021. The Board in D26/07
upheld this position. The Board held in D26/07 that a payment contingent on a person
having served a full 12 months from the date of employment could not be taxed until
he or she has received it when the 12 months has lapsed.

Alex Kim
Salaries tax computation
Year of assessment 2019/20
HK$ HK$ HK$
Salary 760,000 s.9(1)(a)
Bonus 150,000
Transport allowance 96,000
Child education 112,000 ss.9(1)(a),
(2A)(b)
A 1,118,000
Rental value of housing (A × 10%) 111,800 s.9(1)(b),
(2)(a)
Accrued MPF scheme benefita 50,000 161,800 s.9(1)(ae)
Net assessable income b
B 1,279,800
Less: Concessionary deduction –
Approved charitable donation (capped (10,000)
at 35% of B)
Contributions to MPF (18,000) (28,000)
Net income C 1,251,800
Less: Personal allowances
Married person’s allowance (264,000)
Child allowance c
(360,000) (624,000)
Net chargeable income 627,800
Tax at progressive rates (Sch 2):
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 12% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$427,800 17% 72,726
C 88,726
Tax at standard rate (C × 15%) D 187,770
Tax payable (lower of C and D) 88,726
Less: 100% tax reduction s.100(41) d
(20,000)
Net tax payable 68,726

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a
Mr. Kim’s total service years with his employer in Hong Kong is five years. Under ss.9(1)(ae) and 8(2)(cc)(ii),
the accrued benefit in excess of the tax-exempt amount computed under s.8(5) below, would be chargeable to
­salaries tax:

60
Proportionate benefit HK$100, 000
120
HK$50, 000.

The amount chargeable to salaries tax is: HK$100,000 – HK$50,000 = HK$50,000.

b
Mr. Kim’s employer paid him HK$250,000 in July 2020. This is more of a gratuity in nature. The amount is assess-
able to Mr. Kim in the year of assessment he received the payment, that is, 2020/21 (s.11D(a)). However, under
s.11D(b)(i), Mr. Kim could have the amount related back to the service years at a constant rate up to a maximum
period of 36 months ending on his last day of employment with KC1, this date being the earlier date as compared
to the date he was entitled to it in July. Mr. Kim can check to see if it is beneficial to relate back this payment once he
has all the information relevant to his 2020/21 salaries tax filing. He can make the decision to relate back within two
years after the end of the year of assessment in which the payment is made, that is, no later than 31 March 2023.
c
Mr. Kim has two children; one of them was born in the year of assessment 2019/20, thus, he is eligible for a child
allowance in respect of each child and an additional child allowance of HK$120,000 in respect of his daughter.
d
Capped at HK$20,000.

QUESTION 7
(a)

Price at vest (A) HK$280

Strike Price HK$ (B): 148 151 191 206 Total
Option granted (C)
2/1/2016 2/1/2017 2/1/2018 2/1/2019
Vest date
2/1/2020 250 280 320 1,000
Gains HK$ (A − B) × C 33,000 36,120 28,480 74,000
Stock option notional gains HK$171,600

(b) The phantom shares were granted to Henry as a result of his employment with the
company and is thus income chargeable to salaries tax under s.9(1)(a). Phantom shares
are deferred bonus payment. Under s.11D(b)(i), Henry can apply in writing to the IRD
to have the payment related back to the periods in which the services, in respect of
which the payment was made, were performed or exercised. Given that the phantom
shares related to services for the past seven years, the maximum period he can have
the payment related back is three years at a constant rate ending on the date on
which he became entitled to the payment. This request for amendments is allowed
notwithstanding that his earlier assessments might have been conclusive and finalised.
S.11D(b)(i) provides that the application made under this provision for the adjustment
of an assessment shall, be regarded as a valid objection to the assessments issued
earlier. The following is the computation of the amounts to be assessed in the years of
assessment 2016/17 to 2019/20.

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Total no. of months (A) 36

Tax year Gratuity assessable No. of Period
B ÷ A × HK$2,370,000 months (B)
YA 2016/17 197,500 3 1/1/2017–31/3/2017
YA 2017/18 790,000 12 1/4/2017–31/3/2018
YA 2018/19 790,000 12 1/4/2018–31/3/2019
YA 2019/20 592,500 9 1/4/2019–1/1/2020
Total HK$ 2,370,000 36

(c)

Henry and Hanna Heinz Salaries tax

computations
Year of assessment 2019/20
Separate assessment Joint
assessment
Henry Hanna Total
HK$ HK$ HK$ HK$
Salary 2,300,000 480,000
Bonus 1,000,000
Phantom shares (see preceding Note b) 592,500
Other taxable benefits a
250,500
A 4,143,000 480,000
Rental value of housing (A × 10%) 414,300

Gains from stock option exercise (see 171,600

(a) on previous page)
B 4,728,900 480,000
Net assessable income 4,728,900 480,000 5,208,900
Less: Concessionary deduction
Approved charitable donation (300,000) (300,000)
(capped at 35% of B)b
Contributions to mandatory MPF (18,000) (18,000) (36,000)
Net income C 4,410,900 462,000 4,872,900
Less: Personal allowances
Basic/married person’s allowance (132,000) (132,000) (264,000)
Child allowance c
(240,000) (240,000)
Net chargeable income 4,278,900 90,000 4,368,900
Tax at progressive rates (Schedule 2):
On first HK$50,000 2% 1,000 1,000 1,000
On next HK$50,000 6% 3,000 2,400 3,000
On next HK$50,000 10% 5,000 5,000
On next HK$50,000 14% 7,000 7,000
HK$200,000 16,000 3,400 16,000
Balance HK$4,078,900 17% 693,413 708,713

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D 709,413 3,400 724,713

Tax at standard E 661,635 69,300 730,935
rate (C × 15%)

Tax payable (lower of D and E) 661,635 3,400 730,935

Less: 100% tax reduction s.100(1)d (20,000) (3,400) (20,000)
Net tax payable 641,635 – 641,635 710,935

a
Other taxable benefits include reimbursements of Henry’s medical insurance premium that is a contract
between Henry and the insurance company. The reimbursement is thus assessable under s.9(1)(a). Similarly,
the air tickets paid for Henry, Hanna and their twin daughters and the two-week accommodation in the UK
totalling HK$160,500 are taxable holiday journey benefits under s.9(2A)(c).
b
The donation can be claimed under Henry or Hanna but not both (ss.26C(1), (3)(a)). It is beneficial for Henry
to claim the approved charitable donation since Hanna can only claim up to HK$168,000 (35% of HK$480,000)
and her marginal rate is 12% without the deduction (lower than Henry’s 15%). Henry is taxed at the standard
rate of 15%, the donation deduction effectively reduced his tax payable by HK$45,000 (HK$300,000 at 15%).
c
Henry or Hanna can claim child allowance as their twins though 20 years of age, are attending full-time
university. Since Henry’s income level has resulted in him being taxed at the standard rate of 15% (with no
allowances deductible), it is desirable for Hanna to claim the child allowances (s.31(3)).
d
Capped at HK$20,000.

QUESTION 8
Given that Calvin is on an assignment and his assignment negotiation, execution and
enforceability are outside of Hong Kong, it should not be an issue for his employer to
structure his employment as a non-Hong Kong employment. With a non-Hong Kong
employment, Calvin will only be taxed in Hong Kong on the income which is attributable to
services rendered in Hong Kong, including leave days attributable to the Hong Kong services
(s.8(1A)(a)). The IRD uses the time basis of apportionment rule, that is, based on days he
is in Hong Kong to determine the income (including leave pay) chargeable to salaries tax
(DIPN No. 10 (Revised), para. 29).

With regards to his compensation package, housing when provided by an employer

whether through direct rent payments or rent reimbursements is taxed at a deemed value,
which is 10% of the remuneration from the employer after deducting employment expenses
wholly, exclusively and necessarily incurred in producing the income and depreciation
allowances (ss.9(1)(b), 9(1A)(a) and 9(2)).

Certain benefits can also be provided tax-free if structured in accordance with the
provisions of ss.9(1)(a)(iv) and (2A)(a) that exclude from salaries tax any amount paid by
an employer to or for the credit of a person not being the employee in discharge of the
sole and primary liability of the employer to that person. Note that this exclusion is on the
proviso that the benefit is not capable of being converted into cash. Further, this exclusion
does not apply to payments for holiday journey, for example, home leave (s.9(2A)(c)) and
child education (s.9(2A)(b)). The common benefits provided tax-free to an employee in Hong
Kong are fully maintained company car, the provision of medical and health insurance,
utilities, telephone, domestic helper, corporate club membership, use of company assets, for
example, holiday home and boat for private purposes.

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 5
Property Tax

CHAPTER TOPIC LIST

5.1 Property Tax Overview 5.3 Allowable Deductions

5.1.1 Scope of Charge 5.4 Relief and Exemptions
5.1.2 Property Letting Amounting
5.4.1 Government and Consular
to a Business
Properties
5.1.3 Deduction of Property Tax from
5.4.2 Corporations
Profits Tax
5.4.3 Approved Charitable Bodies
5.1.4 Special Circumstances
5.4.4 Chief Executive in Council
5.2 Assessable Value of Land or
5.5 Property Tax Computation
Buildings or Land and Buildings
5.2.1 Special Elements of a Rental 5.6 Obligations of Property Owners
Agreement
5.2.2 Ascertaining the Assessable
Value

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LEARNING OUTCOMES

PRINCIPAL LO2: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES FOR
PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT AND STAMP
DUTY IN HONG KONG
LO2.01: D
 escribe, explain and analyse the following tax issues as they impact and interact
on transactions, individuals and entities: Property tax: Scope of property tax charge
2.01.01 Explain the scope of charge of property tax
2.01.02 Determine whether property letting amounts to a business
2.01.03 Explain whether the scope should cover properties like indefeasible right of use of satellites
or undersea cables
2.01.04 Explain the property tax implications for alternative bond schemes
2.01.05 Describe and apply the relief and exemptions available under property tax
2.01.06 Apply DIPN No. 14 and 50
LO2.02: D
 escribe, explain and analyse the following tax issues as they impact and interact
on transactions, individuals and entities: Property tax: Chargeable property and owners
of land and/or buildings
2.02.01 Explain an owner of a property as defined under the IRO
2.02.02 Describe the obligations of a property owner under the IRO
2.02.03 Apply DIPN No. 14
LO2.43: C
 alculate the following tax liabilities for transactions, individuals and entities: Property
tax: Ascertainment of property tax liability
2.43.01 Calculate the assessable value of a property
2.43.02 Calculate the allowable deductions
2.43.03 Calculate the net assessable value and the property tax payable, including provisional
property tax
2.43.04 Apply DIPN No. 4 and 14

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 P roperty T ax

OPENING CASE

THE YANG FAMILY AND PROFESSOR DUBOIS

M r. and Mrs. Yang live in Hong Kong. They have a grown-up daughter, Miss Yang, who lives
with them. They took out a mortgage in 2013 to purchase their first family home.

Mrs. Yang runs a boutique, Beautiful Clothing Ltd, in Causeway Bay. Beautiful Clothing Ltd
owns the boutique premise and has incurred certain expenditure on repairs and maintenance
during the current year of assessment. Beautiful Clothing Ltd has hired a merchandiser,
Mr. Lee; an accountant, Miss Cheung; and two sales staff, Miss Chan and Miss Wong.

Their daughter, Miss Yang, took a mortgage to invest in a property when she was working
as an office manager. The property has since been rented out as she is living with her parents.
Miss Yang left her job in February 2017 to pursue her passion for oil painting. Miss Yang had
spent six months in France for attending a short course on oil painting instructed by a famous
artist, Professor Dubois.

Mr., Mrs. and Miss Yang have been filing separate tax returns in the past years. Mrs. Yang’s
accountant, Miss Cheung, who is doing the Qualification Programme with the HKICPA told
her about both the risk of being required to pay property tax in addition to profits tax and the
availability of relief for double taxation.

In respect of Professor Dubois, he had spent two years in Hong Kong as the visiting scholar
at Hong Kong University in the 1990s. He acquired a corporation established in the British
Virgin Islands (BVI) to purchase a property in Pokfulam on Hong Kong Island during his stay in
Hong Kong. This property has been rented out for generating income since Professor Dubois
returned to France.

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OVERVIEW

You should have learnt the fundamentals of property tax in Module 9 – Principles of Taxation,
namely that it is charged on any owners of land or a building or of land and a building, situated
in Hong Kong at the standard rate based on the property’s net assessable value.

In this chapter, we will revisit the property tax fundamentals in a more comprehensive
manner, which includes the chargeability of property tax, its basis of assessment, the
compliance obligations of property owners, the relevant tax treatments on special items, such
as premium (i.e. lump sum payment) and irrecoverable rent, and the allowable deductions
in determining the assessable value and net assessable value for computing the property
tax payable.

Where a corporation derives income generated from letting or subletting of property

located in Hong Kong, such rental receipts earned are generally subject to profits tax due to its
amounting to a business. This would trigger a double taxation issue because the same rental
receipts should also be subject to property tax on the basis that the corporation is the owner.
To release the double taxation burden, we will discuss the mechanism under s.5(2)(a) for
applying for exemption from property tax on the basis that the same rental income has been
included in the corporation’s assessable profits subject to profits tax purposes.

Should the exemption be granted by the Inland Revenue Department (IRD), the corporation
would not require to file a separate property tax return nor pay the property tax due, but only
the relevant profits tax will be payable on the same rental receipts.

In the event that the exemption is not approved or the exemption is not granted before the
property tax is due and payable, the corporation will still require to pay the property tax due
upfront, but will be allowed to set off the property tax paid against its profits tax payable if the
rental income has been included in the assessable profits subject to profits tax (s.25). If there is
an excess of property tax paid over any profits tax payable, the amount in excess is refundable
to the corporation.

By the end of this chapter, you will be able to acquire an advanced level of understanding
on the property tax regime of Hong Kong and claim relief for being charged property tax in
addition to profits tax.

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5 . 1
PROPERTY TAX OVERVIEW

Pursuant to Part 2 of the IRO, property tax is charged for each year of assessment on the owner
of any land and/or buildings (‘property’) in Hong Kong at the standard rate (15% from the year
of assessment 2008/09 onwards) on the net assessable value of such property.

Practically speaking, property tax is generally paid only by individuals whose properties
are not part of the assets of their trades or businesses. Where properties are used for trade
or business purposes by individuals, taxpayers are permitted to set off the property tax
paid against their profits tax arising thereon in order to eliminate any possibility of double
taxation (s.25).

Rental income from properties owned by corporations are generally subject to profits tax
and exempt from paying property tax, provided the requisite exemption is claimed by making a
written application to the Commissioner of Inland Revenue (CIR) under s.5(2)(a) of the IRO.

There is a system of provisional property tax assessment that is based on the net
assessable value for the immediately preceding year of assessment. Provisional property tax
assessment is combined with the assessment for that preceding year of assessment.

The IRD has set forth its assessing practice on property tax and provisional property tax
in Departmental Interpretation and Practice Notes (DIPN) No. 14 (Revised) issued in March
2011. Additionally, the IRD has also released DIPN No. 4 (Revised) in February 2006 to cover its
position on the tax treatments on lease premiums, non-returnable deposits, key or tea money
and construction fees, and so on.

5.1.1 Scope of Charge

Property tax is charged for each year of assessment on every person being the owner of
any land or building (or land and buildings) wherever situated in Hong Kong and shall be
computed at the standard rate on the net assessable value of such land or buildings or land
and buildings for each such year (s.5(1)). The standard rate is 15% from the year of assessment
2008/09 onwards.

S.7A of the IRO defines ‘land or buildings’ or ‘land and buildings’ to include piers, wharves,
and other structures. The term ‘buildings’ is also defined to include any part of a building.
In practice, property tax is charged on all parts of buildings separately rated as tenements
under the Rating Ordinance (Cap.116). Thus, an owner of several apartments each of which is
separately rated will receive a separate property tax assessment for each apartment. There
is no mechanism for consolidated assessment to property tax on different lots of land and/or
buildings owned by the same person, except when they are leased out under a single tenancy
agreement.

5.1.1.1 Definition of Owner
Since property tax is assessed on the owner of any property situated in Hong Kong, it is crucial
to refer to the definition of ‘owner’ as provided by s.2(1) of the IRO. Accordingly, owner in
respect of land or buildings or land and buildings is defined to include the following:

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 TAXATION

• a person holding the land or buildings or land and buildings directly from the
government;

• a beneficial owner;

• a tenant for life;

• a mortgagor;

• a mortgagee in possession;

• a person with adverse title to land receiving rent from buildings or other structures
erected on that land;

• a person who is making payments to a co-operative society registered under the

Co-operative Societies Ordinance (Cap.33) for the purpose of the purchase of the land
or buildings or land and buildings;

• a person who holds land or buildings or land and buildings subject to a ground rent or
other annual charge;

• (in so far as common parts are concerned) a corporation registered under s.8 of the
Building Management Ordinance (Cap.344) or a person who, on the person’s own
behalf or on behalf of another person, receives any consideration, in money or money’s
worth, in respect of the right of use of any common parts solely or with another; and

• an executor of the estate of an owner.

5.1.1.2 Change of Ownership
Proof of ownership of property is generally established by reference to the registration thereof
with the Land Registry. In an event that a property has been sold but the assignment of such
property has not been updated with the Land Registry, the ownership of the property may
be evidenced by a legally executed sale and purchase agreement. Such an agreement may
not have to be registered with the Land Registry and, in some circumstances, there may only
be an ‘Instruction for Sale’ acknowledging the payment made by the purchaser pending the
completion of the formal sale and purchase agreement and conveyance.

Where the ownership of property has changed, it is important to determine the timing of
the transfer because this is critical for determining the allocation of property tax liability of the
previous and the new owner.

Generally speaking, ownership is taken to have passed on the date specified in the sale
and purchase agreement, although the title to the property should be regarded as transferred
on the date of the assignment deed. This timing difference between the date of the sale and
purchase agreement and the date of the assignment deed creates a duality of ownership in
that the seller of the property remains as the legal owner whilst the purchaser becomes the
beneficial owner.

In practice, the party who is entitled to receiving rental income from the property will
be charged to property tax and the date on which entitlement to rental income is to be
changed from the seller to the purchaser is generally determined in the sale and purchase
agreement.

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5.1.1.3 Joint Ownership and Husband and Wife

Property Tax is imposed on each property separately rated under the Rating Ordinance. Thus,
if a husband and wife each owns properties separately rated, each is separately assessed.
However, if they jointly own a property, they are jointly assessed.

5.1.1.4 Non-Resident Owner
Hong Kong generally has a territorial tax regime. Property taxation naturally lends itself
to territorial taxation because the property with respect to which it is chargeable is easily
identifiable and immovable. Given that property tax is charged on property situated in
Hong Kong and s.2(1) of the IRO defines owners without making any reference to their
residence status, the concept of tax residence is, therefore, not relevant for the purposes of
property tax unless any provision in any double tax agreement/arrangement (DTA) concluded
by Hong Kong with its trading partners has specific wording to override s.2(1).

Accordingly, an owner of property in Hong Kong is subject to property tax on any

consideration received in respect of the right of use of such property notwithstanding that such
owner may be:

• an individual who is a non-resident for Hong Kong tax purposes or has never visited
Hong Kong; or

• a corporation not carrying on any trade or business in Hong Kong.

Illustrative Example 1
Professor Dubois lives in and is a tax resident of France. He used a BVI company to
acquire a landed property in Pokfulam on Hong Kong Island during his tenure as the
visiting scholar at Hong Kong University in the 1990s. He rented the property out for
generating rental receipts after returning to France. Explain, with reference to the
relevant provisions of the IRO, whether Professor Dubois should be chargeable to
property tax in Hong Kong or not.

Pursuant to s.5(1) of the IRO, property tax shall be charged for each year of assessment
on every person being the owner of any land or buildings wherever situate in Hong Kong.
Property tax should be computed at the standard rate on the net assessable value of
such land or buildings for each such year. Since the BVI company is the legal owner of the
landed property situated in Hong Kong, it should be subject to property tax in respect of
the rental income earned by it.

The BVI company may be resident in France by virtue of Professor Dubois’s

management/control for the purposes of the Hong Kong–France DTA and, if it is, Article 6
of the DTA provides that Hong Kong has taxing rights over rental income derived from the
property, but does not exclude France from taxing the same income, subject to the grant
of tax credit against any French tax under Article 22.

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Key Learning Point

Property tax is charged on the owner of the property situated in Hong Kong, regardless of
the tax residency of the property owner, and is charged on each separately rated property
with no consolidated reporting mechanism, except when the properties are leased out
under a single tenancy agreement. Only joint ownership will be jointly assessed.

5.1.2 Property Letting Amounting to a Business

In DIPN No. 14, the IRD explains its views that the letting and subletting by a corporation and
subletting by any person other than a corporation would amount to a business. The relevant
rental receipt is therefore chargeable to profits tax under s.14 of the IRO. Whilst it is a question
of fact to be determined in each case, the IRD would consider the following circumstances as
strong indication of a business to be subject to profits tax:

• There are substantial numbers of properties let, and the owner has employed
employees to handle the tenancies matters;

• The properties are of a special usage, such as ballrooms, cinemas or restaurants,

and additional services are provided by the landlord who is also the licencee of the
ballroom, cinema or restaurant. Reference is made to Louis Kwan-nang Kwong & Carlos
Kwok-nang Kwong v. CIR (1982) 2 HKTC 541;

• The letting is conducted by a property dealer and the rents are regarded as income of
the property dealing business; or

• The letting is incidental to, and therefore part of the trade or business, such as would
be the situation of a trader who owns a property that he or she uses partly for trade,
and lets out that part which is surplus to his or her immediate requirements.

In the case of subletting, any rental income generated is chargeable to profits tax because
property tax cannot be charged due to the fact that a person who sublets the property is not
the owner of that property.

Key Learning Point

Letting and subletting by a corporation and subletting by any person other than a corporation
would amount to a business. The relevant rental receipts are subject to profits tax.

5.1.3 Deduction of Property Tax from Profits Tax

Pursuant to s.25 of the IRO, any property tax paid by a person in respect of a property is set off
against the person’s profits tax liability for that particular year of assessment, and any excess is
refunded to the person, if the person satisfies the CIR that:

• the profits derived from the property form part of the profits of the trade, profession or
business carried on by the person or

• the property is used or occupied by the person for the purposes of producing
chargeable profits.

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This arrangement is to avoid double taxation on the said consideration and to improve the
taxpayer’s cash flow position. Application has to be lodged to IRD in writing.

Illustrative Example 2
Yannick and Gisela are the oil painting classmates of Miss Yang. Yannick is a French
national, and Gisela is a German. They recently visited Hong Kong to attend an interview
for a postgraduate degree in Chinese painting at Hong Kong University. Given that they
plan to conduct further research in Chinese painting after attaining the postgraduate
degree, they expect to stay in Hong Kong for at least a few years. During this visit to
Hong Kong, they learned from Miss Yang that the potential return rate of investing in
the real property market in Hong Kong was higher than their respective home countries.
Thus, Yannick and Gisela plan to purchase two apartments, one for their own residential
purposes and another one for generating rental income for long-term investment
purposes under Gisela’s name. Yet as a foreign investor, Gisela has no idea about the
statutory obligations in holding a property in Hong Kong to generate rental income,
and whether she should hold the properties directly in her own name or via a limited
company incorporated in Hong Kong.

Required

Explain the possible types of tax to be charged with respect to rental income generated
by a Hong Kong limited company specifically used by Gisela for holding immovable
properties for the purposes of generating rental income in Hong Kong. Ignore any
implications of stamp duty on dutiable instruments in Hong Kong and any relevant taxes
charged in Germany.

Analysis

The Hong Kong limited company to be established by Gisela for holding the apartment
will be liable to property tax under Part 2 of the IRO in respect of the rental income
derived therefrom since it is the owner of the immovable property in Hong Kong.
Given the definition of ‘business’ under s.2 of the IRO includes, inter alia, letting by
any corporation to any person of any premises, the company is therefore prima facie
carrying on a business in Hong Kong and is chargeable to profits tax under Part 4 of the
IRO in respect of the relevant rental income.

Notwithstanding that the subject rental income may be chargeable to both property
tax and profits tax simultaneously, s.25 of the IRO can be applied to allow the property
tax paid therefrom, if any, to be utilised for setting off the profits tax liability of the
Hong Kong limited company for the same year. In addition, the company may apply for
exemption from property tax under s.5(2)(a) of the IRO if the rental income is reported as
assessable to profits tax. The exemption from property tax is to be further discussed in
Section 5.4.2.

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Key Learning Point

Property tax paid by a person in respect of a property is set off against its profits tax
liability for that particular year of assessment, and any excess is refunded to the person
if the person satisfies specific criteria. Also, a taxpayer can apply for exemption from
property tax but be charged to profits tax by writing to IRD if specific criteria are satisfied.

5.1.4 Special Circumstances

Where two or more persons are joint owners or co-owners of any property (whether as tenants
in common or joint tenants), each and every owner will have full responsibility for complying with
the requirements stipulated in the IRO for property tax purposes. Such requirements include, but
are not limited to, the filing of property tax returns and paying the property tax due, s.56A(1).

As s.56A(1) of the IRO does not relieve any person of any obligation under the IRO or
affect any right or obligation of the joint owners or owners in common as between them, it is
important to have a more thorough discussion on the issues arisen from the taxability of the
common area of buildings.

5.1.4.1 Common Parts of Buildings

Based on s.2(1) of the IRO, ‘common parts’ in relation to any land or buildings or land and
buildings is defined as:

(a) the whole of the land or buildings or land and buildings, except such parts as have been
specified or designated in an instrument registered in the Land Registry as being for the
exclusive use, occupation or enjoyment of an owner; and

(b) including, unless so specified or designated in the instrument mentioned in paragraph

(a), those parts of a building specified in Schedule 1 to the Building Management
Ordinance (Cap.344).

In DIPN No. 14, the following two Board of Review (BOR) cases were quoted in order to
provide more clarity on the tax compliance obligations among joint owners or co-owners of any
common areas of properties:

• In BOR case D80/02, it was held that an individual owner of a residential unit in
a building complex was a co-owner of the car parking spaces in the building and
therefore s.56A would be applicable to him.

• In BOR case D27/98, the ‘Incorporated Owners’ formed by the owners of a building
under the Building Management Ordinance (Cap.344) was ruled as the owner of the
common parts of the building.

Hence, the incorporated owners and the persons who receive income in respect of the right
of use of any common parts are specifically included in the definition of ‘owner’ under s.2 of the
IRO. They have to, therefore, fulfil all the tax obligations of a property owner.

In practice, the IRD will normally issue property tax returns and tax demand notes to
the incorporated owners in respect of the common parts. Where the building management
company of the building is responsible for collecting the income in respect of the common parts,
property tax will be assessed on or recovered from the building management company. Having
said that, the IRD may also raise assessments on the individual owners where appropriate.

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Key Learning Point

The property tax compliance obligations in respect of common parts of building have been
clarified with the support of case law.

5.1.4.2 Indefeasible Right of Use of Satellites or Undersea Cables

Under current commercial practice, an international telecommunications satellite or
undersea cable system is very often built and owned by a consortium of members instead
of any individual person because of the magnitude of the capital required and the advanced
technology involved. Access to the capacity usage of the satellite or the undersea cables
is generally obtained through joint ownership of a satellite or of submarine cables or an
indefeasible right of use (IRU) therein.

An IRU is a contractual agreement between the operators of a satellite or submarine

communications cables and its client. It usually gives the purchaser the right to bandwidth or
capacity on the satellite or the undersea cables, including the right to lease that capacity to
someone else but excluding any ownership rights. Generally, the IRU is granted for an extended
period of time equal to the expected lifespan of the satellite or the undersea cables. The costs
of an IRU usually include an upfront premium to cover the costs of construction of the satellite
or undersea cables concerned and the recurring fees to cover the operating and maintenance
costs of the equipment.

The taxability of the IRU of satellite or undersea cables is more relevant to profits tax and
will be covered in those related chapters accordingly because of the following reasons:

• Property tax is imposed on any owner of land or a building, or land and building, situated
in Hong Kong. Thus, any income related to an IRU of a satellite should be regarded as
outside the chargeable scope of property tax as stipulated in s.5 of the IRO; and

• The definition of land or a building, or land and building, as stated in s.7A extends the
coverage to include piers, wharves and other structures. As such, if an undersea cable
is connected to the land of Hong Kong, it may be argued that it falls under the aforesaid
definition and the property tax net. Having said that, the income derived through an
IRU of undersea cables is normally treated as trading profits generated by a consortium
instead of any rental receipt earned by any individual taxpayer.

In this connection, it appears to be more appropriate to discuss the taxability of this topic in
the context of profits tax. As a technical matter, however, the occupation of land by way of an
IRU may be regarded as a separate tenement for the purposes of the charge to property rates
under the Rating Ordinance and, it would follow, in principle, trigger a charge to property tax.

Key Learning Point

An IRU of a satellite is likely to be outside the chargeable scope of property tax. An IRU of
undersea cables is more appropriate under the discussion of profits tax given undersea
cables are typically owned by a consortium rather than an individual.

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5.1.4.3 Alternative Bond Schemes

Islamic finance refers to financial activities that are in compliance with the requirements,
restrictions and prohibitions imposed by Islamic Law, that is, Sharia compliant, a religious
concept that prohibits the payment of interest. Interest must therefore be ‘synthesised’
(i.e. replicated, usually by way of lease or similar periodic payments) in the context of
Islamic finance.

The IRO and Stamp Duty Ordinance were amended in 2013 in order to cover ‘sukuk’ (Sharia
compliant bonds) used in Islamic financial arrangements that are economically equivalent to
debt arrangement for Hong Kong tax and stamp duty purposes. The legislation enacted in 2013
adopted a religious-neutral approach and the term ‘Alternative Bond Schemes (ABS)’ is adopted
to denote the specific arrangements to which the tax treatments apply.

Under the ABS model, any income, expenditures, profits, gains or losses arising from
or attributable to the assets held by sukuk issuers are regarded as owned by the originator
for Hong Kong tax purposes. In this connection, any investment return is not regarded as
consideration payable in respect of the right of use of land or buildings or land and buildings
for property tax purposes in accordance with s.5B of the IRO. Thus, it is more appropriate to
discuss the tax treatments of ABS in the chapters of profits tax and stamp duty.

It is worth noting that the IRD has issued DIPN No. 50, namely, Taxation of Specified ABS,
and Stamp Office Interpretation and Practice Notes No. 6, ABS, to set out its views and practice
on the application of the ABS-related provisions in s.40AB and Schedule 17A of the IRO and the
interpretation and practice of relevant provisions in the Stamp Duty Ordinance, respectively.

Key Learning Point

ABS should be more relevant to the discussions on profits tax and stamp duty in light of
the nature of its income stream and the chargeable scope of property tax.

Knowledge Check Questions

Question 1
Identify which of the following properties is chargeable to property tax if it is rented out for
generating rental income.
A A cottage in Phuket, Thailand
B An apartment block in Tokyo, Japan
C A piece of land in New Territories, Hong Kong
D A commercial building in Sydney, Australia

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Knowledge Check Questions (continued)

Question 2
Identify the basis period for property tax.

Question 3
Identify which of the following scenarios should be charged to profits tax instead of
property tax.
A Madam Chiu, a retired certified public accountant, owns multiple apartments in
Okinawa, Japan. The apartments are rented out to tourists as bed and breakfast rentals
in the summer months.
B Miss Yang rented out her mortgage apartment and moved to live with her parents.
C Madam Kwok, a retired lawyer, owns multiple apartments in Tung Chung. She rented out
all these apartments to people working at the airport, particularly the pilots and flight
attendants. She hired her niece to handle all the tenancy administrative matters for her.
The business was also capable to provide removal services on a requested basis.
D Miss Chan owns a holiday house on Lamma Island. She rented it out occasionally to
long-stay tourists.

Question 4
Identify which of the following scenarios should be charged to property tax.
A Professor Dubois sublet two bedrooms of his house in France as bed and
breakfast rentals.
B Mr. and Mrs. Yang rented one bedroom of their home apartment to David, son of their
close friend living in Canada, for six months when David was an exchange student at
Hong Kong University.
C Madam Meyer, a well-known ballerina, owns a ballroom in Tsim Sha Tsui. She uses this
ballroom to facilitate the operations of her dancing school. Additionally, she often rents
out the property to other ballet dancers for either practising or teaching purposes.
D Amy, Miss Yang’s oil painting classmate from Hong Kong, owns her home apartment in
Shatin. She lives there with her parents.

Question 5
Define the ‘common parts’ of a property.

Question 6
Identify which of the following is not regarded as common parts of a property.
A Kitchen in an apartment
B Washroom in a club house
C Outer wall of a building
D Commercial annex of a housing estate

Question 7
Explain how sukuk is different from conventional bonds.

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5 . 2
ASSESSABLE VALUE OF LAND OR BUILDINGS
OR LAND AND BUILDINGS

The assessable value of any property is the consideration, in money or money’s worth,
payable in a relevant year of assessment, to the order of, or for the benefit of, the owner in
respect of the right of use of that property (s.5B(2)).

The term ‘consideration’ is defined in s.5B(6) to include any consideration payable in respect
of the provision of any services or benefits connected with or related to the right of use of any
property, such as management or services fees payable by a tenant to the owner. However, the
term ‘consideration’ is limited to money or money’s worth, that is, the consideration must be
in cash or something convertible into cash. Where the consideration is other than money, the
money’s worth thereof should be the fair market value of such consideration.

As the definition of assessable value includes consideration payable, this indicates that the
consideration should be accounted for under the accrual basis. This means that, so long as
the tenant is legally liable to pay the consideration in a year of assessment, such consideration
is required to be included in the property tax computation of the assessable value in that
year of assessment, even if the consideration is to be received by the owner in a subsequent
year. If the consideration turns out to be irrecoverable, the owner is entitled to a deduction
for bad debts under s.7C(1), which provides that in ascertaining the assessable value, if any
consideration payable in respect of the property is proved to the satisfaction of the assessor to
be irrecoverable in any year of assessment, the irrecoverable amount shall be allowable as a
deduction in that year of assessment.

It should be noted that it is irrelevant whether the consideration is actually paid to the owner,
as s.5B(2) states that the consideration may be payable to, to the order of, or for the benefit of
the owner. In this regard, it is sufficient that the consideration is payable in respect of the right to
use the particular property irrespective of whether the consideration is paid to the owner or to a
third party, as directed by the owner, or to the order of or for the benefit of the owner.

Regardless of the number of properties an owner has, and the taxable rental income
generated by each individual property, the assessable value of each property should be
computed separately and assessable to property tax correspondingly, unless the respective
properties have been leased out under a single tenancy agreement with an aggregate amount
of rental income for all of the subject properties.

5.2.1 Special Elements of a Rental Agreement

In addition to monthly rent paid to the landlord, there are other special elements in a typical
rental agreement and their respective treatment for property tax purposes is discussed in the
following:

1. Rental deposit: A landlord may, in practice, demand from a tenant a rental deposit that
is refundable upon the termination of the rental contractual terms. As a result of its
refundable nature, such rental deposit should not be regarded as an income element to
the landlord and hence not a consideration chargeable to property tax.

2. Premium (i.e. lump sum payment): Apart from rental deposit, it is also common that a
tenant is required to pay a premium in addition to the monthly rent. For property tax

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purposes, it is irrelevant whether the consideration is of an income nature (e.g. monthly

rental payments) or of a capital nature (e.g. premium on a lease). Unlike the rental
deposit, the premium (lump sum payment) is non-refundable to the tenant upon the
termination of the rental arrangement. It is therefore taxable for property tax purposes.

Premium is defined as any payment in respect of the right of use of property for
a period exceeding one year of assessment and is deemed to be paid on an equal
monthly instalment basis over the leased period of the right of use, or over three years
commencing at the start of the period of the right of use, whichever is the shorter (s.5B(4)).

3. Rent-free Period: It is also a common market practice for a tenant to be offered a

rent-free period that could last from a few days to months depending on the agreement
negotiated and concluded between the landlord and the tenant. Since the landlord
receives no income during this rent-free period, no property tax should therefore be
charged to this rent-free period.

On the spread of premium as discussed in (2), since s.5B(4) stresses on the right of
use as prescribed by the terms of the rental agreement, the rent-free period should be
included in the period for the spread of the premium due to the fact that the tenant has
already had the right of use of the property concerned during the rent-free period.

In respect of the deductibility of government rates paid by a landlord for the rent-
free period, it should be treated as deductible as long as the rent-free period is covered
by the rental agreement and the owner of the property agrees to pay in accordance
with s.5(1A)(b)(i) (See section 5.3 for further discussion on allowable deduction).

As a separate note, if the landlord is a corporation and subject to profits tax, it

would be required, for accounting purposes, to allocate an appropriate portion of the
rental income to this rent-free period according to the relevant Hong Kong Financial
Reporting Standard. In this connection, the relevant income and expenses are treated
as taxable and deductible accordingly (refer to Module 14, Chapter 3 on profits tax and
Module 11, Chapter 5 on recognising revenue).

Illustrative Example 3
Miss Yang let her flat for three years from 1 April 2018 for a premium of HK$480,000 and
a monthly rental income of HK$20,000. The assessable value of the flat for the years of
assessment (YA) 2018/19, 2019/20 and 2020/21 is as follows:

HK$
YA 2018/19
Rental income (HK$20,000 × 12 months) 240,000
Premium spread over (HK$480,000 × 12 ÷ 36) 160,000
Assessable value 400,000
YA 2019/20
Assessable value (same as YA 2018/19) 400,000
YA 2020/21
Assessable value (same as YA 2019/20) 400,000

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5.2.2 Ascertaining the Assessable Value

In ascertaining the assessable value of a leased property, the following examples of the sums
received or receivable by an owner should be included:

• Rent;

• Payment for the right of use of premises under licence;

• Premium (lump sum payment);

• Service charges, management fee, and others paid to the owner; and

• Owner’s expenditure, for example, repairs borne by the tenant.

S.5B(6) specifically includes as consideration any sum payable for the provision of any
services or benefits connected with or related to the right of use of the property. Therefore,
management fees paid by a tenant to a landlord who rents out a building to different tenants
and who provides management services to all the tenants in the building should be included
in ascertaining the assessable value. If it is the tenant’s responsibility to pay management fees
as provided in the rental agreement, the fee paid should not be included in computing the
assessable value, when, although it is paid through the landlord, the landlord merely acts as an
agent for the tenant and does not end up earning the money.

Where the tenancy agreement is silent as regards the party who shoulders the
responsibility of paying the management fee, but the established fact shows that the landlord
is accustomed to paying the management fee to the management service provider out of
the lump sum he receives monthly from the tenant and that he has no right to claim for a
repayment from the tenant, only the net sum received by the landlord (as reduced by the
management fee paid by him) would be included as consideration payable in respect of the
right of use of the relevant property.

Under s.7C(2), any bad debts (i.e. irrecoverable rent) previously approved by the IRD
assessor and deducted as irrecoverable in the prior year of assessment, but which are
subsequently recovered during any year of assessment, should be treated as consideration
payable in the year of assessment that they were recovered.

Key Learning Point

This section covers the ascertainment of the assessable value of a property, including the
tax treatments on those special elements of a rental agreement, including rent, payment
for the right of use of premises under licence, premium (lump sum payment), owner’s
expenditure, irrecoverable rent and management fee, and so on.

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Knowledge Check Questions

Question 8
Identify which of the following is not chargeable to property tax.
A Lump sum payment received by a landlord
B Payment for the right of use of premises under licence received by a landlord
C Management fees paid by tenant as per the agreed terms of the rental agreement
D Jewellery in lieu of monthly rent

5 . 3
ALLOWABLE DEDUCTIONS

The following two items are allowable deductions for deriving the net assessable value (NAV) of
a property for property tax purposes.

1. Government rates agreed and paid by the owner (subject to rates concession,
if any); and

2. A one-off statutory allowance (also known as ‘statutory deduction’) of 20% of the

assessable value after deducting rates, if applicable. The statutory allowance is deemed
to cover all the related expenses incurred by the owner of the property and, thus, all
other actual expenses including repairs, management fees and mortgage loan interest
will not be separately considered for property tax purposes.

Government rent levied under the Government Rent (Assessment and Collection)
Ordinance (Cap.515) is non-deductible for property tax purposes.

Up to this point, you have learned all the sums received or receivable by an owner of a
property situated in Hong Kong, which should be chargeable to property tax. Furthermore, you
have also learned the allowable deductions for ascertaining the assessable value and the net
assessable value for deriving the property tax liability.

Apply and Analyse 1

Let’s walk through the following question in respect of Professor Dubois’s property
located in Pokfulam for applying the relevant knowledge attained. As mentioned in
Illustrative Example 1, Professor Dubois used a BVI company to acquire the property in
Pokfulam on Hong Kong Island during his tenure as the visiting scholar at Hong Kong
University in the 1990s. He rented out the property for generating rental receipts after
returning to France.

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Apply and Analyse 1 (continued)

The terms of the existing tenancy with Dr. Chan are as follows:

• Term: 1 April 2018 to 31 March 2020;

• Rent: HK$45,000 per month;

• Refundable deposit: HK$90,000, being two months of the rent;

• Rates: HK$6,000 per quarter (payable by the landlord); and

• Management fee: HK$4,000 per month (payable by the tenant).

Given that Professor Dubois does not live in Hong Kong, he has engaged with a
local property management agent to assist the BVI company in handling all the leasing
administrative works, such as looking for a new tenant, negotiating and concluding tenancy
agreement, collecting the rental receipts, preparing and filing property tax returns and
dealing with the tenant in respect of any renovation and repairing needs, and so on.
According to the agency service agreement concluded, the BVI company pays 5% of the
gross rental income as the service fees to this agent.

Professor Dubois agreed that rates should be payable by the landlord because of their
government levy nature. However, he has taken a different view on the management fee in
that it should be borne by the actual user of the property, that is, the tenant.

From 1 April 2019 onwards, Dr. Chan moved out of the property without any prior
notice and did not pay rent thereafter. Despite the fact that the service agent had
contacted Dr. Chan many times and issued a recovery notice to him, they received
no response at all. The property was finally vacated on 15 July 2019 and rented to a
visiting scholar of HKU from 1 September 2019 to 31 March 2020 under the same terms
mentioned above. On 30 September 2019, the BVI company received the IRD assessor’s
satisfaction that the 3.5 months of rents outstanding from Dr. Chan was regarded as
irrecoverable.

The BVI company received a profits tax return for the year of assessment 2018/19
from the IRD. However, it refused to complete the profits tax return and requested
the IRD to issue a property tax return to it for the same year of assessment on the
following grounds:

1. It is the legal owner of the property and derives rental income from the letting of it.
As such, it should be subject to property tax instead of profits tax.

2. It is a foreign corporation with no business carried on in Hong Kong except for

holding of an immovable property earning passive rental income. Therefore, it
should not be charged to profits tax in Hong Kong.

Required

Assuming that this BVI company has no other business activity apart from holding this
property located in Pokfulam, Hong Kong,

(a) Explain, with reference to the relevant provisions of the IRO, whether the BVI
company should be charged for property tax in Hong Kong.

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Apply and Analyse 1 (continued)

(b) If the BVI company is chargeable for property tax in Hong Kong, analyse, with
reference to the relevant provisions of the IRO, whether the BVI company is
entitled to claim any deduction for the years of assessment 2018/19 and 2019/20,
respectively. If yes, calculate the amount of each type of deduction.

Analysis

(a) S.5(1) of the IRO provides that property tax shall be charged for each year of
assessment on every person being the owner of any land or buildings wherever
situated in Hong Kong and shall be computed at the standard rate on the net
assessable value of such land or buildings for each such year. As the BVI company
is the legal owner of a landed property situated in Hong Kong, it should be subject
to property tax in respect of the rental income derived from the property.

(b) A total of three types of deductions are allowable to the BVI company under
property tax. S.5(1A)(b) of the IRO provides that any rates agreed to be paid by
the owner and those rates paid by the owner and an allowance for repairs and
outgoings of 20% of the assessable value after deduction of any rates paid can be
deducted when ascertaining the net assessable value. As such, the service fees
paid by the BVI company to the property management agent computed at 5%
of the gross rental income should be regarded as covered by this 20% statutory
allowance and no separate deduction is allowed.

Besides, s.7C(1) of the IRO provides that in ascertaining the assessable value
of any land or buildings for any year of assessment, there shall be deducted any
consideration payable to the owner and proved to the satisfaction of the assessor
to have become irrecoverable during that year of assessment.

(i) YA 2018/19

Under s.5(1A)(b) of the IRO, the BVI company is entitled to claim deduction
in respect of the rates paid by it and the amount allowable for deduction is
HK$24,000 (HK$6,000 × 4).

Also, the BVI company can claim deduction in respect of the 20%
statutory allowance and the amount allowable for deduction is HK$103,200
([HK$540,000 – HK$24,000] × 20%) for YA 2018/19.

Since the rent from Dr. Chan started to be irrecoverable from 1 April 2019,
that is, YA 2019/20 onwards, this bad debt issue did not affect the property tax
computation position of the BVI company for YA 2018/19.

(ii) YA 2019/20

Dr. Chan has defaulted payment of 3.5 months’ rent in respect of the period
from 1 April to 15 July 2019. As the property was vacated and the IRD assessor
had agreed to treat the outstanding rent as irrecoverable, the 3.5 months’
rent for the sum of HK$157,500 (HK$45,000 × 3.5) should be allowable as a
deduction in the year of assessment 2019/20. Assuming that the BVI company
had used the deposit of HK$90,000 to offset part of the irrecoverable rent, the
net irrecoverable rent became HK$67,500 (HK$157,500 – HK$90,000).

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Apply and Analyse 1 (continued)

The BVI company is entitled to claim deduction in respect of the rates paid
during the months that it has rental income generated, that is, the first 3.5
months under the lease with Dr. Chan and the seven months with the visiting
scholar. Hence, the deductible amount should be HK$21,000 (HK$6,000 ×
4 × 10.5 / 12).

Additionally, there is a 20% statutory allowance available to the BVI

company. The relevant deductible amount should be HK$76,800 ([(HK$472,500
– HK$67,500) – HK$21,000] × 20%).

Key Learning Point

When deriving the NAV, government rates are deductible but not government rent.
A one-off statutory allowance of 20% applies in computing the NAV. Actual amount of
expenditure incurred is disregarded.

Knowledge Check Question

Question 9
Identify which of the following is a non-deductible item for property tax.
A Government rates
B Government rent
C Bad debts
D Statutory allowance

5 . 4
RELIEF AND EXEMPTIONS

5.4.1 Government and Consular Properties

Property tax is not charged when the owner of the property is the government of the
Hong Kong Special Administrative Region. Further exemption is granted under the Consular
Relations Ordinance (Cap.557) to properties owned by foreign government consulates and
used as consular premises or residences.

5.4.2 Corporations
Under s.5(2)(a) of the IRO, any corporation carrying on a trade, profession or business in
Hong Kong may apply in writing to the CIR for an exemption from property tax, where it is

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entitled under s.25 to a set-off of the property tax that, if exemption were not granted under
s.5(2)(a), would be paid by the corporation.

The exemption provided under s.5(2)(a) only applies to corporations and not individuals,
partnerships, or other persons. The term ‘corporation’ is defined in s.2(1) to mean any company
that is either incorporated or registered under any enactment or charter in force in Hong Kong
or elsewhere, but does not include a co-operative society or a trade union.

An application under s.5(2)(a) should be made for each property and may be lodged, in
practice, when filing the property tax return, by the corporation making a statement to the
effect that the property is occupied or used by it for the purpose of producing the corporation’s
profits subject to profits tax.

Once an exemption is granted by the CIR, the corporation is exempted from property
tax in respect of the relevant property in all subsequent years until there is a change in the
circumstances, which renders the corporation ineligible for the exemption originally granted.

5.4.2.1 Clubs or Trade Associations

Pursuant to s.24(1), a taxpayer who owns a club or similar institution, which receives from
its members not less than half of its gross receipts on revenue account (including entrance
fees and subscriptions), shall be deemed not to carry on a business and thus not assessable
to profits tax (see Chapter 3, Section 3.10.6.7). If such a club or similar institution receives
less than half of its gross receipts from members, the whole of its income from transactions
both with members and others (including entrance fees and subscriptions) shall be deemed
to be receipts from a business and it shall therefore be chargeable in respect of the profits
therefrom.

Whilst s.24(2) stipulates that a person carries on a trade, professional or business

association in such circumstances that more than half its receipts by way of subscriptions
are from persons who claim or would be entitled to claim that such sums were allowable
deductions for the purposes of s.16, such person shall be deemed to carry on a business, and
the whole of the income of such association from transactions both with members and others
(including entrance fees and subscriptions) shall be deemed to be receipts from business, and
such a person shall be chargeable in respect of the profits therefrom.

In the IRBRD D84/04, a club, incorporated in Hong Kong as a company limited by

guarantee, allowed telecommunication companies to make use of its premises for installation
of equipment for providing communication services in return for considerations that were
received for YAs 1995/96 to 2000/01. The club was a private members’ club and derived
substantially more than 50% of its income from voting members during the relevant YAs.
Therefore, it was deemed as not carrying on a business in Hong Kong for profits tax purposes
in accordance with s.24. However, the IRD did issue property tax assessment for the YAs
mentioned. The decision of the BOR could be summarised as follows:

• Both ss.24 and 25 fell within Part IV of the IRO and they should be read together. S.24
deemed that the club was not carrying on a business, it must follow that the club did
not come within the scope of s.25, that is, it could not be entitled to relief under s.25
that applied only to those ‘carrying on a trade, profession or business’.

• Property tax and profits tax should be regarded as separate taxes and in the absence of
any express provision in the IRO or any applicable established taxing principle it must
follow that the club could not be relieved from property tax by virtue of s.24 alone.

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• S.25 was intended to provide relief from double taxation, that is, where property tax is
payable, any profits tax payable shall be reduced. Where no profits tax is payable, the
section has no application.

5.4.3 Approved Charitable Bodies

Charitable bodies recognised by the IRD or trusts of a public character are exempt from
property tax pursuant to s.88 of the IRO. A list of approved charitable bodies or trusts of a
public character is published in the Government Gazette on a periodical basis and a list is
maintained on the official website of the IRD.

5.4.4 Chief Executive in Council

By virtue of s.87 of the IRO, the chief executive of the Hong Kong Special Administrative Region
(HKSAR) in council may exempt any person, office or institution from payment of the whole or a
portion of the property tax liability.

Apply and Analyse 2

Let’s make reference to the scenario of Professor Dubois’s case mentioned in Illustrative
Example 1 and walk through the following questions together.

(a) If the BVI company is chargeable to property tax in Hong Kong, analyse if any
exemption from property tax is available to the BVI company assuming the rental
income is also chargeable to profits tax.

(b) Explain, with reference to the relevant provisions of the IRO, whether the BVI
company should be charged with profits tax in Hong Kong. If the BVI company is
liable for profits tax in Hong Kong, analyse if any exemption from profits tax can
be claimed by the BVI company, assuming the rental income is also chargeable for
property tax.

(c) Justify whether the BVI company is free to choose the type of tax to be charged
in Hong Kong in respect of the rental income derived from the letting of property
owned by it.

Analysis

(a) S.25 of the IRO provides relief to a person carrying on a trade, profession or
business in that any profits tax payable by such a person in respect of that year
of assessment shall be reduced by the amount of property tax paid. In addition,
under s.5(2)(a) of the IRO, any corporation carrying on a trade, profession or
business in Hong Kong shall, on application made in writing to the CIR, be entitled
to exemption from property tax in respect of any land or buildings owned by the
corporation where the corporation would be entitled under s.25 to a set-off of the
property tax paid.

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Apply and Analyse 2 (continued)

(b) S.14(1) of the IRO provides that profits tax shall be charged for each year of
assessment on every person carrying on a trade, profession or business in
Hong Kong in respect of his or her assessable profits arising in or derived from
Hong Kong for that year from such trade, profession or business. ‘Business’ is
defined under s.2(1) of the IRO to include letting or subletting of any premises
by any corporation. S.2(1) also defines ‘corporation’ to mean any company that is
either incorporated or registered under any enactment or charter in force in Hong
Kong or elsewhere.

There should be no dispute that the BVI company is a corporation and it

derived rental income from the letting of property. Pursuant to s.2(1) of the
IRO, the letting of property by the BVI company, being a corporation, already
constitutes a business. Given that the property concerned was situated in Hong
Kong, the business of letting must be carried on by the BVI company in Hong
Kong. As the source of the rental income is clearly in Hong Kong, it follows
that the profits of letting business of the BVI company should be chargeable to
profits tax in Hong Kong under s.14(1) of the IRO. There is no provision under
the IRO that provides relief or allows exemption from profits tax, except in
exceptional circumstance (e.g. a charitable institution).

(c) The BVI company is not entitled to choose the type of tax to be charged. Under
the provisions of the IRO, the BVI company should be charged to both property
tax and profits tax in respect of the rental income derived from the letting of
property. However, for the avoidance of double taxation, it can claim exemption
from property tax under s.5(2)(a) or reduction of profits tax payable by the amount
of property tax paid under s.25 as relief if the IRD demands both taxes at the
same time.

Key Learning Point

The following owners of property are exempt from property tax:

• HKSAR government;

• Foreign government consulates;

• Corporations that are chargeable to profits tax in respect of the rental income; and

• Approved charitable bodies.

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Knowledge Check Question

Question 10
Identify which of the following owners of property is not exempt from property tax.
A Hong Kong Community Chest
B Po Leung Kuk
C The HKSAR government
D Miss Yang

5 . 5
PROPERTY TAX COMPUTATION

Property tax is computed at the standard rate on the net assessable value (NAV) of any
property. The NAV and the property tax liability are arrived at using the following pro forma.
Please remember that property tax is computed on each individual property even though an
owner has owned more than one property, except that one tenancy has covered more than
one property.

Name of owner of a specific property

Property tax computation for year of assessment 20XX/XY
Basis period: 1 April 20XX to 31 March 20XY
HK$’000 Notes
Rental income A
Add: Premium (Lump sum payment) B
Fee for services provided by landlord C
Expenses paid by tenant on landlord’s behalf D
Bad debts recovered E
F =A+B+C+D+E
Less: Irrecoverable rent (Bad debt) (G)
Assessable value H =F–G
Less: Government rates paid by landlord (I)
J
Less: Statutory allowance at 20% of J (K) = J × 20%
Net assessable value (NAV) L
Property tax thereon at 15% of NAV M = L × 15%

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Apply and Analyse 3

Mr. Lee, the merchandiser of Beautiful Clothing Ltd, acquired a residential flat in Tai Wai
of Hong Kong with a mortgage loan obtained from a local bank. The apartment was let to
Betsy with the following terms:

• Period of lease: 1 April 2018 to 31 March 2020 (24 months);

• Rent-free period: 1 April 2018 to 30 April 2018 (1 month);

• Monthly rent: HK$25,000;

• Premium: HK$120,000 payable on 1 April 2018; and

• Government rates and rent: Payable by the landlord.

Despite taking legal actions against Catherine, a former tenant, Catherine did not settle
the outstanding rent of HK$75,000, being rent owed for the period from 1 November
2017 to 31 January 2018. Catherine was declared bankrupt on 30 April 2018. The
assessor accepted that the outstanding rent was irrecoverable when the tenant declared
bankruptcy.

On 1 June 2018, Mr. Lee received outstanding rent of HK$40,000 from, Derek, another
former tenant. The total amount owed by this tenant was HK$60,000 and this amount was
allowed as irrecoverable rent in the year of assessment 2015/16.

During the year ended 31 March 2019, Mr. Lee has incurred the following expenses:

• Government rates of HK$10,000 (after rates concession);

• Government rent: HK$8,000;

• Mortgage loan interest: HK$230,000; and

• Commission to property agent for the new tenancy: HK$25,000.

Required

Compute Mr. Lee’s property tax liability for the year of assessment 2018/19 with all your
workings shown. Ignore provisional property tax.

Analysis

Mr. Lee
Property tax computation for year of assessment 2018/19
Basis period: 1 April 2018 to 31 March 2019
HK$
Rental income (HK$25,000 × 11) 275,000
Add: Premium (HK$120,000 × 12 ÷ 24)) 60,000
Irrecoverable rent recovered 40,000
375,000
Less: Irrecoverable rent (Bad debt) (75,000)

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Apply and Analyse 3 (continued)

Mr. Lee
Property tax computation for year of assessment 2018/19
Basis period: 1 April 2018 to 31 March 2019
HK$
Assessable value 300,000
Less: Government rates paid by landlord (10,000)
290,000
Less: 20% Statutory allowance (58,000)
Net assessable value (NAV) 232,000
Property tax thereon at 15% of NAV 34,800

Apply and Analyse 4

Beautiful Clothing Ltd runs a boutique business in Hong Kong and all of its income is
chargeable to profits tax pursuant to s.14(1) of the IRO. The company owns its office
premises. On 1 April 2018, it let part of its office premises to Mr. Cha, a fashion designer, as
his creative studio, for a period of four years under the following terms:

• Monthly rent: HK$20,000 payable on the first day of a month;

• Lump sum payment (premium): HK$480,000 on 1 April 2018;

• Management fee: HK$4,000 per month paid by the landlord; and

• Government rates and rent: HK$5,000 and HK$4,000, respectively, per quarter paid
by the landlord.

During the year of assessment 2018/19, Beautiful Clothing Ltd has incurred the
following expenses related to the leased area of the office premises:

• Repairs: HK$40,000; and

• Renovation expenses: HK$105,000.

The accountant, Miss Cheung, has recently joined the company and noticed that
the company has not lodged any application for exemption from property tax. Beautiful
Clothing Ltd has derived an assessable profit of HK$1,000,000 for the year of assessment
2018/19. The above income and expenditure in relation to the leased area have been
included in the accounts of Beautiful Clothing Ltd and have been adjusted in the
ascertainment of its assessable profits for the year of assessment 2018/19.

Required

(a) Compute the property tax payable of Beautiful Clothing Ltd for the year of
assessment 2018/19. Ignore provisional property tax and any rates concession.

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Apply and Analyse 4 (continued)

(b) Compute the net profits tax payable/refundable of Beautiful Clothing Ltd for the
year of assessment 2018/19, if property tax for the year of assessment 2018/19 has
been paid. Ignore provisional profits tax and any tax reduction.

(c) Advise Beautiful Clothing Ltd on the conditions for an application for exemption
from property tax.

Analysis

(a) Beautiful Clothing Ltd

Property tax computation for year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Rental income (HK$20,000 × 12) 240,000
Add: Premium (HK$480,000 × 12 ÷ 36) 160,000
Assessable value 400,000
Less: Government rates paid by landlord (HK$5,000 × 4) (20,000)
380,000
Less: Statutory allowance at 20% (76,000)
Net assessable value (NAV) 304,000
Property tax thereon at 15% of NAV 45,600

Notes:

(i) The repairment expenses of HK$40,000 and renovation expenses of HK$105,000 incurred by
Beautiful Clothing Ltd are not allowed to be deducted separately for property tax purposes because
they are meant to be covered by the statutory allowance of 20% of the Assessable Value.

(ii) Under s.5B of the IRO, a premium received by the landlord may be spread over the shorter of:

• the lease term; or

• three years.

(b) Beautiful Clothing Ltd

Profits tax computation for year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Assessable profits 1,000,000
Profits tax thereon at 8.25% 82,500
Less: Property tax paid and set off per s.25 of IRO (45,600)
Balance of profits tax due 36,900

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Apply and Analyse 4 (continued)

(c) Under s.5(2)(a), a corporation carrying on a trade, profession or business in Hong
Kong is eligible to claim exemption from property tax by submitting a written
application to the CIR if the corporation would be entitled under s.25 to a set-off of
the property tax, which, if exemption were not granted under s.5(2)(a), would be
paid by the corporation. Under s.25, a person is allowed a set-off of the property
tax paid in respect of a property against its profits tax liability if:

• the profits derived from the property concerned are part of the assessable
profits of the trade carried on by the person; or

• the property is occupied by the person for the purpose of producing profits
chargeable to profits tax.

Apply and Analyse 5

Miss Cheung, the accountant of Beautiful Clothing Ltd, concluded a rental agreement to
lease her apartment to Mr. Williams, an expatriate, on 1 January 2017 for a term of three
years at a monthly rent of HK$20,000. Government rates (HK$1,500 per quarter after
concessions) were paid by Miss Cheung. From 1 February 2018, Mr. Williams did not pay
any rent. He then moved out of the property on 31 May 2018 and was untraceable.

The property was then let to Mr. Jenkins, another expatriate, on 1 July 2018 for a term
of 2.5 years under the following terms:

• Lump sum payment: HK$50,000;

• Monthly rent: HK$25,000;

• Rent deposit: HK$50,000;

• Management fee: HK$20,00 per month payable by landlord; and

• Government rates: HK$1,500 per quarter payable, after concessions, by landlord.

It was agreed by the IRD assessor that the rent owed by Mr. Williams was irrecoverable
after he had moved out from the property in May 2018.

Required

(a) Compute the property tax liabilities of Miss Cheung for the year of assessment
2018/19. Ignore provisional property tax.

(b) Explain to Miss Cheung the treatment of the irrecoverable rent as provided
under the IRO.

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Apply and Analyse 5 (continued)

Analysis

(a) Miss Cheung: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Rent (HK$20,000 × 2 months) (i.e. 1 April 2018–31 May 2018) 40,000
Rent (HK$25,000 × 9 months) (i.e. 1 July 2018–31 March 2019) 225,000
265,000
Premium (HK$50,000 × 9 ÷ 30) 15,000
280,000
Less: Irrecoverable rent (HK$20,000 × 4 months) (80,000)
Assessable value 200,000
Less: Government rates (HK$1,500 × 4 × 11 ÷ 12) (5,500)
194,500
Less: 20% Statutory allowance (38,900)
Net assessable value 155,600
Property tax thereon at 15% 23,340

Notes:
1. The rental deposit, being a refundable upfront payment, should not be included as part
of the considerations received by Miss Cheung for property tax purposes.
2. As Miss Cheung, the owner and landlord, agreed to pay the government rates in respect
of leased property, the total amount of government rates of HK$5,500 (HK$6,000 ×
11 ÷ 12) paid by her should be allowable for deduction from the assessable value
(s.5(1A)). Note that only 11 months of the government rates are deductible since the
property had only been rented out for 11 months during the year of assessment.

(b) In accordance with s.7C(1) of the IRO, if it is proved to the satisfaction of the IRD
assessor that the overdue rent has become irrecoverable, the irrecoverable rent is
allowed to be deducted from the assessed consideration in the year of assessment
that it becomes irrecoverable. It should not be set off directly with rental income.

Should the irrecoverable rent exceed the assessed consideration, the

excessive amount can be carried back and deducted from the assessable value
of the relevant land and/or buildings for the next most recent year of assessment
according to s.7C(3) of the IRO.

In case the amount of irrecoverable rent is recovered subsequently, the

recovered amount should be assessed in the year of recovery pursuant to s.7C(2)
of the IRO.

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Key Learning Point

Students should familiarise themselves with the pro forma of property tax computation.
They should also be reminded that property tax computation should be prepared for each
individual property for each individual YA instead of preparing according to the owner of
the property, except where one tenancy covers more than one property.

Knowledge Check Questions

Question 11
Briefly explain the treatment of bad debts in the property tax regime.

Question 12
Miss Yang leased out her mortgaged property from 1 April 2018 to 31 March 2019. The
monthly rent was HK$20,000. Compute the property tax liability of Miss Yang for the year
of assessment 2018/19.

Question 13
Briefly explain how premium (lump sum payment) is assessed according to the relevant
provisions of property tax in the IRO.

5 . 6
OBLIGATIONS OF PROPERTY OWNERS

DIPN No. 14 has set forth the following obligations of property owners, regardless of individuals
or corporations, and whether they are Hong Kong residents or not:

1. Filing of returns, s.51(1): Property owners are obligated to complete the property tax
returns issued to them with due care and submit the tax returns to the IRD within the
time limit stipulated in the tax returns (which is normally one month from the date
of issuing the return). A property owner must complete and submit the tax return
notwithstanding that the related property is occupied by the owner or any other person
without consideration.

2. Notification of chargeability to tax, s.51(2): Every person who is chargeable to property

tax for any year of assessment but has not received a tax return should notify the CIR
in writing that he or she is chargeable within four months after the end of that year of
assessment.

3. Notification of cessation of ownership, s.51(6): Where the ownership of the property has
transferred, the seller or the transferor is required to notify the IRD of the change in
writing within one month after the sale or transfer is effected.

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4. Notification of change of address, s.51(8): In the event that a property tax payer changes
his or her address, he or she should, within one month, inform the CIR in writing of the
particulars of the change.

5. Keeping of sufficient rental records, s.51D: The owner of a property is required to keep
sufficient records of rent received, such as rental agreements and duplicates of rent
receipts, to enable his or her property tax liability to be readily ascertained by the IRD.
The records mentioned should be retained for a period of not less than seven years.

6. Notification of change in exemption status, s.5(2)(c): The property owner must notify the
CIR in writing within 30 days of any change in the ownership or use of the property or
any other circumstances affecting the exemption previously granted if the owner is a
corporation exempted from property tax under s.5(2)(a).

7. Responsibility of joint owners or co-owners, s.56A: Where two or more persons are
joint owners or owners in common of any property, each and every owner is fully
responsible for fulfilling the obligations of a property owner as if the sole owner,
including the completion and submission of property tax returns and paying the
tax liabilities quantified. Moreover, this section does not relieve any person of any
obligation under the IRO or affect any right or obligation of the joint owners or owners
in common as between themselves. In addition, if any person has paid property tax for
which he or she would not have been liable except for the provisions of s.56A(1), he or
she may recover such tax from the person who is liable to pay it.

Key Learning Point

A property owner is required to comply with certain obligations as stipulated in the IRO
and DIPN No. 14.

Knowledge Check Questions

Question 14
Identify the timeline for notifying the IRD in respect of any change of the ownership of
a property.
A As soon as possible
B Within 15 days after the transaction is effected
C There is no need to separately notify the IRD as relevant information will be passed
along from the Land Registry
D Within one month after the transaction is effected

Question 15
Describe how long the rental records must be retained.

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SUMMARY

• Property tax is charged on the owners of land and/or buildings in Hong Kong and is computed
at the standard rate on the net assessable value of the property.

• The assessable value is computed by taking into account the consideration receivable by the
owner in respect of the right of use of the property. Examples of consideration to be included
in the assessable value are gross rent received or receivable, payment for the right of use of
premises under licence, lump sum premium, service charges or management fees paid to the
owner, and the owner’s expenditure paid by the tenant. While irrecoverable consideration
could be deducted, any sums previously deducted as irrecoverable and then recovered should
be treated as consideration in the year of recovery.

• The net assessable value is the assessable value less rates paid by the property owner and a
20% statutory allowance for repairs and outgoings.

• A corporation letting property in Hong Kong is regarded as carrying on business in Hong Kong
and should be subject to profits tax in respect of its property income. However, if the income
from property chargeable to property tax is included in the taxpayer’s profits for profits tax
purposes, or if the property owned by the taxpayer is occupied for producing the taxpayer’s
chargeable profits, the amount of property tax paid will be set off against the amount of
profits tax payable. Any excess property tax paid will be refunded.

• As an alternative, corporations carrying on a trade, profession or business in Hong Kong, on

application made in writing to the commissioner, may be exempt from paying property tax
that would otherwise be set off against their profits tax liability.

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MIND MAP

SCOPE OF CHARGE DEFINITION OF OWNER

Property tax is charged on the owner of any ‘Owner’, as defined in s.2 of the IRO, includes a
land and/or building situated in Hong Kong person holding the land and/or building directly
It is computed at the standard rate (currently from the government, a beneficial owner,
at 15%) on the net assessable value of the a tenant for life, a mortgagor and a mortgagee
chargeable property in possession, and so on

OBLIGATIONS OF PROPERTY OWNERS PROPERTY TAX COMPUTATION

PROPERTY TAX
DIPN No. 14 Net assessable value (NAV)
Specified the timeline for property tax All considerations in money or money’s worth
compliance administrative matters, such include, but not limited to, the following
as the filing of property tax return, records • Rent
retention, notifying the IRD regarding change • Payment of right of use of premises under licence
of property ownership and address, and so on • Lump sum premium

ALLOWABLE DEDUCTIONS RELIEFS AND EXEMPTIONS

Irrecoverable rent S.5(2)(a) exemption
Government rates S.25 relief
20% Statutory allowance INTERACTION WITH PROFITS TAX
Rental receipts earned from land and/or
buildings are subject to profits tax if such receipts
are earned from a trade or business carried on
by the recipient. The following transactions are
classified as carrying on a business
• Letting or sub-letting by a corporation
• Subletting by any other person

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. The property is not situated in Hong Kong.
Answer B is incorrect. The property is not situated in Hong Kong.
Answer C is correct. Only this property is situated in Hong Kong.
Answer D is incorrect. The property is not situated in Hong Kong.

Question 2
Property tax is charged for each year of assessment with a basis period from 1 April to
31 March of the subsequent year.

Question 3
Answer A is incorrect. The properties concerned are located outside of Hong Kong. Hence,
any income derived is outside of the chargeable scope of both property tax and profits tax.
Answer B is incorrect. The rental receipts earned by Miss Yang should be subject to
property tax.
Answer C is correct. The properties are located in Hong Kong, and Madam Kwok had
hired an employee to handle all the tenancy administrative matters and the provision of
additional services. Hence, the income derived should be subject to profits tax instead of
property tax.
Answer D is incorrect. The rental receipts earned by Miss Chan should be subject to
property tax.

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Question 4
Answer A is incorrect. The property concerned is not situated in Hong Kong and is
therefore outside the property tax net.
Answer B is correct. The rental receipts earned by Mr. and Mrs. Yang is subject to property
tax because they are the joint owners of the property concerned.
Answer C is incorrect. The rental income generated by the dancing school as an
incorporated business should be subject to profits tax instead of property tax.
Answer D is incorrect. No income has been derived in this scenario.

Question 5
Based on s.2(1) of the IRO, ‘common parts’ in relation to any land or buildings or land and
buildings is defined as:
• the whole of the land or buildings or land and buildings, except such parts as have
been specified or designated in an instrument registered in the Land Registry as
being for the exclusive use, occupation or enjoyment of an owner; and
• including, unless so specified or designated in the instrument mentioned in
paragraph (a), those parts of a building specified in Schedule 1 to the Building
Management Ordinance (Cap.344).

Question 6
Answer A is correct. It is not included in the definition of common parts in s.2(1) of the IRO.
Answer B is incorrect. It is included in the definition of common parts stipulated in s.2(1)
of the IRO.
Answer C is incorrect. It is included in the definition of common parts stipulated in s.2(1)
of the IRO.
Answer D is incorrect. It is included in the definition of common parts stipulated in s.2(1)
of the IRO.

Question 7
The main difference between sukuk and conventional bonds is that the issuance of
the latter does not require to be in compliance with the Sharia principles that prohibit
payments for use of money, that is, interest. To tackle this precept, alternative financial
arrangements have been developed to ensure that the return from many of these
arrangements is economically equivalent to interest.
Though commonly called Islamic bonds, sukuk are in essence the trust certificates
backed by Sharia-acceptable assets. The form of the documentation and the issue
process are similar to those of an issue of conventional bonds. However, the instrument,
rather than being a debt obligation, confers rights on the holders as beneficiaries under
a trust of the relevant asset backing the deal. The holders’ return is thus profit derived
from their beneficial ownership of the asset rather than interest on a debt. Many sukuk
are economically equivalent to conventional bonds, but some sukuk are non-debt
arrangements, such as equity instruments.

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Question 8
Answer A is incorrect. Lump sum payments received by a landlord should be treated as
consideration received by an owner of the leased property. Hence, it should be included in
ascertaining the assessment value for property tax purposes.
Answer B is incorrect. Payment for the right of use of premises under licence received
by a landlord should be treated as consideration received by an owner of the leased
property. Hence, it should be included in ascertaining the assessment value for property
tax purposes.
Answer C is correct. According to DIPN No. 14, if it is the tenant’s responsibility to pay
management fees as provided in the rental agreement, the fee so paid should not be
included in computing the assessable value even though it is paid through the landlord,
when the landlord merely acts as an agent for the tenant.
Answer D is incorrect. Jewellery should be regarded as money’s worth and its fair value
should represent the rental receipts.

Question 9
Answer A is incorrect. Government rates are deductible for property tax purposes.
Answer B is correct. Government rent levied under the Government Rent (Assessment and
Collection) Ordinance (Cap.515) is not deductible for property tax purposes.
Answer C is incorrect. Bad debts are deductible for property tax purposes.
Answer D is incorrect. Statutory allowance is deductible for property tax purposes.

Question 10
Answer A is incorrect. The Hong Kong Community Chest is a charitable institution as
recognised and approved by the IRD, hence is exempt from property tax.
Answer B is incorrect. Po Leung Kuk is a charitable institution as recognised and approved
by the IRD, hence is exempt from property tax.
Answer C is incorrect. Property tax is not charged to the HKSAR government.
Answer D is correct. Miss Yang, being the owner of her let property, is not exempt from
property tax on her rental receipts earned.

Question 11
In order to recognise an overdue rent as irrecoverable or bad debt for property tax
purposes, such amount is required to be proved to the satisfaction of the IRD assessor to
have become irrecoverable during that year of assessment for it to be deductible from the
assessable value (s.7C(1)).
If the bad debt amount is subsequently recovered, it is treated as assessable
consideration arising in the year of assessment in which it is recovered (s.7C(2)).
If the bad debt deduction exceeds the assessable value in the year in which it became
irrecoverable, the excess can be deducted from assessable value of the most recent
previous year, that is, carry back (s.7C(3)).

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Question 12
Miss Yang: Property tax computation for the year of assessment 2018/19
Basis period: 1 April 2018 to 31 March 2019

HK$
Rental income (HK$20,000 × 12) 240,000
Assessable value 240,000
Less: Statutory allowance at 20% (48,000)
Net assessable value 192,000
Property tax thereon at15% 28,800

Question 13
A premium or lump sum payment is a consideration received by an owner of a property,
generally at the commencement of a tenancy arrangement. Given that the premium
usually relates to the entire lease period and for a period of more than one year of
assessment, it is allowed to be spread over the shorter of:

• the lease term; or

• a maximum of three years, that is, 36 months.

Question 14
Answer A is incorrect. According to s.51(6) of the IRO, the IRD should be notified within
one month.
Answer B is incorrect. According to s.51(6) of the IRO, the IRD should be notified within
one month.
Answer C is incorrect. According to s.51(6) of the IRO, the IRD should be notified within
one month.
Answer D is correct. According to s.51(6) of the IRO and as explained in DIPN No. 14.

Question 15
A taxpayer/property owner must keep sufficient business records for at least seven years
of rent received in order to enable the relevant tax liability to be readily ascertained.
Those records are, but not limited to, rental agreements and duplicates of rent receipts,
and so on.

EXAM PRACTICE

QUESTION 1
Mr. Yip is a property investor currently owning four properties in Hong Kong held for
deriving rental income. The details of the property leasing matters for the year ended
31 March 2019 are as follows:

Property A

This is a shop purchased by Mr. Yip in early 2017. It was let to a tenant carrying on a
stationery retail business on 1 July 2017 on the following terms:

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• Term of lease: three years from 1 July 2017;

• Monthly rental: HK$100,000 payable in advance on the first day of each month;

• Premium: HK$120,000 payable on 1 July 2017;

• Deposit: HK$200,000 payable on 1 July 2017 and refundable upon completion of the
lease; and

• Rates: HK$6,600 per quarter (after the rates concession) payable by Mr. Yip.

During the year ended 31 March 2019, there was a water leakage in the shop and the
tenant had paid HK$25,000 to fix it. Mr. Yip refused to reimburse the amount to the tenant
notwithstanding that Mr. Yip as the landlord is responsible for the cost of repairs and
maintenance to the property under the tenancy agreement. Eventually the tenant deducted
the repair cost from the rental, and only paid HK$75,000 as rental in December 2018.

Property B

This is a residential flat acquired by Mr. Yip more than 10 years ago. Mr. Yip entered into a
new lease contract with a tenant on 1 April 2017 on the following terms:

• Term of lease: two years from 1 April 2017;

• Monthly rental: HK$18,000 payable in advance on the first day of each month;

• Deposit: HK$36,000 payable on 1 April 2017 and refundable upon completion of

the lease and

• Rates: HK$4,500 per quarter (after the rates concession) payable by Mr. Yip.

Due to financial difficulties, the tenant has only paid HK$10,000 per month as rental since
1 August 2017, and from 1 May 2018 the tenant did not pay any rent to Mr. Yip at all. The
tenant finally moved out from the flat on 1 July 2018 and at the same time Mr. Yip re-occupied
the flat and set it aside as vacant. Subsequent to the request made by Mr. Yip, the IRD finally
agreed to treat the outstanding debt as irrecoverable bad debt on 1 March 2019.

Properties C and D

Properties C and D are two independent residential flats adjacent to each other under
separate deeds. These two properties were purchased from a property developer in
September 2018 and, upon the acquisition, Mr. Yip immediately leased these two flats to a
tenant under a single tenancy agreement. The details are as follows:

• Term of lease: one year from 1 October 2018;

• Monthly rental: HK$20,000 in total for both properties payable in advance on the
first day of each month;

• Deposits: HK$40,000 payable upon commencement of lease and refundable upon

completion of the lease; and

• Rates: HK$3,000 for both properties per quarter (after the rates concession) payable
by Mr. Yip.

Required:

Compute the property tax liabilities of Mr. Yip for the year of assessment 2018/19. (Adapted
from Module D December 2014 paper)

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QUESTION 2
Mrs. Chan has been a housewife since getting married to Mr. Chan. As she had no property,
Mr. Chan specifically set out in his will that a residential property was to be passed to her
after his death. Mrs. Chan inherited that property upon the passing away of Mr. Chan in
September 2017. She subdivided that residential property into three cubicle rooms. Through
the introduction of the neighbours, Mrs. Chan knew Adrian, Benjamin and Clive and licenced
the cubicle rooms to them on the following terms:

Adrian Benjamin Clive

(Licence A) (Licence B) (Licence C)
Dates of the written licence 1/12/2017 1/4/2018 The terms of the
licence were verbally
agreed on 1/4/2018
Terms of the licence Two years from Six months Six months
1/12/2017 to from 1/4/2018 from 1/4/2018
30/11/2019 to 30/9/2018 to 30/9/2018
Monthly licence fees HK$5,000 HK$4,000 HK$3,000
Rates, government rent and To be paid by Mrs. Chan
management fees
Deposit Equivalent to one month’s licence fee to be paid by
Adrian, Benjamin and Clive on the commencement of
their respective licences. The deposits were to be held by
Mrs. Chan over the tenure of the licences. The licencees
agreed that the deposits would be forfeited to set off their
outstanding licence fees and the cost of repair if there was
damage to the cubicle rooms.
Usage To be possessed exclusively by the respective licencees.
As it is a residential property, the cubicle rooms can only be
used for residential purposes.
Provision of furniture by Mrs. Chan Nil

On its expiry, Licence B was renewed for a further two months to 30 November 2018
(Licence B1) at the same monthly licence fee. No written licence was entered into in respect
of Licence B1. Benjamin did not pay the licence fee for the month of November 2018.
He asked Mrs. Chan to use the deposit to offset the licence fee of that month.

Clive did not pay his licence fee from June 2018 onwards. He moved out of the property
on 30 November 2018. The assessor of the IRD accepts that Mrs. Chan is unable to recover
the licence fees from July 2018 and after.

Mrs. Chan handled the subdividing and the licensing matters on her own as the issues were
simple and straightforward. She appointed a decoration company and incurred renovation
costs of HK$10,000 in the year of assessment 2017/18 in subdividing the property into three
cubicle rooms and reconstructing the sewerage system. That aside, she paid the following
expenses in the year of assessment 2018/19 in licensing the cubicle rooms:

Rates HK$3,500 (after rates concession)

Government rent HK$7,000
Management fees HK$12,000

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Required:

Determine, with explanations in support, the type of tax that Mrs. Chan was chargeable
to and compute her tax liability for the year of assessment 2018/19 with respect to the
licence fees income. Mrs. Chan does not elect to have her income assessed under personal
assessment (ignore provisional tax and tax reduction for the year, if any).

(Adapted from Module D June 2015 paper)

QUESTION 3
Mr. Kitaguchi, Mr. Yang’s cousin, acquired a property in Kennedy Town on 1 February 2009,
right after the global credit crisis. The acquisition of this property was partly financed by a
mortgage loan. The property was let to Mr. Jenkins on 1 April 2017 for a term of two years at
a monthly rent of HK$28,000 payable in advance. Government rates of HK$3,600 per quarter
and management fee of HK$2,100 per month were payable by the tenant.

Mr. Jenkins failed to pay any rent after 1 October 2018, and he moved out of the premises
on 31 December 2018 after the following agreement had been made with Mr. Kitaguchi:

• Mr. Jenkins would pay all the rates up to 31 December 2018;

• Mr. Kitaguchi allowed Mr. Jenkins to settle the outstanding rent on or before
30 June 2019; and

• The management fees for the months of November and December 2018 were to be
paid by Mr. Kitaguchi.

After Mr. Jenkins moved out of the premises, the property was occupied by Mr.
Kitaguchi’s uncle, who came over from Japan to visit Hong Kong for 12 weeks, without any
rent. Both government rates and management fee incurred during this period were paid
by Mr. Kitaguchi’s uncle. Mr. Kitaguchi’s uncle gave Mr. Kitaguchi a gold bracelet worth
HK$50,000 for the right of use of the property during his visit.

After his uncle had moved out, Mr. Kitaguchi incurred a sum of HK$60,000 to redecorate
his property and carry out some minor repairs in March 2019. The property was then leased
out again to Mr. Leung on 1 April 2019 under the following terms:

• Rental period: 1 April 2019–30 September 2021;

• Monthly rent: HK$30,000 payable in advance;

• Premium (i.e. lump sum payment): HK$540,000 payable on 1 April 2019;

• Government rates: HK$3,800 per quarter payable by the landlord; and

• Management fee: HK$2,500 per month payable by the tenant.

Meanwhile, Mr. Jenkins declared bankruptcy on 1 May 2019. As a result, Mr. Kitaguchi
could not recover any rent from Mr. Jenkins. He had secured an agreement with the IRD
assessor that the outstanding rent owed by Mr. Jenkins was irrecoverable. Mr. Kitaguchi had
also paid mortgage loan interest of HK$140,000 and HK$155,000 to the bank for the years
ended 31 March 2019 and 31 March 2020, respectively.

Required:

(a) Advise Mr. Kitaguchi on the obligations of property owner under the IRO in respect of
the notification of chargeability of tax and the keeping of records of his rental income
from the property.

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(b) Advise Mr. Kitaguchi on the proper treatments of the rental income irrecoverable from
Mr. Jenkins as provided under the IRO.

(c) Compute the property tax payables of Mr. Kitaguchi for the years of assessment
2018/19 and 2019/20 with the assumption that Mr. Kitaguchi has not elected personal
assessment for these two years of assessment. Please disregard any provisional
property tax and government rates concession.

QUESTION 4
Mr. Chin and Mr. Tan co-own a property in Prince Edward with ownership ratio of 40% and
60%, respectively. The purchase of this property was mainly financed by a mortgage loan
with a local bank. The property had been leased out to Mr. Kim for quite a few years under
the following terms:

• Monthly rent: HK$20,000;

• Government rates: HK$3,000 per quarter payable by the landlord; and

• Management fee: HK$1,800 per month payable by the tenant.

Mr. Kim had suffered financial difficulties and was only able to pay HK$10,000 per
month since 1 February 2019. Although Mr. Kim had promised to pay back the outstanding
balance of the rent once his financial position improved and the owners had agreed to his
request, Mr. Kim had not paid any rent starting from 1 June 2019. Mr. Kim eventually moved
out of the property on 31 January 2020 and was then untraceable. It was agreed by the IRD
assessor that the rent owed by Mr. Kim was irrecoverable after he had moved out from the
property on 31 January 2020.

The property was re-leased out to Mr. Arndt on 1 March 2020 for a period of three years
under the following terms:

• Lump sum payment: HK$450,000 payable on 1 March 2020;

• Monthly rent: HK$25,000;

• Government rates: HK$3,000 per quarter payable by the landlord; and

• Management fee: HK$2,000 per month payable by the tenant.

The co-owners had incurred the following expenses during the years of assessment
2018/19 and 2019/20:

2018/19 2019/20
HK$ HK$
(i) Outstanding management fee owed by Mr. Kim 10,800
(ii) Repairs and decoration 6,500 20,000
(iii) Mortgage loan interest 60,000 82,000
(iv) Government rates 9,000 12,000

Mr. Chin elected for personal assessment for the years of assessment 2018/19
and 2019/20.

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Required:

(a) Compute the net assessable values transferred to personal assessment in respect
of the property owned by Mr. Chin and Mr. Tan for the years of assessment 2018/19
and 2019/20.

(b) Clearly state the circumstances where rental income derived by an individual from land
and/or building should be subject to profits tax instead of property tax.

QUESTION 5
Hywel owns an office unit in Admiralty. This unit was leased out on 1 March 2018 for three
years under the following terms:

Monthly rent: HK$80,000 per month; plus HK$10,000 per month for the usage of
furniture and IT related equipment
Premium: HK$360,000 paid on 1 March 2018
Rental free period: One month from 1 March 2018
Rental deposit: Three months of rental that is returnable to the tenant upon the expiry
of the lease agreement after deducting any outstanding rental in arrears
and any cost of damage made to the property
Government rent: HK$4,800 per quarter payable by landlord
Government rates: HK$8,000 per quarter payable by landlord
Management fees: HK$5,000 per month payable by tenant

Some additional information are listed as follows:

(i) When purchasing this office unit a few years ago, Hywel borrowed a loan of
HK$5,000,000 from a local bank for financing the acquisition. Hywel paid interest of
HK$250,000 on this bank loan for the year ended 31 March 2019.

(ii) Hywel has engaged a property service agent to manage the lease related affairs
on his behalf. The agent charges Hywel a monthly agency fee of 5% of the gross
monthly rental of the unit.

(iii) The agent discovered and informed Hywel that part of the office was sublet by the
tenant to a third party from 1 September 2018 onwards for a monthly rental of
HK$30,000.

(iv) HK$80,000 was incurred for some repairing works done for this office unit in
December 2018. This amount was shared equally by Hywel and the tenant.

(v) Since January 2019, the tenant has failed to make the monthly rent although
Hywel was advised that all outstanding rentals would be settled in the second
quarter of 2019.

Required:

(a) Prepare the property tax computation for Hywel for the year of assessment 2018/19.

(b) Advise to Hywel the tax treatments applicable to each of items (i) to (v) for property
tax purposes.

(c) State and explain the types of owner of property that are exempt from property tax.

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ANSWERS TO EXAM PRACTICE

QUESTION 1

Mr. Yip: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$ HK$
Property A
Rent (HK$100,000 × 12 months) (i.e. 1 April 2018–31 March 2019) 1,200,000
Premium (HK$120,000 × 12 ÷ 36) (i.e. 1 April 2018–31 March 2019) 40,000
Assessable value 1,240,000
Less: Government rates (HK$6,600 × 4) (26,400)
1,213,600
Less: 20% Statutory allowance (242,720)
Net assessable value 970,880
Property tax thereon at 15% 145,632

Property B
Rent (HK$18,000 × 3 months) (i.e. 1 April–30 June 2018) 54,000
Less: Irrecoverable rent {[(HK$8,000 × 9) + (HK$18,000 × 2)] – HK$36,000} (72,000)
Assessable value (18,000)
Net assessable value 0
Property tax thereon at 15% 0

Note:

Under s.7C(3) of the IRO, the excess of irrecoverable rent can only be used to offset the
assessable value of the same property in the latest year of assessment in which that
assessable value is sufficient, and cannot offset the assessable value of other properties
for the same year of assessment.

Properties C and D
Rent (HK$20,000 × 6 months) (i.e. 1 October 2018–31 March 2019) 120,000
Less: Government rates (HK$3,000 × 2) (Case No. D7/02) (6,000)
114,000
Less: 20% Statutory allowance (22,800)
Net assessable value 91,200
Property tax thereon at 15% 13,680
Total property tax due 159,312

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QUESTION 2
Mrs. Chan was the owner of the property as defined in s.2 of the IRO. The licence fees were
the consideration for the use of the property. Unless there was substantial evidence that
Mrs. Chan carried on a letting business, Mrs. Chan should be chargeable to property tax.

Her property tax liability in respect of the licence fees income is computed as follows:

Mrs. Chan: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Licence fee income from
Adrian (HK$5,000 × 12 months) 60,000
Benjamin (HK$4,000 × 8 months) 32,000
Clive (HK$3,000 × 8 months) 24,000
116,000
Less: Irrecoverable rent (HK$3,000 × 5 months) (15,000)
Assessable value 101,000
Less: Government rates (3,500)
97,500
Less: 20% Statutory allowance (19,500)
Net assessable value 78,000
Property tax thereon at 15% 11,700

QUESTION 3
(a) Pursuant to s.51(2) of the IRO, every person who is chargeable to property tax for any
year of assessment, but has not received a tax return, should notify the CIR in writing
that he or she chargeable within four months after the end of that year of assessment.

Meanwhile, s.51D(1) of the IRO provides that any person who is the owner of land
and/or buildings situated in Hong Kong is required to keep sufficient records in English
or Chinese of the rental income to enable the assessable value of that land and/or
buildings to be readily ascertained, and to retain such records for a period of not less
than seven years after the completion of the transactions, acts or operations to which
they relate.

The preservation of the above records is not required if:

• The CIR has specified that such rental records need not be preserved; or

• The corporation that was the owner of the property has been dissolved.

(b) According to s.7C(1) of the IRO, if it is proved to the satisfaction of the IRD assessor that
the overdue rent of Mr. Jenkins has become irrecoverable, the irrecoverable rent is
allowed to be deducted from the assessed consideration of Mr. Kitaguchi in the year of
assessment that it becomes irrecoverable.

Should the irrecoverable rent exceed the assessed consideration of Mr. Kitaguchi,

the excessive amount can be carried back and deducted from the assessable value of
the relevant property for the next most recent year of assessment pursuant to s.7C(3)
of the IRO.

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In case the amount of irrecoverable rent is recovered subsequently, the recovered

amount should be assessed in the year of recovery in accordance with s.7C(2)
of the IRO.

(c) Mr. Kitaguchi: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Rent (HK$28,000 × 9 months) (i.e. 1 April 2018–31 December 2018) 252,000
Gold bracelet 50,000
Assessable value 302,000
Less: 20% Statutory allowance (60,400)
Net assessable value 241,600
Property tax thereon at 15% 36,240

Mr. Kitaguchi: Property tax computation for the year of assessment 2019/20

Basis period: 1 April 2019 to 31 March 2020

HK$
Rent (HK$30,000 × 12 months) (i.e. 1 April 2019–30 March 2020) 360,000
Add: Premium (HK$540,000 × 12 ÷ 30 months) 216,000
576,000
Less: Irrecoverable rent (HK$28,000 × 3 months) (84,000)
Assessable value 492,000
Less: Rates (HK$3,800 × 4 quarters) (15,200)
476,800
Less: 20% Statutory allowance (95,360)
Net assessable value 381,440
Property tax thereon at 15% 57,216

QUESTION 4
(a) Mr. Chin and Mr. Tan: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Rent (HK$20,000 × 12 months) (i.e. 1 April 2018–31 March 2019) 240,000
Less: Rates paid by landlord (9,000)
Assessable value 231,000
Less: 20% Statutory allowance (46,200)
Net assessable value (NAV) 184,800
NAV transferred to personal assessment of Mr. Chin (at 40% of ownership) 73,920

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Mr. Chin and Mr. Tan: Property tax computation for the year of assessment 2019/20

Basis period: 1 April 2019 to 31 March 2020

HK$
Rent:
(HK$20,000 × 10 months) (i.e. 1 April 2019–31 January 2020) 200,000
(HK$25,000 × 1 month) (i.e. March 2020) 25,000
Add: Premium (HK$450,000 × 1 ÷ 36 month) 12,500
237,500
Less: Irrecoverable rent (see Note) (200,000)
Assessable value 37,500
Less: Rates (HK$3,000 × 4 quarters × 11 ÷ 12) (11,000)
26,500
Less: 20% Statutory allowance (5,300)
Net assessable value 21,200
NAV transferred to personal assessment of Mr. Chin (at 40% of ownership) 8,480

Note: Breakdown of irrecoverable rent

HK$
From February 2019 to May 2019 (HK$10,000 × 4 months) 40,000
From June 2019 to January 2020 (HK$20,000 × 8 months) 160,000
Total 200,000

(b) The following rental income derived by an individual will be subject to profits tax:

• subletting by an individual of:

(i) any premises or

(ii) portion of any premises

held by him under a lease or tenancy other than from the government of the
HKSAR; and

• letting and related activities carried out by an individual, which amount to carrying
on a trade or business as a matter of fact.

QUESTION 5
(a) Hywel: Property tax computation for the year of assessment 2018/19

Basis period: 1 April 2018 to 31 March 2019

HK$
Rent (HK$90,000 × 12 months) (i.e. 1 April 2018–31 March 2019) 1,080,000
Premium (HK$360,000 × 12 ÷ 36) (i.e. 1April 2018–31 March 2019) 120,000

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HK$
Repairing expenses paid by tenant 40,000
Assessable value 1,240,000
Less: Government rates borne by landlord (HK$8,000 × 4) (32,000)
1,208,000
Less: 20% Statutory allowance (241,600)
Net assessable value 966,400
Property tax thereon at 15% 144,960

Notes:

(i) The value assessable for property tax purposes for a year of assessment is the consideration in
money or money’s worth payable in that year of assessment to the owner of the property. Hence, the
aforementioned rent includes the fees of HK$10,000 per month charged for the usage of furniture and
IT related equipment.

(ii) Under s.5B of the IRO, a premium received by the landlord may be spread over the shorter of:

• the lease term; or

• three years.

(b) The property tax treatment applicable to each of the items are set forth as follows:

(i) Interest incurred in respect of bank loan borrowed for the purposes of acquiring
property is non-deductible for property tax purposes. Instead, a one-off statutory
allowance of 20% of the assessable value after deducting rates is provided. This
statutory allowance is deemed to cover all the related expenses incurred by the
owner of the property, and thus, all other actual expenses including repairs,
management fees and mortgage loan interest will not be separately considered for
property tax purposes.

(ii) Similar to (i) above, the service fees charged by the property service agent for
handling lease affairs are deemed to be covered by the aforementioned statutory
allowance. Hence, it is not separately allowed as a deduction.

(iii) The fact that the tenant has sublet the property for generating sublease income
should not affect Hywel’s property tax position. The tax implications of subletting
the property rests with the tenant instead.

(iv) The amount of the repairs expenses shared by the tenant is regarded as
discharging part of the landlord’s liability because repairs relating to the property
are regarded as the responsibility of the landlord. In this connection, the portion of
the repair cost shared and paid by the tenant should be treated as the additional
consideration earned by Hywel and assessable to property tax accordingly.

(v) Under current rules, bad debt deduction is allowed only when the taxpayer has
secured the IRD assessor’s agreement that the rental payment is irrecoverable.
Thus, no bad debt deduction will be allowed to Hywel’s property tax position for
the year of assessment 2018/19 on the basis that the property was still under lease
and the outstanding rental payment remained as ‘consideration payable’ to him,
although the tenant has defaulted on rental payment since January 2019.

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(c) The current property tax regulation provides the following types of relief and
exemption:

(i) Government: Property tax is not charged when the owner of the property is the
Government of the Hong Kong Special Administrative Region.

(ii) Consular: Pursuant to the Consular Relations Ordinance (Cap.557), properties

owned by foreign government consulates and used as consular premises or
residences are exempt from property tax.

(iii) Approved charitable organisations: Charitable bodies recognised by the IRD or

trusts of a public character are exempt from property tax in accordance with s.88
of the IRO.

(iv) Corporations: S.25 of the IRO provides relief to a person carrying on a trade,
profession or business in that any profits tax payable by such a person in respect
of that year of assessment shall be reduced by the amount of property tax
paid. In addition, under s.5(2)(a) of the IRO, any corporation carrying on a trade,
profession or business in Hong Kong shall, on application made in writing to the
CIR, be entitled to exemption from property tax in respect of any land or buildings
owned by the corporation where the corporation would be entitled under s.25 to a
set-off of the property tax paid.

(v) Owners with exemptions granted by the chief executive in council: By virtue of s.87
of the IRO, the chief executive of the Hong Kong Special Administrative Region in
Council may exempt any person, office or institution from payment of the whole or
a portion of the property tax liability.

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 6
Personal
Assessment

CHAPTER TOPIC LIST

6.1 Personal Assessment Overview 6.4 Benefits of Electing for Personal

6.1.1 What Is Personal Assessment? Assessment
6.4.1 How Personal Assessment May
6.2 Persons Who May Elect for
Personal Assessment Reduce Tax Liability
6.4.2 When Personal Assessment Is
6.2.1 Eligibility Criteria
Not Advantageous
6.2.2 A Married Taxpayer and
His/Her Spouse 6.5 Personal Assessment
6.2.3 Deceased Taxpayer Computations
6.5.1 Calculation of Total Income
6.3 Election for Personal
Assessment 6.5.2 Tax Computation Under
Personal Assessment –
6.3.1 How to Elect for Personal
Individual Taxpayer
Assessment
6.5.3 Tax Computation under
6.3.2 Time Limit for Election for
Personal Assessment –
Personal Assessment
A Married Couple

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LEARNING OUTCOMES

PRINCIPAL LO6: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES
FOR PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT
AND STAMP DUTY IN HONG KONG
LO6.01: Describe, explain and analyse the following tax issues as they impact and interact
on transactions, individuals and entities: Personal assessment: Election of personal
assessment
6.01.01 Explain the issues, including eligibility and application procedures, relating to personal
assessment election
6.01.02 Analyse how a taxpayer can benefit from a personal assessment election
6.01.03 Determine the different circumstances under which a personal assessment election is not
advantageous
6.01.04 Apply DIPN 18
LO6.02: Calculate the following tax liabilities for transactions, individuals and entities:
Personal assessment: Ascertainment of tax liability under personal assessment
6.02.01 Calculate total income and tax payable under personal assessment for individual
and spouses

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OPENING CASE

MR. AND MRS. YANG

M r. and Mrs. Yang live in Hong Kong. They have an adult daughter, Nicole, who lives with
them. Mr. Yang is a senior manager in an international company based in Hong Kong.
He took out a mortgage in 2015 to purchase their first family home.

Mrs. Yang is a sole proprietor of a boutique in Causeway Bay. She started small and her
business was doing well until the last two years, when she faced an increasingly competitive
retail environment. For the year of assessment 2019/20, the business suffered a loss. Besides
her business, Mrs. Yang owns an apartment that is rented out. The apartment was purchased
using bank financing. Mrs. Yang’s father lives in a registered nursing home in Hong Kong and
she pays for all his expenses.

Nicole took out a mortgage to invest in a property when she was working as an office
manager. The property has since been rented out as she is living with her parents. Nicole left
her job in February 2019 to pursue her passion for oil painting.

Mr. and Mrs. Yang and Nicole have been filing separate tax returns in the past years. In the
tax year 2017/18, Mr. Yang noticed that Mrs. Yang paid more taxes than him despite a lower
total income. Mrs. Yang’s accountant, who is studying the qualification programme with the
HKICPA, told her about personal assessment.

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OVERVIEW

In Chapters 3 to 5, we have learned how the income of an individual from trade, business,
profession, employment or office, as well as from pensions and property, are taxed under
the Hong Kong schedular tax system; that is, income from trade, business and profession are
subject to profits tax, income from an employment, office and pensions are charged salaries
tax and rental income is assessed property tax. This chapter deals with personal assessment,
an alternative method of taxing the aggregate income of an individual in a single combined
assessment. This alternative method of assessment may be advantageous to an individual
taxpayer and/or spouse as certain deductions, allowances, set-offs, as well as tax reductions,
may not be available when the income of the taxpayer and/or spouse are assessed separately
under the scheduler system of taxation. In particular, personal assessment enables individual
taxpayers to access the progressive tax rates of taxation prescribed for salaries tax – but not for
profits tax or property tax.

This chapter provides an overview of personal assessment, identifies the taxpayers who
are eligible to elect for personal assessment and the procedures and time limits to make
the election. The chapter explains and illustrates how a taxpayer can obtain tax savings by
electing for personal assessment under different scenarios and when personal assessment
may not be advantageous to the taxpayer. Guidance is also provided on the steps involved in
computing the total income, reduced total income and the tax payable for an individual as well
as a married couple under personal assessment. We shall further consider practical examples
to enable you to form a better understanding of the provisions in the IRO relevant to personal
assessment.

By the end of this chapter, you will be able to identify the taxpayers who are eligible to elect
for personal assessment, describe personal assessment, how and when an election should be
made, analyse and prepare the tax computations for both an individual taxpayer and a married
couple to make the determination as to whether a taxpayer and/or spouse would benefit from
a personal assessment on the basis of a given fact pattern.

6 . 1
PERSONAL ASSESSMENT OVERVIEW

Hong Kong has a schedular income tax regime with three taxing schedules; namely, profits tax
on business/trading income, salaries tax on employment income and pensions, and property
tax on rental income. The schedular system is distinguishable from the common personal
taxation regimes in many other countries whereby individual taxpayers are subject to one

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 P ersonal A ssessment

single income tax on their total taxable income, irrespective of the income type. Personal
assessment operates as a de facto, albeit limited, general income tax by aggregating all Hong
Kong sourced incomes for individuals.

6.1.1 What Is Personal Assessment?

Personal assessment is an alternative method to assess the income of eligible Hong Kong
resident individuals and married taxpayers. Under personal assessment, all assessable incomes
of a resident individual taxpayer and his/her spouse, if applicable, are aggregated and taxed in
a single assessment at the tax rates applicable to salaries tax (Exhibit 6.1).

Schedular System Personal Assessment

Profits Tax Property Tax Salaries Tax Aggregate all three
income sources
Business or Employment
Rental
Trading Income and Total Income
Income
Income Pension
Business/Trading Income + Rental Income +
Employment Income + Pension

Three different taxes

and three different
assessments
One single
assessment

EXHIBIT 6.1 Schedular system versus personal assessment

Key Learning Point

Personal assessment is an alternative method of computing the tax liability of a Hong Kong
resident individual and/or the individual’s spouse jointly whereby all taxable income types
are aggregated and taxed in a single assessment.

6 . 2
PERSONS WHO MAY ELECT FOR PERSONAL
ASSESSMENT

Personal assessment is available only to individual taxpayers. S.41 of the IRO sets out the
criteria an individual taxpayer must meet in order to elect for personal assessment. Essentially,
there are two key requirements, namely, age and residence.

6.2.1 Eligibility Criteria

Under s.41(1), individuals may elect for personal assessment if they meet the following criteria:

• aged 18 or above, or if under 18, both parents are dead; and

• either ordinarily resident in Hong Kong or a temporary resident

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For the purposes of personal assessment, s.41(4) defines a temporary resident as an

individual who stays in Hong Kong for a period/periods totalling more than:

• 180 days during the tax year in respect of which personal assessment election
is made; or

• 300 days in two consecutive tax years, one of which relates to the tax year in respect of
which personal assessment is elected.

The word ‘reside’ is defined in the Shorter Oxford English Dictionary as ‘to dwell
permanently or for a considerable time, to have one’s settled or usual abode, to live, in or at a
particular place’.

While the term ‘ordinarily resides’ is not defined in the IRO, case law has established that
the term ‘ordinary resident’ must be given its everyday meaning and whether a person is an
ordinary resident of a jurisdiction is a question of fact to be determined on a case by case basis.
There is extensive common law and Hong Kong case law on point, including:

• IRC v Lysaght (1928) AC 234: the taxpayer was an ordinarily resident in the United
Kingdom as a result of his regular monthly business visits for about a week over a
period of three years to attend board meetings of a company where he was a director.
In this case, the court held that despite the taxpayer having no permanent home in
the United Kingdom, he was a resident of that country. Here, the meaning of ‘ordinary’
was considered as opposed to ‘extra-ordinary’ and the court concluded that the
person’s frequent visits to the UK were regular and substantial and expected as long
as he remained on the board as a director, such that the visits were part of the normal
pattern of his life.

• Reg v Barnet London Borough Council ex parte Shah (1983) 2 AC 309: ‘ordinary resident’ is
to be construed in its ‘natural and ordinary meaning’ and ‘refers to a man’s abode in a
particular place or country which he has adopted voluntarily and for settled purposes
as part of the regular order of his life for the time being, whether of short or of long
duration’. Lord Scarman, page 343.

• Vallejos Evangeline B. v Commissioner of Registration and Another (2013) 2 HKLRD 533:

‘ordinary residence’ in each case is dependent on the legislative intent of the statute
in question. In the case of Vallejos, the court took into account the fact that foreign
domestic helpers entering and residing in Hong Kong were subject to highly restrictive
conditions that marked out foreign domestic helpers as a class as not ordinarily
resident. Here, the Court of Final Appeal adopted the contextual and purposive
approach in the interpretation of ‘ordinary resident’ over the established meaning in
common law.

In the Inland Revenue Department (IRD) pamphlet ‘A Brief Guide to Personal Assessment’,
the IRD has expressed its interpretation of ‘ordinarily resides’ on page 6:

A person will be regarded as ‘ordinarily resident in Hong Kong’ if he/she resides in Hong Kong
voluntarily and for a settled purpose (such as for education, business, employment or family, etc.)
with sufficient degree of continuity. Such person should habitually and normally reside in Hong
Kong, apart from temporary or occasional absences of long or short duration, and is living in Hong
Kong as an ordinary member of the community for all purposes of his/her daily life.

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The IRD’s interpretation is consistent with the position adopted by Hong Kong courts and
the board as shown in D11/15, where the taxpayer, his spouse and their three children applied
for emigration to an overseas country, C, in 1989. His wife moved to country C in 1992 and
returned to Hong Kong after acquiring the citizenship of country C. The couple’s children went
to country C for their education in the years 2003 and 2006. The taxpayer was a civil servant
and applied for retirement to join his children in country C in 2006.

The following are additional relevant facts:

• The taxpayer left Hong Kong in October 2006 and, since then, returned to Hong Kong
between one and four times a year, totalling 23 to 40 days’ stay in each year during the
years of assessment 2007/08 to 2013/14.

• His wife’s visits to Hong Kong ranged between 9 and 28 days each year over the
same period.

• He stayed in his Hong Kong property during each visit.

• He maintained his banking facilities in Hong Kong (loan, accounts, credit card and
safe deposit box services), Mandatory Provident Fund (MPF) membership, Hong Kong
driver’s licence and Hong Kong mobile phone number.

• The taxpayer received pension and rental income from Hong Kong during the years of
assessment 2008/09 to 2012/13 and elected for personal assessment.

The IRD assessed the taxpayer property tax for the years of assessment 2008/09 to 2012/13
on the basis that he is not eligible for personal assessment and the taxpayer appealed to the
board. The board considered the following and dismissed the appeal:

• ‘Ordinary resident’ must be considered in its original meaning and whether a person is
an ordinary resident of a country is a question of fact.

• When the taxpayer left Hong Kong to join his children in October 2006, his departure
cannot be considered as temporary but rather for settlement purposes.

• His infrequent visits and short duration of stay did not exhibit a sufficient degree of
continuity and could not be seen as habitually and normally residing as an ordinary
member of a community for all purposes of his daily life.

• Having the right to reside in Hong Kong does not necessarily mean ordinarily resident
in Hong Kong.

• That he had property at his disposal, bank accounts, an MPF bank account, a driver’s
licence and mobile phone number showed a connection with Hong Kong, but were
taken in the round insufficient to amount to ordinary residence.

6.2.2 A Married Taxpayer and His/Her Spouse

Prior to the year of assessment 2018/19, a married individual must elect for personal
assessment jointly with his/her spouse if both of them earned assessable incomes and did not
live apart from each other. This requirement has been relaxed from the year of assessment
2018/19. Under s.41(1), a married taxpayer who meets the age and residence requirements
may elect for personal assessment on his or her own.

S.41(1A) further provides that a married taxpayer not living apart from his/her spouse,
and where both of them have income assessable to tax and either one or both of them meet

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 TAXATION

the age and residence requirements under s.41(1), may elect for personal assessment jointly
with his or her spouse. S.41(1B) requires that if an individual or his/her spouse is chargeable
to salaries tax under s.10(3) (i.e. joint assessment for salaries tax), the individual may not elect
for personal assessment unless the individual and his/her spouse jointly make an election
under s.41(1A).

Under s.43(2B) any tax chargeable to a taxpayer and his/her spouse under personal
assessment shall be apportioned between them in accordance with the following formula (see
Illustrative Example 11 in Section 6.4.2):

Reduced income of spouse/Combined total reduced income Tax payable

However, any additional assessment (see Chapter 2 on additional assessment) shall be

issued to the taxpayer whose income is being assessed.

Note that a married taxpayer refers to a heterosexual married taxpayer or a same-sex

married taxpayer following the recent Hong Kong Court of Final Appeal case, Leung Chun Kwong
v Secretary for the Civil Service (2019) 22 HKCFAR 127 (see Chapter 4, Section 4.1).

Illustrative Example 1 – Additional Assessment under Personal

Assessment
Mr. Choi worked for a Hong Kong-based US software company and Mrs. Choi received
rental income from a small unit in Hong Kong in which she had invested. The couple
elected for personal assessment for the year of assessment 2018/19. Both Mr. and
Mrs. Choi received the 2018/19 notices of assessment in April 2020. Mr. Choi’s employer
did not reflect the stock option gains in his Form IR56B when Mr. Choi exercised his stock
options in January 2019. This error was subsequently reported to the IRD.

Although the total tax payable under personal assessment was allocated to Mr. and
Mrs. Choi based on their reduced income relative to the combined reduced income, the
notice of additional assessment would be issued to Mr. Choi under s.43(2B).

Further, where a married taxpayer and his/her spouse had elected for personal
assessment, an objection or appeal made in respect of any assessment raised as a result
of the election, is deemed to be made by both the taxpayer and his/her spouse jointly.

6.2.3 Deceased Taxpayer

In the case of an eligible deceased taxpayer, the deceased’s executor would have the same right to
elect for personal assessment on the deceased’s total income as would the person if still living.

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Illustrative Example 2 – Deceased Taxpayer

Master Huang, deceased, had a registered sole proprietorship business providing qigong
classes in Hong Kong. For the year of assessment 2019/20, the business made a loss
of HK$150,000. In the same year, he received rental income of HK$380,000 and paid
mortgage interest of HK$120,000 on his investment property. Master Huang died in July
2020 and his daughter, who works and lives in Singapore, is his executor.

Can Miss Huang elect for personal assessment on behalf of her late father? Under
s.41(2) of the IRO, Miss Huang would have the same right as her late father. Given that the
late Master Huang met the age and residence requirements, he would have been eligible
for personal assessment if he had not died. Therefore, Miss Huang is able to elect for
personal assessment on his behalf.

Exhibit 6.2 provides the decision flowchart to ascertain if a taxpayer is eligible to

elect for personal assessment under legislation which was in effect prior to the 2018/19
proposed change while Exhibit 6.3 provides the decision flowchart effective from the year
of assessment 2018/19.

An
individual

Age 18 or
above? no
Both parents no
dead?
yes
yes

Hong Kong
permanent or no
temporary
resident?
no
Married?
yes
no yes
Married?

yes
no
Living together?
Spouse is Hong
yes yes Kong
no
permanent or
Spouse has temporary
no
assessable resident?
income?

yes

Spouse meets
no age and
residency
criteria (above)?

yes

Joint election by
Taxpayer can make
both Taxpayer and Taxpayer is not
election on his/her
his/her spouse eligible
own (s.41(1))
(s.41(1A))*

EXHIBIT 6.2 Personal assessment eligibility prior to year of

assessment 2018/19

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Illustrative Example 2 (continued)

An
individual

Age 18 or
above? no
Both parents no
dead?
yes
yes

Hong Kong
permanent or no
temporary
resident?
no
Married?
yes
no
Married? yes

yes
Spouse is Hong
yes Kong
no no
Living together? permanent or
temporary
yes resident?

Spouse has
no
assessable
income?

yes

yes
Joint
no
assessment
under s.10(3)?
Spouse meets
age and
residency
criteria (above)?

yes
Joint election by
Taxpayer/spouse
both Taxpayer and Taxpayer is not
can make election on
his/her spouse eligible
his/her own (s.41(1))*
(s.41(1A) & (1B))

*Effective 2018/19, a married taxpayer may elect for personal assessment separately from
his/her spouse.

EXHIBIT 6.3 Personal assessment eligibility (s.41(1) and

s.41(1A) & (1B)) effective from the Year of Assessment
2018/19

Key Learning Point

An individual taxpayer must meet both the age and residence requirements to be eligible
for personal assessment.

Knowledge Check Questions

Question 1
Identify which of the following taxpayer(s) cannot elect for personal assessments.
A Mr. Yang was born in Hong Kong and Mrs. Yang is a Malaysian citizen. Mr. and Mrs. Yang
have their marital home in Hong Kong and would like to elect for personal assessment
for the year of assessment 2016/17.

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Knowledge Check Questions (continued)

B Mr. Lai is 17 years old and single. He moved from Guangzhou to Hong Kong to live with
his uncle when his parents died two years ago.
C Mr. Wong derived both salary and rental income. His wife has no income but has losses
brought forward from two years ago under personal assessment.
D James holds a Hong Kong passport. He relocated to Suzhou in 2015 but maintains his
investment property in Hong Kong. James fell ill and was admitted to the Gleneagles
Hospital in Hong Kong in January 2017. He died in March 2017. State whether James’s
executor can elect for personal assessment on his behalf.

Question 2
Answer the following questions.
(a) Mr. Yun is a sole proprietor and Mrs. Yun is a secretary at an accounting firm. Mr. and
Mrs. Yun elected for personal assessment for the year of assessment 2018/19 and
the notice of assessment along with the demand notes were sent to Mr. and Mrs. Yun
as follows:

• Mr. Yun – HK$20,000

• Mrs. Yun – HK$300

The assessor subsequently issued an additional assessment as there was an error

in the adjusted net profit. Identify who will be served the notice of additional
assessment.

(b) David Smith works as a regional IT manager and he travels frequently for work. His
wife, a Hong Kong resident, is a sole proprietor with a shop in Stanley market. Her
business made a loss of HK$240,000 and she has no other income in the year of
assessment 2017/18. State whether David can elect for personal assessment.

(c) Ms. Li, separated from her Hong Kong resident husband, returned to her parents’
home. State whether her husband can elect for personal assessment.

(d) Mr. Tam, an accountant, with Hong Kong property income, was seconded to his
employer’s main office in Melbourne, Australia, for 36 months or ‘such longer period
as mutually agreed upon’. The Australian office sponsored Mr. Tam under an employer
nomination permanent resident visa. He was paid by the Australian office during the
secondment and received Medicare (medical) benefits. Mr. Tam stayed in an apartment
that he purchased shortly after his arrival in Melbourne. Mr. Tam was actively involved
in his local football club in Melbourne, where he was a member. He returned to Hong
Kong every year for two to three weeks to visit his parents. After 36 months, in February
2019, Mr. Tam returned to Hong Kong as his ageing father’s health was deteriorating
quickly. State whether Mr. Tam can elect for personal assessment for the years of
assessment 2017/18 and 2018/19.

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6 . 3
ELECTION FOR PERSONAL ASSESSMENT

6.3.1 How to Elect for Personal Assessment

Election for personal assessment must be made in writing. The simplest way for a taxpayer who
wishes to elect for personal assessment is to complete Part 6 of his/her tax return for the tax
year concerned at the time the return is filed.

Alternatively, the taxpayer can make an election by completing Form IR76C ‘Election
for Personal Assessment and Claim for Deductions and Allowances’ within the time limits
stipulated in the IRO (see Section 6.3.2).

Married taxpayers electing for personal assessment must sign each other’s tax return or
the completed Form IR76C.

6.3.2 Time Limit for Election for Personal Assessment

S.41(3) stipulates the time limits within which a taxpayer can elect for personal assessment. The
taxpayer must lodge the written election with the commissioner within the later of:

• two years after the end of the year of assessment in respect of which an election is
made, for example, for an election relating to the year of assessment 2016/17, the
election must be made no later than 31 March 2019; or

• one month after an assessment of income or profits forming part of the taxpayer’s total
income for the year of assessment concerned becomes final and conclusive under s.70; or

• such further period, if any, as the commissioner may allow as being reasonable in the
particular circumstances.
Under s.64, a taxpayer has one month from the date of the notice of assessment to object
to the assessment issued if he/she disagrees with it. S.70 provides that an assessment becomes
final and conclusive if no objection was made within the time stipulated under s.64. ‘One
month after an assessment of income or profits’ becomes final and conclusive therefore means
two months after the issue of the notice of assessment, additional assessment or amended
assessment in the absence of an objection (see Chapter 2 on assessments).

It is important to note that a notice of assessment issued as a result of a subsequent

personal assessment election would not extend the objection time limits of any profits tax,
salaries tax or property tax assessments issued earlier, or affect the finality of income or profits
included in the overall income (s.64(7)).

Illustrative Example 3 – Time Limit for Election

On 30 December 2019, Mr. and Mrs. Yang’s tax representative advised them to lodge
an application for personal assessment in respect of the year of assessment 2017/18 as
it would generate significant tax savings for them. Incidentally, Mr. and Mrs. Yang had
received the salaries tax, profits tax and property tax notices of assessment on 1 January
2019. They did not object to any of the assessments issued.

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Illustrative Example 3 (continued)

Could Mr. and Mrs. Yang still lodge an application for personal assessment for the year
of assessment 2017/18 on 30 December 2019?

The relevant dates for Mr. and Mrs. Yang are:

• Two years after the end of year of assessment 2017/18. The end of the year
of assessment 2017/18 falls on 31 March 2018. Two years from then would be
31 March 2020.

• The due date for the lodgement of an objection is one month from the date of
the notice of assessment, in this case, 1 February 2019. Thus, the assessments
were final and conclusive on this date. One month from 1 February 2019 was
1 March 2019.

The later of the relevant dates was 31 March 2020. So Mr. and Mrs. Yang were able to
submit the election for personal assessment in respect of the year of assessment 2017/18
on 30 December 2019.

Apply and Analyse 1

As Mrs. Yang went through her documents to complete the Form IR76C, she noticed that
certain expenses were disallowed in arriving at the net assessable profit in her profits tax
assessment. Mrs. Yang would like to know if she could object to the expense disallowances
when the notice of assessment under personal assessment is subsequently issued.

Analysis

Under s.64(7), Mrs. Yang would no longer be able to lodge an objection to the profits tax
assessment issued to her on 1 January 2019. The due date for objection was 1 February
2019 and the assessment issued subsequently under the personal assessment election
would not extend the objection date for the profits tax assessment. The net assessable
profit was finalised and conclusive on 1 February 2019 and this amount would be included
in the total income for personal assessment purposes.

Key Learning Point

Personal assessment election must be made in writing either by completing Part 6 of the
taxpayer’s return or by lodging the completed Form IR76C within the time limits stipulated
in s.41(3).

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Knowledge Check Questions

Question 3
Miss Tsui, a Hong Kong resident, received salary income and rental income. Last month
Miss Tsui received the 2017/18 notice of amended assessment issued in respect of an
appeal that was recently resolved with the IRD. She was not aware of personal assessment.
Her niece told her to consider personal assessment and Miss Tsui would like to submit
her application to the IRD. Explain whether Miss Tsui can lodge her personal assessment
application for the year of assessment 2017/18.

Question 4
In preparing for the submission of Forms IR76C, Miss Tsui (mentioned in Question 3)
noticed that she had reported the wrong amount of net assessable value for her property
in her 2018/19 return. She has received the 2018/19 property tax assessment in January
2020. State whether Miss Tsui can object to the notice of assessment issued under
personal assessment on the basis that the property income was overstated for the year of
assessment 2018/19. Explain your conclusion.

6 . 4
BENEFITS OF ELECTING FOR PERSONAL
ASSESSMENT

6.4.1 How Personal Assessment May Reduce Tax Liability

As we have learned in earlier chapters, an individual’s income subject to property tax and
profits tax are assessed at the standard tax rate of 15% and the two-tiered rates of 7.5%/15%
(with effect from the year of assessment 2018/19), respectively. Income from employment or
office and pension is taxed at progressive rates prescribed in Schedule 2 on net chargeable
income or at the 15% standard rate on net income, whichever is lower under salaries tax. Note
that net chargeable income is net income less personal allowances under Part 5 (see s.12B). In
practice, personal assessment enables individual taxpayers to access the progressive rates of
salary tax, as distinct from the charges to profits tax and property tax, which are charged at the
flat standard rates. In circumstances considered in further detail below, personal assessment
can assist individuals who may otherwise be disadvantaged relative to salaried employees
whose only source of income is from an employment or office or pension by decreasing their
aggregate liability to income tax.

Under personal assessment, the total income of the taxpayer and/or spouse is reduced by
the following deductions to arrive at the reduced total income:

• Mortgage interest incurred on money borrowed to finance the purchase of the property
that generated the rental income, up to the net assessable value of the said property
(s.42(1)).

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• Concessionary deductions under Part 4A:

°° approved charitable donation (s.26C);

°° elderly residential care expenses (s.26D);

°° home loan interest (s.26E);

°° contributions to recognised retirement schemes (s.26G);

°° qualifying premiums paid under voluntary health insurance scheme (s.26K);

°° qualifying annuity premiums paid under a qualifying deferred annuity policy

(s.26O); and

°° tax deductible MPF voluntary contributions (s.26S).

• Current year business losses and losses brought forward from the prior year under
personal assessment.

For a married taxpayer, the inter-spouse transfer of unused concessionary deductions and
unutilised business losses set-off is applied to further reduce the taxpayer or his/her spouse’s
reduced total income.

As in the case of salaries tax, allowances under Part 5 are deducted from reduced total
income to arrive at total chargeable income. The tax payable is calculated by applying the
progressive tax rates prescribed in Schedule 2 on total chargeable income or the standard rate
on reduced total income, whichever is lower.

The s.100 one-time tax reduction available to profits tax and salaries tax assessments
is also extended to personal assessment. Exhibit 6.4 shows an overview of the benefits of
personal assessment.

Given the preceding deductions, inter-spouse transfer, allowances and one-time tax
reduction personal assessment may provide a tax saving to a taxpayer and/or spouse.

The following sections look at each benefit of personal assessment and how it may apply to
the taxpayer.

6.4.1.1 Rental Property Mortgage Interest Deduction

As we have learned in Chapter 5, property tax is charged on the net assessable value of the
property. Net assessable value is the income received from rental less any rates paid and
less the 20% statutory deduction for repairs and outgoings. Any interest incurred on moneys
borrowed to acquire the property is not deductible for property tax purposes. However,
under personal assessment, a taxpayer may claim the mortgage interest incurred on moneys
borrowed to finance the purchase of the property.

Specifically, s.42(1) provides that ‘there shall be deducted from that part of the total income
arising from paragraph (a) the amount of any interest payable on any money borrowed for the
purpose of producing that part of the total income’. S.42(1) allows the taxpayer with property
income to claim a deduction on the mortgage interest incurred up to the net assessable value
of the property under personal assessment.

The wording of s.42(1) requires the mortgage interest to be directly related to the rental
income. Thus, any interest incurred in period(s) where the property was not let out, that is, no
rental income produced, is not deductible.

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Net Assessable Value of

Assessable Profits Net Assessable Income
Rental Property
(Otherwise subject to (Otherwise subject to
(Otherwise subject to
Profits Tax) Salaries Tax)
Properly Tax)

Benefits of Personal
Total Income
Assessment

Deduction is otherwise not

Less: mortgage Interest on rental property (limited
available under Property Tax
to Net Assessable Value of each property)
assessment

Such deductions ore otherwise

Less: Concessionary Deductions under Part 4A of
only available under Salaries
the IRO
Tax assessment

Losses, spouse's unused

Less: current year adjusted losses and losses
concessionary deductions and
brought forward from previous year(s). if applicable
excess tax losses can be used
Less: unused concessionary deductions/excess tax
to reduce taxpayer's other
losses from spouse
types of Assessable Income

Reduced Total Income

Such allowancess are

otherwise only available under Less: Allowances under Part 5 of the IRO
Salaries Tax assessment

Total Chargeable income

Lower property and business Tax Payable = the lower of:

Income earners have access to progressive tax rates applied on Total Chargeable
lower progressive tax rates Income OR
standard tax rate on Reduced Total Income

Tax reduction is otherwise not

available under Properly Tax
— S.100(4) Tax reduction
assessment

EXHIBIT 6.4 Benefits of personal assessment

Illustrative Example 4 – Deduction Limited to ‘that part’ of Rental

Income and Net Assessable Value of the Property
Referring to the Opening Case, Nicole Yang’s previous tenant moved out at the end of
March 2019 when the lease expired. She took the opportunity to do some repair work on
her apartment. The renovated apartment was leased from 1 May 2019 for a monthly rent
of HK$30,000 and she paid monthly mortgage interest of HK$25,000 on the property.
Nicole did not pay any rates. The following illustrates the amount of mortgage interest
deductible for the year of assessment 2019/20 under s.42(1).

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Illustrative Example 4 (continued)

HK$
Assessable value (HK$30,000 × 11) 330,000
Less: 20% statutory deduction (s.5(1A)(b)(ii))  
(HK$330,000 × 20%) (66,000)
Net assessable value 264,000
Less: Deductible mortgage interest  
(HK$25,000 × 11a = 275,000)b (264,000)
Reduced assessable value Nil
Net chargeable income Nil
Tax payable Nil

a
 he mortgage interest relating to the month of April 2019 of HK$25,000 is not
T
deductible as the property was not let out during the month (s.42(1)).
b
Interest deduction is limited to the net assessable value of the property.

Had Nicole not elected for personal assessment, she would have had to pay property tax
amounting to HK$39,600 as computed below.

Property tax HK$

Net assessable value (as above) 264,000
Tax payable @ 15% 39,600

 y electing for a personal assessment, Nicole is able to claim the mortgage interest, which
B
would otherwise not be deductible under a property tax assessment. Nicole has no income
tax liability for the year of assessment 2019/20 under personal assessment.

In a situation where a taxpayer and/or spouse have multiple rental properties in Hong
Kong and interest was incurred on each of the properties, s.42(1) specifically limits the interest
deductions for each property to ‘that part’ of the rental income assessable, that is, the net
assessable value of each said property. Any excess would not be available for set off against the
taxpayer’s income from other rental properties or from any other income type.

Illustrative Example 5 – Deduction Limited to ‘That Part’ of Rental

Income and Net Assessable Value of the Property
Mr. Leung, married, and a Hong Kong resident, has three properties in Hong Kong
that he rented out for the full year. He inherited one of the properties from his
late grandfather and took bank financing to invest in two of his other properties.
The following are Mr. Leung’s rental income and mortgage interest for the year ended
31 March 2020.

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Illustrative Example 5 (continued)

Property Rental income Mortgage Net assessable
HK$ interest (A) value (B)
HK$ HK$
Royal Court, Mid-Levels 336,000 Nil 268,800
Lucky Building, Tsim Sha Tsui 222,000 100,000 177,600
Merton, Kennedy Town 312,000 450,000 249,600
870,000 550,000 696,000

Property 1 Property 2 Property 3 Total

HK$ HK$ HK$ HK$
Net assessable value (B) 268,800 177,600 249,600
Less: Mortgage interest (A = B if B ≤ A) Nil (100,000) (249,600)a
Reduced assessable value 268,800 77,600 0 346,400

a
 he excess interest incurred of HK$200,400 (HK$450,000 − HK$249,600) cannot be used to offset the net
T
assessable value of properties 1 and 2 under s.42(1).

 espite the limitation on interest deductible, Mr. Leung’s net assessable value has been
D
reduced from HK$696,000 to HK$346,400 under personal assessment.

Apply and Analyse 2

We have seen from the preceding example how s.42(1) applies to Nicole and Mr. Leung.
Let us now apply s.42(1) to Jack Poon.

In 2014, Jack bought his first property, Windsor Court in Hong Kong, through bank
financing. Since acquiring the property, he has rented it out and continued to live with
his parents. In 2017, he took out a second mortgage to finance the purchase of another
investment property, Parc Oasis, near his parents in Kowloon Tong. This apartment has
also been rented out since purchase. Jack proposed to his long-time girlfriend Lisa Lum in
2018 and they wanted to purchase their marital home jointly. Jack re-mortgaged Windsor
Court, the couple married and bought an apartment in Mid-Levels on 1 April 2019. Jack
provided his tax representative, Mr. Broad, with the following rental income and mortgage
interest details for the year of assessment 2019/20.

Property Rental Income (A) Net Assessable Value Mortgage Interest

HK$ (NAV) (80% of A) HK$
HK$
Windsor Court 240,000 192,000 180,000
Parc Oasis 228,000 182,400 190,000

Analysis

We have learned that under s.42(1) only that part of the interest payable on any money
borrowed for the purposes of producing that part of the rental income would be deductible
in computing the reduced total income under personal assessment.

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Apply and Analyse 2 (continued)

To comply with s.42(1), Mr. Broad would need to determine if the above mortgage
interest was fully incurred for the purposes of generating the rental income assessable
to tax. He noticed that the mortgage interest on Windsor Court was HK$50,000 when he
prepared Jack’s tax filing last year.

Jack told Mr. Broad he had re-mortgaged Windsor Court to secure additional borrowing
from his bank to finance the purchase of their residence in Mid-Levels on 1 April 2019.
Based on Jack’s bank statements, the interest on Windsor Court would have been
HK$40,000 for the year if Jack had not re-mortgaged the loan.

Based on the information provided, Mr. Broad computed the interest deductible under
s.42(1) as follows:

Property NAV Interest Amount deductible

under s.42(1)
HK$ HK$ HK$
Windsor Court 192,000 180,000 40,000a
Parc Oasis 182,400 190,000 182,400
a
 nly the interest relating to the money originally borrowed on Windsor Court qualifies for
O
deduction under s.42(1). The additional borrowing secured when the loan was
re-mortgaged was for a private purpose and not for the purpose of producing rental income.

Further, the interest deductible for Parc Oasis is limited to the net assessable value of
the said property.

In this case, Mr. Broad would look into claiming the mortgage interest incurred on the
acquisition of Jack’s residence in Mid-Levels (the interest not deductible under s.42(1)) under
s.26E, being home loan interest concessionary deduction. Home loan interest deduction is
capped at HK$100,000 for the year of assessment 2019/20 – see Section 6.4.1.2.

6.4.1.2 Part 4A: Concessionary Deductions

In Chapter 4, we saw how concessionary deductions can reduce a taxpayer’s assessable income
under salaries tax. Under s.42(2), the same concessionary deductions are allowable to a taxpayer
who elects for personal assessment under the same conditions as in the case of salaries tax.

To recap, Part 4A concessionary deductions are:

• approved charitable donations (s.26C);

• elderly residential care expenses (s.26D and Schedule 3C);

• home loan interest (s.26E and Schedule 3D);

• contributions to recognised retirement schemes (s.26G and Schedule 3B);

• qualifying premiums paid under voluntary health insurance scheme (s.26K and Schedule 3E);

• qualifying annuity premiums paid under a qualifying deferred annuity policy (s.26O and
Schedule 3F); and

• Tax deductible MPF voluntary contributions (s.26S and Schedule 3F).

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Given that the preceding deductions are not available under property tax or profits tax
(except for approved charitable donations which are allowable under profits tax), it would be
advantageous for a taxpayer and his/her spouse with income assessable to profits tax and
property tax and who have made the preceding payments to elect for personal assessment.
Under personal assessment, these deductions would reduce the taxpayer’s and his/her
spouse’s total income subject to tax. As in the case of salaries tax, the amount deductible under
each category is prescribed in the IRO (see Chapter 4, Section 4.6.6).

S.42(5)(c)(i) stipulates that any excess concessionary deductions over the total income
of a taxpayer cannot be carried forward to set off against future income of the taxpayer.
However, the excess could be set off against the taxpayer’s spouse’s total income
(s.42(5)(c)(ii)) – see Transfer of Excess/Unused Spouse Business Loss or Concessionary
Deductions in Section 6.4.1.3.

Illustrative Example 6 – Home Loan Interest and Elderly Residential

Care Expenses
Continuing from Illustrative Example 5 under Section 6.4.1.1, Mr. Leung told his tax
representative that he paid mortgage interest of HK$120,000 for the apartment he
lived in and he also paid HK$140,000 for the care of his 85-year-old grandmother at a
registered care home in Hong Kong.

From the Opening Case, for the year of assessment 2019/20, his tax representative has
computed Mr. Leung’s reduced total income under personal assessment as follows:

Property 1 Property 2 Property 3 Total

HK$ HK$ HK$ HK$
Net assessable value (B) 268,800 177,600 249,600
Less: Mortgage interest (A = B if B ≤ A) Nil (100,000) (249,600)
Reduced assessable value 268,800 77,600 0 346,400

Less: Concessionary deductions

– Home loan interesta (100,000)
– Elderly residential care expenses b
(100,000)
Reduced total income 146,400

a
The maximum deduction is HK$100,000 for the year of assessment 2019/20 (s.26E and Schedule 3D).
b
Deduction is capped at HK$100,000 for the year of assessment 2019/20 (s.26D and Schedule 3C).

6.4.1.3 Business Losses Set-off

There is no grouping of loss relief in Hong Kong. Business losses incurred in the carrying on of a
trade or business by way of sole proprietorship or partnership by a taxpayer and/or spouse in
one business is not transferable to another profit generating business for set-off. Each business
is assessed separately under the profits tax regime. The losses can, however, be carried
forward for set off against a future year’s profits of that same business or the taxpayer’s share

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of a future year’s partnership’s profits (see Chapter 3). Similarly, any business losses generated
(past or current year) by a taxpayer and/or spouse cannot be used to set off against income
assessed under salaries tax or property tax.

Current Year Business Loss

Under personal assessment, all types of income of an individual taxpayer that are chargeable
to Hong Kong tax, including business profits, are aggregated and taxed under one assessment.
In calculating the reduced total income of a taxpayer, any business loss or share of loss
incurred by him/her during the year would be deducted from his/her total income (s.42(2)).
Any unutilised loss can be carried forward to be set off against the total income of the taxpayer
in subsequent years (s.42(5)(b)(i)).

Illustrative Example 7 – Current Year Loss Set-off

Mr. Chan, a Hong Kong permanent resident, is a sole proprietor with two separate
registered businesses. Due to fierce competition from big online retailers, his camera
business made a loss of HK$400,000 for the year ended 31 March 2020. His mobile
phone business generated an assessable profit of HK$350,000. If Mr. Chan had not
elected for personal assessment, he would have profits tax liability for his mobile phone
business and a loss carried forward for his camera business as computed below:

Profits Tax Camera Mobile phones

HK$ HK$
Assessable profit/(Adjusted loss) (400,000) 350,000

Tax @ 15% Nil 52,500

Less: 100% tax reduction capped at HK$20,000 (s.100(2)) (20,000)
Net tax payable Nil 32,500
Loss carried forward (400,000) Nil

If Mr. Chan were to elect for personal assessment, his tax position would be as follows:

Personal Assessment HK$

Assessable profit/(Adjusted loss):
  Camera (400,000)
  Mobile phones 350,000
Reduced total income/(loss carried forward) (50,000)
Tax payable Nil
Loss carried forward (50,000)

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 y electing for personal assessment, Mr. Chan has no income tax to pay for the year of
B
assessment 2019/20, as he is able to deduct the loss incurred by his camera business from
the profit derived from his mobile phone business. The excess loss of HK$50,000 would be
carried forward to set off against his total income in future years (s.42(5)(b)(i)).

Transfer of Excess/Unused Spouse Business Loss or Concessionary Deductions

In Section 6.4.1.2, we learned that excess concessionary deductions are not available to carry
forward to be set off against the future year’s income of the taxpayer. In the case of a married
taxpayer electing for personal assessment, the excess concessionary deductions of one
spouse can be transferred to set off against the reduced total income of his/her spouse (see
s.42(5)(c)(ii)). Similarly, where a married taxpayer has taxable income and his/her spouse has
excess or unused business losses, the unused loss would first be transferred to the taxpayer
to reduce his/her reduced total income under personal assessment. Any excess loss after the
inter-spouse set-off would be carried forward in the spouse’s name for set-off against a future
year’s total income under personal assessment (s.42(5)(b)(ii)).

Illustrative Example 8 – Transfer of Excess Spouse Concessionary

Deductions and Business Loss
From the Opening Case, for the year of assessment 2019/20, Mr. Yang’s employment
income was HK$780,000 and he contributed to MPF. He also paid home mortgage interest
of HK$100,000. Mrs. Yang’s business generated a loss of HK$800,000 (computed in
accordance with Part 4 of the IRO). She received HK$35,000 per month from her rental
property and incurred mortgage interest of HK$300,000. Mrs. Yang also paid HK$140,000
for the care of her father at a local nursing home.

Election for Personal Assessment Mr. Yang Mrs. Yang Total

HK$ HK$ HK$
Salaries 780,000
Net assessable value of property (HK$420,000 less 336,000
20% statutory deduction)
Less: Mortgage interest (300,000)
Less: Concessionary deductions
– Home loan interesta (100,000)
– Contributions to MPF b
(18,000)
– Elderly residential care expenses c
(100,000)
662,000 (64,000)
Less: Current year business loss (800,000)
(864,000)
Less: Excess concessionary deductions and loss   64,000
transferred to spouse (s.42(5) (a)(ii)) (662,000) 598,000
Loss carried forward Nil (202,000)
Combined reduced total income Nil
Net chargeable income Nil
Tax payable Nil
a
Home loan interest deduction is capped at HK$100,000 (s.26E, Schedule 3D).
b
Deduction is limited to the mandatory contribution of HK$18,000 (s.26G).
c
Deduction is capped at HK$100,000 for the year of assessment 2019/20 (s.26D and Schedule 3C).

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 nder personal assessment, Mrs. Yang’s excess concessionary deductions and business
U
loss can be transferred to set off against Mr. Yang’s total income, resulting in no tax
payable for Mr. Yang.

Business Losses Carried Forward

In Section 6.4.1.3 we have learned that business losses can be brought forward to set off
against the total income of the taxpayer in future years when personal assessment is elected.

Should the taxpayer with losses brought forward have no income assessable to tax in
the following year, he or she would not be able to elect for personal assessment. However,
the loss brought forward would be available for set-off against the income of the taxpayer’s
spouse if he or she had elected for personal assessment in that following year as if there was
an aggregation of both parties’ income (see s.42(6)). Any excess loss after the set-off would be
carried forward under the name of the taxpayer.

The brought forward losses would continue to be carried forward to subsequent years if
the taxpayer had not elected for personal assessment in the following year.

Apply and Analyse 3

Example 1

Ken and Lin Wong are married and Hong Kong permanent residents. Ken works part-time
and manages two of his investment properties in Hong Kong. Lin operates a small café
in Wanchai as a sole proprietor. Ken’s parents, both 65 years of age and retired, live with
them throughout the year of assessment.

Lin has a business loss brought forward from the year 2017/18 of HK$350,000 after
setting off some of the losses available against Ken’s income for that year.

For the year ended 31 March 2019, Ken received a salary income of HK$120,000 and he
contributed HK$6,000 to MPF. His rental income and mortgage interest on the properties
were as follows:

Property located at: Rental income Mortgage interest

HK$ HK$
Central 360,000 250,000
Wanchai 240,000 100,000
600,000 350,000

In the same year, Lin’s café generated a small assessable profit of HK$50,000 (before
the loss brought forward of HK$350,000).

Analysis

Let us compute the net assessable value of Ken’s properties.

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Apply and Analyse 3 (continued)

Property located at: Rental income (A) Mortgage Statutory Net

HK$ interest deduction (B)a assessable
HK$ HK$ value (A – B)
HK$
Central 360,000 250,000 72,000 288,000
Wanchai 240,000 100,000 48,000 192,000
600,000 350,000 120,000 480,000

a
20% of (A) (See s.5(1A)(b))

Given that there would be excess losses brought forward for Lin, Ken and Lin elected
for personal assessment. The following is the tax computation under personal assessment.

Ken and Lin Wong

Year of assessment 2018/19

Personal assessment election Ken Lin Total
HK$ HK$ HK$
Net assessable value of property (as above) 480,000
Salary income 120,000
Assessable profit – Café 50,000
600,000 50,000

Less: Mortgage interest (as above)a (350,000)

Less: Contributions to MPF (6,000)
Less: Loss Brought forward (350,000)
Reduced total income 244,000 (300,000)
Less: Loss transferred to spouse s.42(5) (244,000) 244,000
Loss carried forward Nil (56,000)
Combined reduced total income Nil
Net chargeable income Nil
Tax payable Nil

a
 s the interest incurred on each property is less than the net assessable value of the respective property, the
A
interest incurred is fully deductible.

Example 2

Ken was offered a very good price for his Central property, and he sold the property on
1 April 2019. Ken used the proceeds to repay his Wanchai property mortgage and started
a mobile phone business. His business was doing very well and generated an assessable
profit of HK$350,000 (before donations) for the year ended 31 March 2020. He donated
HK$150,000 to an approved charity in Hong Kong. As well as running his business, Ken
maintained his part-time job and his salary income was HK$132,000. He contributed
HK$6,600 to MPF. Lin ceased her café business at the beginning of April 2019 to take care
of her mother-in-law who started to show signs of dementia.

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Apply and Analyse 3 (continued)

Analysis

Year of assessment 2019/20

Personal assessment election Ken Lin HK$
HK$ HK$
Assessable profit – Mobile businessa 227,500
Salary income 132,000
Assessable profit – Café Nil
Total income 359,500
Less: Approved charitable donations b
(27,500)
Less: Contributions to MPF (6,600)
Less: Business loss brought forward (56,000)
Reduced total income/(Loss carried forward) 325,400 (56,000)
Less: Transfer of loss brought forward from (56,000) 56,000
spouse – s.42(6)c
269,400 Nil
Combined reduced total income 269,400
Less: Allowances (Schedule 4)
– Married person’s allowance (264,000)
– Dependent parent’s allowance d
(200,000)
Net chargeable income Nil
Tax payable Nil

a
Ken’s assessable profit from his mobile business is arrived at as follows:

HK$
Assessable profit before donations 350,000
Less: Deductible donations  
Capped at 35% × HK$350,000 (122,500)
Assessable profit after donations 227,500

b
The amount of approved charitable donations deductible under personal assessment is computed as follows:

HK$
Assessable profit before donations 350,000
Salary income 132,000
Total income 482,000
Deductible donations  
Capped at 35% × HK$482,000 168,700
Less: Claimed under assessable profits (122,500)
Maximum deductible amount 46,200

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Apply and Analyse 3 (continued)

Given that Ken made a donation of HK$150,000 and only HK$122,500 is deductible under profits tax, the balance
of the donation of HK$27,500 can be deducted against his salary income under personal assessment, since the
maximum donations deductible under personal assessment is HK$46,200 as previously computed.

For further details on the computation of deductible approved charitable donations, see Chapters 3 and 4.
c
 iven that Lin had no chargeable income for the year 2019/20, Ken is able to elect for personal assessment on
G
his own and yet set off the loss brought forward from Lin’s business as if there is an aggregation of income.
d
 he dependent parent and additional dependent parent allowances for year of assessment 2019/20 is
T
HK$50,000 each per parent (s.30(3)). Thus HK$50,000 × 2 × 2 parents = HK$200,000.

6.4.1.4 Allowances under Part 5, Access to Progressive Tax Rates and s.100 Tax Reduction
We learned in Chapter 4 that a taxpayer chargeable to salaries tax is eligible for personal
allowances under Part 5 of the IRO (s.28 to s.32). Profits and property taxpayers are not eligible
for these personal allowances. However, a taxpayer and/or spouse are eligible for the same Part 5
allowances under personal assessment. Similarly, a taxpayer or a married couple filing jointly
(Section 4.8 of Chapter 4) is charged at the lower of the progressive tax rates on his/her or their
net chargeable income or the standard rate on net income under a salaries tax assessment. The
progressive tax rates are not available to assessments under profits tax and property tax.

A taxpayer whose income is subject to either profits tax or salaries tax is entitled to a
s.100 tax reduction in computing the net profits or salaries tax payable by the individual.
The s.100 tax reduction is an amount equal to 100% of his/her tax payable subject to a
maximum reduction of HK$20,000 under each profits tax or salaries tax (Schedule 43)
assessment for the year 2019/20. Under personal assessment, the taxpayer and/or spouse are
also eligible for the same s.100 one-time tax reduction, again capped at HK$20,000. This tax
reduction is not extended to a taxpayer whose income is charged to property tax.

Illustrative Example 9 – Personal Allowances

In Sections 6.4.1.1 and 6.4.1.2, we have seen in Illustrative Examples 5 and 6 how
Mr. Leung’s total income was reduced by mortgage interest incurred and concessionary
deductions. Here, we will consider how the allowances impact his total chargeable
income under personal assessment and compare this with his tax position had he not
elected for personal assessment.

If Mr. Leung had not elected for personal assessment, he would be charged property
tax as follows:

Property Rental Mortgage Net assessable Property tax

income (A) Interest (B) value (A × 80%) liability (@15%)
HK$ HK$ HK$ HK$
Royal Court, Mid-Levels 336,000 Nil 268,800 40,320
Lucky Building, Tsim Sha Tsui 222,000 100,000 177,600 26,640
Merton, Kennedy Town 312,000 450,000 249,600 37,440
870,000 550,000 696,000 104,400

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Illustrative Example 9 (continued)

Mr. Leung’s tax payable under personal assessment is computed as follows:

Property 1 Property 2 Property 3 Total

HK$ HK$ HK$ HK$
Net assessable value 268,800 177,600 249,600
Less: Mortgage interest (A = B if B ≤ A) – (100,000) (249,600)
268,800 77,600 – 346,400
Less: Concessionary deduction
– Home loan interest (100,000)
– Elderly residential care expenses (100,000)
Reduced total income 146,400
Less: Allowances
– Married person’s allowance (264,000)
Net chargeable income Nil
Tax payable under personal assessment Nil

It is beneficial for Mr. Leung to elect for personal assessment given that the mortgage
interest, home loan interest, elderly residential care deductions as well as the married
person’s allowances are deductible under personal assessment. Such deductions would
not have been available under property tax assessment.

Illustrative Example 10 – Allowances, Access to Progressive Tax Rates

and s.100 Tax Reduction
Mr. Lo, a Hong Kong permanent resident, works as a network engineer in a small
Hong Kong company. Mr. Lo also has a sole proprietorship business. His salary was
HK$280,000 and his business made a profit of HK$270,000 in the year of assessment
2017/18 (computed in accordance with Part 4 of the IRO). His wife, Mrs. Lo, has no
taxable income. They have an eight-year-old son. State whether personal assessment is
beneficial for Mr. Lo for the year of assessment 2017/18.

No election for personal assessment

Profits Tax HK$ HK$
Assessable profit 270,000

Tax @ 15% 40,500

Less: 75% tax reduction capped at HK$30,000 (s.100(2)) (30,000)
Net tax payable 10,500

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Illustrative Example 10 (continued)

Salaries Tax HK$ HK$

Salary income 280,000
Less: Concessionary deductions
– Contributions to MPF (18,000)
262,000
Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (100,000) (364,000)
Net chargeable income Nil
Tax payable Nil

Election for Personal Assessment HK$ HK$ HK$

Assessable profit 270,000
Salary income 280,000 550,000
Less: Concessionary deductions
– Contributions to MPF (18,000)
Reduced total income A 532,000

Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (100,000) (364,000)
Net chargeable income 168,000
Tax at progressive rates:
On first HK$45,000 2% 900
On next HK$45,000 7% 3,150
On next HK$45,000 12% 5,400
HK$135,000 9,450
Balance HK$33,000 17% 5,610
B 15,060
OR
Tax at standard rate (A × 15%) C 79,800
Tax payable (lower of B and C) 15,060
Less: 75% tax reduction (s.100(4)) (11,295)
Net tax payable 3,765

The tax savings under personal assessment is HK$6,735 (HK$10,500 − HK$3,765).

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Summary:

1. Mr. Lo’s tax payable is lower under personal assessment as he is able to set off the
‘excess’ allowances not applicable to his salary income against his business profit.

2. He also benefits from a lower effective tax rate charged on his business profit under
the progressive tax rate table.

3. Note though that by electing for personal assessment, Mr. Lo’s business and salary
income are combined and taxed under a single assessment, resulting in only a one-time
tax reduction instead of twice when he is assessed separately under profits tax and
salaries tax.

6.4.2 When Personal Assessment Is Not Advantageous

We have in the previous sections illustrated how a resident taxpayer and/or spouse can benefit
from personal assessment through the following deductions:

• mortgage interest for property owners with rental income;

• business losses;

• concessionary deductions;

• allowances; and

• one-time tax reduction for property owners with rental income.

In addition, taxpayers with lower income may benefit from the lower tax rates under
the progressive tax rate table. However, personal assessment may not be advantageous for
a salaried taxpayer with business income assessable under profits tax with effect from the
year of assessment 2018/19 due to the implementation of the two-tiered profits tax regime.
An election for personal assessment under such a scenario:

• will result in only a one-time claim of the 100% tax reduction up to a maximum amount
of HK$20,000 (for the year of assessment 2019/20) instead of twice, once under salary
tax assessment and once under profits tax assessment; and

• may yield an effective tax rate in excess of 7.5% on the business profit as the marginal
tax rate under the progressive tax rate table is 17%.

Given that concessionary deductions, allowances and the one-time tax reduction are also
available under salaries tax assessment, there would be no tax benefit for a taxpayer and/
or spouse to elect for personal assessment if the taxpayer and/or spouse only have income
subject to salaries tax. In fact, it would not be beneficial for a married couple whose income
sources are subject to salaries tax only to elect for personal assessment. This is because under
separate assessments, the taxpayer and his/her spouse are likely to benefit from a lower
effective tax rate under the progressive tax rate table and, most importantly, each of them
would be able to claim the 100% tax reduction up to HK$20,000 (for the year of assessment
2019/20) under separate assessments.

The following examines various scenarios where it would not be beneficial for the taxpayer
and/or spouse to elect for personal assessment.

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Illustrative Example 11 – Personal Assessment Is Not Advantageous

Davy and his wife Blanc live and work in Hong Kong. Blanc makes beautiful costume
jewellery and, in addition to her employment, she operates a small business selling her
handmade costume jewellery online in Hong Kong. For the year ended 31 March 2020,
Davy earned HK$360,000 and Blanc’s annual salary was HK$240,000. Both contributed to
MPF in Hong Kong. Blanc’s business made an assessable profit of HK$100,000.

Separate Assessment – Salaries Tax Davy Blanc

HK$ HK$
Salaries 360,000 240,000
Less: Concessionary deduction – Contributions to MPFs (18,000) (18,000)
A 342,000 222,000
Less: Basic allowance (132,000) (132,000)
Net chargeable income 210,000 90,000
Tax at progressive rates:
On first HK$50,000 2% 1,000 1,000
On next HK$50,000 6% 3,000 2,400
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000 3,400
Balance HK$10,000 17% 1,700
B 17,700 3,400
OR
Tax at standard rate (A × 15%) C 51,300 33,300

Tax payable (lower of B and C) 17,700 3,400

Less: 100% tax reduction (s.100(1)) (17,700) (3,400)
Net tax payable Nil Nil

Separate Assessment – Profits Tax

Assessable profit 100,000
Tax @ 7.5% 7,500
Less: 100% tax reduction (s.100(2)) (7,500)
Net tax payable Nil

Personal Assessment – Davy and Blanc Davy Blanc Total

HK$ HK$ HK$
Salaries 360,000 240,000
Assessable profit 100,000
360,000 340,000

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Illustrative Example 11 (continued)

Personal Assessment – Davy and Blanc Davy Blanc Total

HK$ HK$ HK$
Less: Concessionary deductions
– Contributions to MPF (18,000) (18,000)
Reduced total income 342,000 322,000
Combined reduced total income A 664,000
Less: Married person’s allowance (264,000)
Net chargeable income 400,000
Tax at progressive rates:
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$200,000 17% 34,000
B 50,000
OR
Tax at standard rate (A × 15%) C 99,600
Tax payable (lower of B and C) 50,000
Less: 100% tax reduction capped  
at HK$20,000 (s.100(4)) (20,000)
Net tax payablea 15,452 14,548 30,000

a
 nder s.43(2B), the tax payable under personal assessment is to be apportioned between Davy and Blanc based
U
on the ratio of his/her reduced total income to the combined reduced total income, that is,

Davy = 342,000 ÷ 664,000 × HK$30,000;

Blanc = 322,000 ÷ 664,000 × HK$30,000.

Below are the tax positions of Davy and Blanc with and without personal assessment:

Davy Blanc Total

HK$ HK$ HK$
Personal assessment 15,452 14,548 30,000
Separate assessment:
Salaries tax Nil Nil Nil
Profits tax – Nil Nil
15,452 14,548 30,000
Additional tax payable under personal assessment 30,000

Davy and Blanc would have been worse off by HK$30,000 if they had elected for personal assessment.

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 he key reason that personal assessment is not beneficial for Davy and Blanc is because
T
of the one-time 100% tax reduction (capped at HK$20,000) available to Davy under
salaries tax and to Blanc both under salaries tax and profits tax. This tax reduction is only
available once under the joint personal assessment whereas they were eligible for the tax
reduction three times when assessed separately.

If Davy and Blanc had elected for personal assessment, the IRD has indicated – on page 5 of
the pamphlet ‘A Brief Guide to Personal Assessment’ – that it would disregard the election and
issue the notices of assessment under salaries tax and profits tax as if no election was made,
with a note attached to inform them that personal assessment is not advantageous for them.

Another situation in which personal assessment may not be advantageous is when the
taxpayer’s total income is high, unless the taxpayer’s income comprised only property income
(see Illustrative Example 13). As we have learned, salaries tax and personal assessment are
charged based on the lower of the progressive tax rates on net/total chargeable income or the
standard tax rate of 15% on net income. In the case where the income mix includes income
subject to salaries tax as well as assessable income of less than $2,000,000 subject to profits tax
where the 7.5% profits tax rate is applicable, aggregating the total income of a taxpayer could raise
the effective tax rate charged on his/her salary income, resulting in higher tax payable overall.

Illustrative Example 12 – High-Income Taxpayers

If Mrs. Yang’s business (from our opening case and Illustrative Example 8) were to
generate an assessable profit of HK$2,000,000 instead of a loss of HK$800,000 for the
year of assessment 2019/20, state whether it will still be advantageous for Mr. and
Mrs. Yang to elect for personal assessment.

No Election for Personal Assessment

Mr. Yang – Salaries Tax HK$ HK$ HK$
Salary income 780,000
Less: Concessionary deductions
– Home loan interest (100,000)
– Contributions to MPF (18,000)
– Elderly residential care expenses (100,000)
A 562,000
Less: Married person’s allowance (264,000)
Net chargeable income 298,000
Tax at progressive rates:
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$98,000 17% 16,660
B 32,660
OR

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Illustrative Example 12 (continued)

No Election for Personal Assessment
Mr. Yang – Salaries Tax HK$ HK$ HK$
Tax at standard rate (A × 15%) C 84,300
Tax payable (lower of B and C) 32,660
Less: 100% tax reduction (s.100(4)) capped (20,000)
at HK$20,000
Net tax payable 12,660

Mrs. Yang – Property Tax and Profits Tax HK$

Property Tax
Net assessable value (HK$35,000 × 12) × 80% 336,000
Tax payable @ 15% 50,400

Profits Tax
Assessable profit 2,000,000
Tax payable @ 7.5% 150,000
Less: 100% tax reduction (s.100(2)) capped at HK$20,000 (20,000)
Net tax payable 130,000

Election for Personal Assessment HK$ Mr. Yang Mrs. Yang Total
HK$ HK$ HK$
Salaries 780,000
Net assessable value (property) 336,000
Assessable profit 2,000,000
Total income 780,000 2,336,000
Less: Mortgage interest (300,000)
Less: Home loan interest (100,000)
Less: Contributions to MPF (18,000)
Less: Elderly residential (100,000)
care expenses
Reduced total income 662,000 1,936,000
Combined reduced total income A 2,598,000
Less: Married person’s allowance (264,000)
Net chargeable income 2,334,000
Tax at progressive rates:
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$2,134,000 17% 362,780

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Illustrative Example 12 (continued)

Election for Personal Assessment HK$ Mr. Yang Mrs. Yang Total
HK$ HK$ HK$
B 378,780
OR
Tax at standard rate (A × 15%) C 389,700
Tax payable (lower of B and C) 378,780
Less: 100% tax reduction (s.100(4)) (20,000)
capped at HK$20,000
Net tax payablea 91,421 267,359 358,780

a
 nder s.43(2B), the tax payable under personal assessment is to be apportioned between Mr. and Mrs. Yang
U
based on the ratio of his/her reduced total income to the combined reduced total income, that is,

Mr. Yang: HK$(662,000 ÷ 2,598,000) × 358,780 = HK$91,421;

Mrs. Yang: HK$(1,936,000 ÷ 2,598,000) × 358,780 = HK$267,359.

Below are the tax positions of Mr. and Mrs. Yang with and without personal assessment:

Mr. Yang Mrs. Yang Total

HK$ HK$ HK$
Personal assessment 91,421 267,359 358,780
Separate assessment:
  Salaries tax 12,660 Nil 12,660
  Property tax Nil 50,400 50,400
  Profits tax Nil 130,000 130,000
12,660 180,400 193,060
Additional tax payable 78,761 86,959 165,720

 he key reasons personal assessment is not beneficial for Mr. and Mrs. Yang when their
T
filing is combined are:

• The one-time tax reduction was granted under both salaries tax (Mr. Yang) and profits
tax (Mrs. Yang) when separately assessed instead of just a one-time tax reduction under
personal assessment.

• The aggregation of income has resulted in an increase in the effective tax rate on
Mr. Yang and Mrs. Yang’s income and Mrs Yang’s business profit.

Under personal assessment, Mrs. Yang’s assessable profits of HK$2,000,000 would be

taxed at a much higher effective rate, i.e. 17% instead of the 7.5% under the two-tiered
profits tax rate regime.

The following examines how income mix can impact the outcome of personal assessment as
compared to separate assessments under the schedular tax system.

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Apply and Analyse 4

Example 1

Let us revisit Illustrative Example 10 in Section 6.4.1.4. We have seen earlier that Mr. Lo
benefited from a small tax saving under personal assessment when there were excess
allowances after offsetting against his chargeable salary income when separately assessed.
Below is an analysis of Mr. Lo’s tax positions if his salary income was increased to HK$450,000
for the year of assessment 2017/18 (instead of HK$280,000 in Illustrative Example 10).
All other facts remain the same.

Analysis

No Election for Personal Assessment

Profits Tax HK$ HK$
Assessable profit 270,000

Tax @ 15% 40,500

Less: 75% tax reduction capped at HK$30,000 (s.100(2)) (30,000)
Net tax payable 10,500

Salaries Tax HK$ HK$ HK$

Salary income 450,000
Less: Concessionary deduction
– Contributions to MPF (18,000)
A 432,000
Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (100,000) (364,000)
Net chargeable income 68,000
Tax at progressive rates
On first HK$45,000 2% 900
Balance HK$23,000 7% 1,610
B 2,510
OR
Tax at standard rate (A × 15%) C 64,800

Tax payable (lower of B and C) 2,510

Less: 75% tax reduction (s.100(1)) (1,883)
Net tax payable 627

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Apply and Analyse 4 (continued)

Election for Personal Assessment HK$ HK$

Assessable profit 270,000
Salary income 450,000 720,000

Less: Concessionary deductions

 – Contributions to MPF (18,000)
Reduced total income A 702,000
Less: Allowances
 – Married person’s allowance (264,000)
 – Child allowance (100,000) (364,000)
Net chargeable income 338,000
Tax at progressive rates:
 On first HK$45,000 2% 900
 On next HK$45,000 7% 3,150
 On next HK$45,000 12% 5,400
HK$135,000 9,450
 Balance HK$203,000 17% 34,510
B 43,960
OR
Tax at standard rate (A × 15%) C 105,300

Tax payable (lower of B and C) 43,960

Less: 75% tax reduction capped at  
HK$30,000 (s.100(4))
(30,000)
Net tax payable 13,960

Below are the tax positions of Mr. Lo with and without personal assessment:

HK$ HK$
Personal assessment 13,960
Separate assessment:
 Salaries tax 627
 Profits tax 10,500 11,127
Additional tax payable under personal assessment 2,833

 ote that personal assessment is no longer beneficial when there is an increase in

N
Mr. Lo’s salary because the effective tax rate on his salary income is increased when
his total income is aggregated. Further, he can only get a one-time tax reduction
instead of twice under separate assessments.

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Apply and Analyse 4 (continued)

Example 2

What if Mr. Lo’s total income remained at HK$720,000 as noted previously but his
assessable business profit increased to HK$440,000 (instead of HK$270,000) while his
salary remained at HK$280,000? Explain whether it would still be disadvantageous for
Mr. Lo to elect for personal assessment.

Analysis

Let’s have a look at Mr. Lo’s tax position without personal assessment:

No Election for Personal Assessment

Profits Tax HK$ HK$
Assessable profit 440,000
Tax @ 15% 66,000
Less: 75% tax reduction capped at HK$30,000 (s.100(2)) (30,000)
Net tax payable 36,000

Salaries Tax HK$ HK$

Salary income 280,000
Less: Concessionary deduction
– Contributions to MPF (18,000)
262,000
Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (100,000) (364,000)
Net chargeable income Nil
Tax payable Nil

HK$ HK$
Personal assessment (as in above) a
13,960
Separate assessment:
 Salaries tax Nil
 Profits tax 36,000 36,000
Tax savings under personal assessment 22,040

a
Total income is unchanged.

 lthough Mr. Lo’s total income is the same under both examples, his tax outcome
A
with and without personal assessment election is different. This is because:

1. Under personal assessment, he is able to set off the ‘excess’ allowances over his
salary income against his business profits.
2. Under personal assessment, he is able to lower the effective tax rate on his
business profit under the progressive tax rate table although marginal.
3. Again, as highlighted in Illustrative Example 10 under Section 6.4.1.4, he is only
entitled to one set of the s.100 tax reduction under personal assessment.

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Apply and Analyse 4 (continued)

From the preceding information, we have seen that personal assessment may not be
beneficial to some taxpayers depending on the quantum and character of the incomes
they receive. Generally, it would not be advantageous for high-income taxpayers to elect
for personal assessment because:

• Aggregation could result in the income being taxed at a higher effective tax rate, as
we have seen in Mr. and Mrs. Yang’s situation (Illustrative Example 12).

• Only a single s.100 tax reduction would be given compared to multiple reductions
under separate assessments, that is, profits tax and salaries tax assessments. See
Illustrative Example 11.

• When the income from properties (where mortgage interest deduction is not
applicable) and business profits reach the standard tax rate zone, the tax position
would be the same as that under separate assessments.

Example 3

Now, let us have a look at Mr. Lo’s position if he were to derive the same amount of income
as in Example 2 for the year of assessment 2018/19 (with the two-tiered profits tax regime).

Election for Personal Assessment

(year of assessment (YA) 2018/19) HK$ HK$
Assessable profit 440,000
Salary income 280,000 720,000

Less: Concessionary deductions

– Contributions to MPF (18,000)
Reduced total income A 702,000
Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (120,000) (384,000)
Net chargeable income 318,000

Tax at progressive rates

 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
 Balance HK$118,000 17% 20,060
B 36,060
OR
Tax at standard rate (A × 15%) C 105,300

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Apply and Analyse 4 (continued)

Election for Personal Assessment

(year of assessment (YA) 2018/19) HK$ HK$
Tax payable (lower of B and C) 36,060
Less: 100% tax reduction capped (20,000)
at HK$20,000
Net tax payable 16,060

No Election for Personal Assessment (YA 2018/19)

Profits Tax HK$ HK$
Assessable profit 440,000

Tax @ 7.5% 33,000

Less: 100% tax reduction capped at HK$20,000  
(20,000)
Net tax payable 13,000

Salaries Tax (YA 2018/19) HK$ HK$

Salary income 280,000
Less: Concessionary deduction
– Contributions to MPF (18,000)
262,000
Less: Allowances
– Married person’s allowance (264,000)
– Child allowance (120,000) (384,000)
Net chargeable income Nil
Tax payable Nil

Let’s compare Mr. Lo’s tax position with and without personal assessment:

YA 2018/19 HK$ HK$

Personal assessment (as per above) 16,060
Separate assessment:
 Salaries tax Nil
 Profits tax 13,000 13,000
Additional tax under personal assessment 3,060

 lthough Mr. Lo’s total income and the income types are the same as in Example
A
2, it is no longer beneficial for him to elect for a personal assessment with the
introduction of the two-tiered profits tax regime. This is because his business profit
is below HK$2,000,000. Thus, the profit is taxed at the lower profits tax rate of 7.5%
while the effective tax rate under the progressive tax rates is higher than the profits
tax rate of 7.5%.

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The one exception worth noting relates to a taxpayer and his/her spouse whose only
source of income is from property. Under such a scenario, personal assessment will always
be beneficial, irrespective of the taxpayer and/or spouse’s income level. This is because
under personal assessment, the taxpayer and spouse can claim the mortgage interest on the
property and can apply the one-time tax reduction under s.100(4) against the tax payable.
The mortgage interest deduction and one-time tax reduction are not provided under property
tax assessments.

Illustrative Example 13 – Taxpayer with High Property Income

Mr. Lai, single and retired, invested in a villa in Repulse Bay when he was at the height of
his investment banking career. He took out a mortgage to help finance the purchase of
the property. The villa was rented out for HK$4,200,000 and he paid mortgage interest of
HK$1,000,000 in the year of assessment 2019/20. If Mr. Lai had not elected for personal
assessment, his property tax payable would be HK$504,000 as computed below.

Property Tax HK$

Net assessable value (HK$4,200,000 × 80%) 3,360,000
Property tax @ 15% 504,000

Election for Personal Assessment HK$ HK$

Net assessable value (as above) 3,360,000
Less: Mortgage interest (1,000,000)
Reduced total income A 2,360,000
Less: Basic allowance (132,000)
Net chargeable income 2,228,000
Tax at progressive rates:
 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
 Balance HK$2,028,000 17% 344,760
B 360,760
OR
Tax at standard rate (A × 15%) C 354,000

Tax payable (lower of B and C) 354,000a

Less: 100% tax reduction (s.100(4)) (20,000)
capped at HK$20,000
Net tax payable 334,000
Tax savings under personal assessment 170,000

a
 or a high-income earner like Mr. Lai, the 15% standard rate on the reduced total income is likely to yield a lower
F
tax than the progressive tax rates because the top marginal tax rate is 17% for chargeable income in excess of
HK$200,000.

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 r. Lai is able to reduce his assessable income through the mortgage interest deduction
M
and the first HK$20,000 of tax payable is waived. The deduction and tax reduction would not
have been available to Mr. Lai had he been charged under property tax.

From the preceding example, we can see that there is merit for a Hong Kong resident
taxpayer whose only source of income is from property to elect for personal assessment
irrespective of his/her income level. The extent of the tax savings increases when the taxpayer
financed the purchase of the property through borrowings and paid interest during the periods
when the property was rented out.

Key Learning Point

The following are the benefits of personal assessment:

• Deductibility of interest incurred on money borrowed to acquire the rental

property.

• Offset of business losses against income from another business, property,

employment, office and pension.

• Concessionary deductions are allowable.

• Eligibility for personal allowances.

• Tax charged at progressive rates and tax reduction are available to taxpayer whose
income is from property.

Knowledge Check Questions

Question 5

Identify which of the following is not a benefit of personal assessment.

A Taxed under the progressive tax rate table for a sole proprietor.
B Deductibility of mortgage interest incurred on the taxpayer’s property in Canada.
C Eligibility for s.100 tax reduction in the case of a property income taxpayer.
D Ability to claim married person’s allowance for a partner of a firm.

Question 6

Identify which of the following statements about personal assessment are correct.
(I) There is no benefit for a high property income taxpayer to elect for personal assessment.
(II) Personal assessment is not advantageous to a taxpayer who derives only salary income.
(III) A high-income taxpayer would be subject to the 17% marginal tax rate under personal
assessment.
(IV) It is always beneficial for a taxpayer whose only income chargeable to tax is from
property to elect for personal assessment.

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Knowledge Check Questions (continued)

A I, II and III
B I, III and IV
C II and IV
D I and IV

6 . 5
PERSONAL ASSESSMENT COMPUTATIONS

By now, we have looked at a number of illustrative examples showing how tax is computed
under personal assessment. This section walks you through the steps involved in a personal
assessment tax computation for an individual as well as for married taxpayers.

6.5.1 Calculation of Total Income

Under personal assessment, the total income of a taxpayer is the aggregate of the following:

• net assessable value of a property for property tax purposes;

• net assessable income from employment, office and pension; and

• assessable profits computed in accordance with the profits tax provisions.

To recap, the net assessable value of a property under property tax is:

Rental income
Less: Irrecoverable rent (s.7C(1))
Add: Recoverable bad rent (s.7C(2))
= Assessable value (AV)
Less: Rates agreed and paid by owner (s.5(1A)(b)(i))
Less: Statutory allowance for repairs and outgoings (20% of AV less deductible rates) (s.5(1A)(b)(ii))
= Net assessable value (NAV)

The net assessable income from employment, office and pension is calculated as follows
(s.11B and s.12):

Employment, office income and pension

Less: Outgoings and expenses wholly, exclusively and necessarily incurred in producing the above
income and not of private or domestic and capital in nature – s.12(1)(a)
Less: Depreciation allowances – s.12(1)(b)
Less: Expenses for self-education – s.12(1)(e)
Less: Any excess – ss.12(1)(c) & (d)
Add: Balancing charge – s.12(5)
= Net assessable income (NAI)

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See Chapter 4 for details on what constitutes income from employment, office and pension
and deductions available in arriving at the net assessable income.

The assessable profits are the profits chargeable to profits tax, being the total business
income adjusted in accordance with Part 4 of the Ordinance.

Accounting net profit

Add: Non-deductible expenses, e.g. private expenses, salary paid to proprietor, accounting
depreciation, non-deductible donations, fines, etc.
Less: Non-taxable income, e.g. interest, capital receipts, etc.
Less: Depreciation allowances – Part 6
Add: Balancing charge – Part 6
Less: Loss brought forward from prior year
= Assessable profits (AP)

Chapter 3 explains in detail how assessable profits are computed for profits tax purposes.

6.5.2 Tax Computation Under Personal Assessment – Individual Taxpayer

The following are the steps in preparing the tax computation under personal assessment:

Step 1: Aggregation of total income

Once we have calculated each of the above net assessable value, net assessable income and
assessable profits, we add all three together to arrive at total income.

Total income NAV NAI AP

Step 2: Compute reduced total income

We reduce the total income by the following deduction to arrive at the ‘reduced total income’:

Total income (A)

Less: Mortgage interest deductible (up to NAV) – see Section 6.4.1.1
Less: Concessionary deductions under Part 4A – see Section 6.4.1.2
• Approved charitable donations
• Elderly residential care expenses
• Home loan interest
• Mandatory contributions to recognised retirement schemes
• Qualifying premiums paid under voluntary health insurance scheme
• Qualifying annuity premiums paid under a qualifying deferred annuity policy
• Tax deductible MPF voluntary contributions
Less: Current year business loss – see Section 6.4.1.3
Less: Loss brought forward under personal assessment
= Reduced total income (B)

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Step 3: Net chargeable income

Personal allowances for which a taxpayer is eligible are then deducted to arrive at the net
chargeable income:

Reduced total income (B)

Less: Personal allowances under Part 5 – see Section 6.4.1.4
= Net chargeable income (C)

Step 4: Calculate the tax payable

As we learned in Chapter 4 and the earlier sections of this chapter, the tax rates applicable
to salaries tax are also applicable for personal assessment purposes. This means that the tax
payable (D) is the lower of:

• Progressive tax rates (Schedule 2) on net chargeable income.

• Standard tax rate (Schedule 1) on reduced total income.

The one-off 100% tax reduction up to a maximum of HK$20,000 (for the year of assessment
2019/20) granted to salaries and profits tax payers is also available under personal assessment.
Thus, the net tax payable is computed as follows:

Tax payable from above (D)

Less: (100% × D) or HK$20,000, whichever is lower
= Net tax payable

Illustrative Example 14 – Tax Computation for an Individual Taxpayer

under Personal Assessment
Helen Chan is a business executive resident in Hong Kong. She also has income from
renting out a property in Kowloon Tong.

Year of assessment 2019/20

HK$
Annual salary 430,000
Rental income: Kowloon Tong 144,000
Mortgage interest on borrowing to finance the purchase of the Kowloon 70,000
Tong property
HKU MBA course fee paid after deducting the amount reimbursed by her employer 120,000
Approved charitable donation 50,000

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Illustrative Example 14 (continued)

Below is Helen Chan’s personal assessment tax computation:

Steps Net assessable income (NAI): HK$ HK$

1. Aggregate all Salary income 430,000
assessable incomes
Less: Self-education expenses a
(100,000) 330,000
Net assessable value of
property (NAV):
Rental income 144,000
Less: 20% statutory deduction (28,800) 115,200
Total income 445,200
2. Less: Deductions Mortgage interest (70,000)
Approved charitable donationb (50,000)
Reduced total income A 325,200
3. Less: Personal Basic allowance (132,000)
allowances
Net chargeable income 193,200
4. Calculate tax:
Progressive rates:
(Schedule 2)
On first HK$50,000 2% 1,000
On next HK$50,000 6% 3,000
On next HK$50,000 10% 5,000
Balance HK$43,200 14% 6,048
B 15,048
OR
Standard rate (A × 15%) C 48,780
(Schedule 1)
Tax payable (lower of B and C) 15,048
Less: 100% tax reduction capped at
HK$20,000 (s.100(4)) (15,048)
Net tax payable Nil

a
The amount of self-education expenses deductible under s.12(1)(e)/Schedule 3A is capped at HK$100,000.
b
The maximum amount of approved charitable donation deductible under s.26C is computed as follows:

HK$
NAI + NAV 445,200
Less: Mortgage interest (70,000)
Add: Self-education expenses 100,000
= 475,200
35% thereof 166,320

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Key Learning Point

The following are the steps to compute the tax payable under personal assessment:

1. Calculate NAV, NAI and AP if applicable and aggregate these; that is, NAV + NAI + AP.

2. Less applicable deductions, for example, mortgage interest, concessionary

deductions, current business losses and past year’s loss brought forward under
personal assessment to arrive at reduced total income.

3. Deduct personal allowances applicable to arrive at net chargeable income.

4. Apply the tax rates set out under Schedule 2 to net chargeable income and
compare with the tax on reduced total income using the standard rate in
Schedule 1.

5. Deduct tax reduction (100% up to HK$20,000 for year of assessment 2019/20) from
the lower of the tax computed in (4) to arrive at the net tax payable.

6.5.3 Tax Computation under Personal Assessment – A Married Couple

In the case of a married couple personal assessment election, the reduced total income of the
taxpayer and his/her spouse would first be computed separately before aggregation to arrive
at the combined/joint reduced total income (s.42(10)). Steps 1 and 2 (in Key Learning Point in
Section 6.5.2) would be calculated for the taxpayer and his/her spouse individually. For the
purpose of computing the combined reduced total income, a taxpayer who got married during
the tax year where a personal assessment election is made, shall be treated as married from
the commencement of the year of assessment.

The combined reduced total income is net income after offset of excess concessionary
deduction and/or net loss transferred from the taxpayer’s spouse. Any remaining unutilised
losses will be carried forward to the following year of assessment under the spouse’s name for
set-off against a future year’s income where personal assessment is elected.

Illustrative Example 15 – Married Couple Taxpayers

Mr. Yang consulted his uncle, who was a tax manager in a big public accounting firm before
he retired two years ago. He provided him with the following information and asked if it
would be advantageous for him and his wife to elect for personal assessment in respect of
the year of assessment 2018/19. Mr. Yang also told his uncle that his wife made a donation
of HK$120,000 to Oxfam Hong Kong, an approved charitable organisation, to provide
moral support to their daughter who was actively involved in the charity.

Mr. Yang HK$ Mrs. Yang HK$

Salary 750,000 Business profit after donation of HK$120,000 200,000
Home loan interest 120,000 Rental income 420,000
Contributions to MPF 18,000 Mortgage interest 310,000
Elderly care expenses 140,000

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Illustrative Example 15 (continued)

Mr. Yang’s uncle prepared the following tax computation for the year of assessment
2018/19:

Mr. Yang Mrs. Yang Total

HK$ HK$ HK$
1. Calculate total income individually:
Net assessable income 750,000
Assessable profita 208,000
Net assessable value of propertyb 336,000
750,000 544,000
2. Reduce by the following:
Less: Mortgage interest (310,000)
Less: Concessionary deductions
– Approved charitable (8,000)
donationc
– Home loan interestd (100,000)
– Contributions to MPF d
(18,000)
– Elderly residential care expenses d
(100,000)
Reduced total income 632,000 126,000
Aggregated reduced total income A 758,000

3. Claim personal allowances

Less: Married person’s allowancee (264,000)
Net chargeable income 494,000

4. Calculate tax:
Tax at progressive rates (Schedule 2):
 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
 Balance HK$294,000 17% 49,980
B 65,980
OR

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Illustrative Example 15 (continued)

Mr. Yang Mrs. Yang Total

HK$ HK$ HK$
Tax at standard rate (Schedule 1) C 113,700
(A × 15%)
Tax payable (lower of B and C) 65,980
Less: 100% tax reduction capped at  
HK$20,000 (s.100(4))f (20,000)
Net tax payableg 38,337 7,643 45,980

Let’s have a look at Mr and Mrs Yang ‘s taxes without personal assessment for the year
of assessment 2018/19.

HK$
Profits tax – Mrs. Yang
Assessable profitsa 208,000

Tax at 7.5% 15,600

Less: 100% tax reduction (s.100(2)) (15,600)
Net tax payable Nil

Property tax – Mrs. Yang

Net assessable valueb 336,000

Tax at 15% 50,400

Salaries Tax – Mr. Yang

Net assessable income (as above) 750,000

Less: Concessionary deduction

– Home loan interest (as above) (100,000)
– Contributions to MPF (as above) (18,000)
– Elderly residential care expenses (100,000) (218,000)
Net income A 532,000
Less: Personal allowances
– Married person’s allowance (264,000)
Net chargeable income 268,000

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Illustrative Example 15 (continued)

HK$
Tax at progressive rates (schedule 2):
 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$68,000 17% 11,560
B 27,560

Tax @ standard rate (A × 15%) C 79,800

Tax payable (lower of B and C) 27,560

Less: 100% tax reduction (s.100(1)) capped
(20,000)
at HK$20,000
Net tax payable 7,560

Based on the above, Mr. Yang’s uncle confirmed that it would be beneficial for Mr. and
Mrs. Yang to elect for personal assessment. Their total tax liability of HK$45,980 under
personal assessment would be lower than that of HK$57,960 (HK$50,400 + HK$7,560)
under separate assessments.
a
As we learned in Chapter 3, adjustments are to be made to the accounting business profit in accordance with the
provisions of Part 4 to arrive at assessable profit. Thus, we would compute the non-deductible donations, if any,
and add back any non-deductible amount to arrive at the assessable profit.

HK$
Accounting business profit 200,000
Add: Donations to approved charitable organisation 120,000
Less: Deductible donations  
35% × (HK$200,000 + 120,000) (112,000)
= Assessable profit 208,000

b
The net assessable value of Mrs. Yang’s rental property is:
HK$420,000 less 20% statutory deduction thereof = HK$336,000
c
 nder personal assessment, Mrs. Yang is able to claim the excess donations made of HK$8,000 given that she
U
has other chargeable rental income:

HK$
Business profit before deduction of donations 320,000
Add: Net assessable value of property 336,000
Less: Mortgage interest on property (310,000)
Total income 346,000

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Illustrative Example 15 (continued)

HK$
Deductible approved donations:  
35% × HK$346,000 121,100
Less: Amount claimed under business profit (See Note a) (112,000)
Balance of deductible approved donations 9,100
Thus, the balance claimable under personal assessment: 8,000
HK$(120,000 − 112,000)

If the approved charitable donation made is more than the above deductible amount of HK$121,100, the excess
could be transferred to and claimed by Mr. Yang as long as the total amount claimed did not exceed 35% of the
combined total income.

HK$
Mrs. Yang:
Business profit before deduction of donations 320,000
Add: Net assessable value of property 336,000
Less: Mortgage interest on property (310,000)
Mr. Yang:
Net assessable income 750,000
Total income 1,096,000
   
Deductible approved donations under combined personal  
assessment:  
35% × HK$1,096,000 383,600

d
The maximum amounts deductible for the year of assessment 2018/19 are as follows:

HK$
Home loan interest (Schedule 3D) 100,000
Mandatory contributions to recognised retirement schemes (Schedule 3B) 18,000
Elderly residential care expenses (Schedule 3C) 100,000

e
The married person’s allowance under Schedule 4 is HK$264,000.
f
S.100(4) one-time tax reduction is capped at HK$20,000 for the year of assessment 2018/19.
g
 he tax payable under personal assessment is to be apportioned between Mr. and Mrs. Yang under s.43(2B) as
T
follows:
HK$(632,000 ÷ 758,000) × HK$45,980 = HK$38,337;
HK$(126,000 ÷ 758,000) × HK$45,980 = HK$7,643.

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Further, we have learned in Transfer of Excess/Unused Spouse Business Loss or

Concessionary Deductions in Section 6.4.1.3 that the excess concessionary deductions or
business loss of a taxpayer or his/her spouse is to be transferred and set off against the
income of the other spouse to arrive at the combined reduced income (see Transfer of Excess/
Unused Spouse Business Loss or Concessionary Deductions in Section 6.4.1.3 and Illustrative
Example 8).

Apply and Analyse 5

We continue with Illustrative Example 8, Transfer of Excess Spouse Concessionary
Deductions and Business Loss, in Section 6.4.1.3. Mrs. Yang’s accountant noticed a
duplicate revenue entry in her 2019/20 book. She made the correction and Mrs. Yang’s
adjusted loss computed in accordance with the profits tax provisions is now HK$1,500,000
instead of HK$800,000.

Her property lease expired in March 2020. Her property agent advised her not to
extend the lease as her condominium was the target of an en-bloc sale to a big Chinese
investor. The property was sold en-bloc in June 2020.

Mr. Yang’s salary was adjusted on 1 April 2020 and his annual salary is now
HK$800,000. After discussions with her family, Mrs. Yang also decided to deregister her
business on 31 March 2020 and take a career break.

Given the huge business loss Mrs. Yang’s business generated, prima facie, it is
likely beneficial for Mr. and Mrs. Yang to elect for personal assessment. Consider what
we have learned so far and estimate Mr. and Mrs. Yang’s tax liability for the year of
assessment 2020/21.

Election for Personal Assessment

Year of Assessment 2019/20 Mr. Yang Mrs. Yang Total
HK$ HK$ HK$
Salaries 780,000
Net assessable value 336,000
Less: Mortgage interest (300,000)
Less: Home loan interest a
(100,000)
Less: Contributions to MPF (18,000)
Less: Elderly residential care expensesb  
(100,000)
662,000 (64,000)
Less: Current year business loss (1,500,000)
(1,564,000)

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Apply and Analyse 5 (continued)

Election for Personal Assessment

Year of Assessment 2019/20 Mr. Yang Mrs. Yang Total
HK$ HK$ HK$
Less: Excess concessionary deduction   64,000
and loss transferred to spouse – s.42(5)
(662,000) 598,000
Loss carried forward Nil (902,000)
Combined reduced total income Nil
Net chargeable income Nil
Tax payable Nil

With the brought forward loss from Mrs. Yang’s business, Mr. Yang is able to elect for
personal assessment even though Mrs. Yang has no income (see s.42(6)) and the loss
brought forward is available for set-off as if there was an aggregation of income.

Year of Assessment 2020/21 Mr. Yang Mrs. Yang Total

HK$ HK$
Salaries 800,000
Less: Home loan interest a
(100,000)
Less: Contributions to MPF (18,000)
Elderly residential care expensesb (100,000)
582,000
Less: Transfer of loss brought forward    
from spouse (ss.42(5) and 42(6))
(582,000) 582,000
Loss carried forward Nil (320,000)
Combined reduced total income Nil
Net chargeable income Nil
Tax payable Nil

a
Home loan interest deduction is capped at HK$100,000 (s.26E and Schedule 3D).
b
Elderly residential care expenses deduction is capped at HK$100,000 (s.26D and Schedule 3C).

If Mr. and Mrs. Yang had not elected for personal assessment for 2019/20, the mortgage
interest on Mrs. Yang’s rental property would not have been deductible and there would
not be excess concessionary deductions. Mrs. Yang’s business loss would be trapped and
not available for set-off against Mr. Yang’s income and she would have a property tax
liability to pay. With personal assessment, neither Mr. Yang nor Mrs. Yang have any tax
payable. For the year of assessment 2020/21, Mr. Yang is able to offset the loss brought
forward from Mrs. Yang’s business against his total income.

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Exhibits 6.5 and 6.6 provide an overview of the personal assessment tax computation for
an individual taxpayer and the personal assessment tax computation for a married couple,
respectively.

Assessable Profits Net Assessable Income

Net Assessable Value
(office/employment/
of rental property
pension)

Step 1 Aggregate all income of taxpayer

= Total Income (A)

Step 2 Less: Mortgage interest on rental property (limited to Net

Reduce – Assessable Value of each property) – s.42(1)
‘A’ by
these
items, if
any – ss.42(1)
and (2) – Less: Concessionary Deductions under Pert 4A – s.42(2)(a)

– Less: Current year business losses – s.42(2)(b)

Less: Losses brought forward from previous year(s) under

– personal assessment s.42(5)

= Reduced Total Income (B)

Step 3
Less
allowance(s) – Less: Allowances under Part 5 – s.42(A)(1)

= Net Chargeable Income (C)

Tax Payable (D) – s.43 = the lower of:

Step 4 (1) progressive tax rates applied on ‘C’; and
Apply the (2) standard tax rate × ‘B’
tax rates
applicable to
salaries tax
Less: Tax reduction under s.100(4) i.e. prescribed% × D or prescribed
– maximum amount whichever is lower

= Tax Payable

EXHIBIT 6.5 Personal assessment computation (individual taxpayer)

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Step 1
Aggregate all NAV + NAI + AP (Taxpayer) NAV + NAI + AP (Spouse)
assessable
income
individually
= Total income – Taxpayer (A1) Total income – Spouse (A2)

Less: Mortgage interest on Less: Mortgage interest on

– rental property (limited to rental property (limited to
Step 2 each NAV) each NAV)
Reduce A1
and A2 by
these items,
if any, to Less: Concessionary Less: Concessionary
arrive at B1 Deductions under Part 4A Deductions under Part 4A
and B2, – Less: Current year business Less: Current year business
respectively losses losses
– ss.42(1) and Less: Loss brought forward Less: Loss brought forward
(2)

Reduced Total Income Reduced Total Income

= Taxpayer (B1) Spouse (B2)

Step 3
inter-spouse
Transfer of excess Transfer of excess
set-off –
s.42(5)
– concessionary deductions and concessionary deductions and
loss loss

Step 4
Aggregation
of income = Combined Reduced Total Income (B)

Step 5 – Less: Allowances under Part 5 – s.42(A)(1)

Less
allowance(s)
= Net Chargeable Income (C)

Tax Payable (D) – s.43 = the lower of:

Step 6 (1) progressive tax rates applied on ‘C’; and
Apply the tax (2) standard tax rate × ‘B’
rates
applicable to
salaries tax
Less: Tax reduction under s.100(4) i.e. prescribed% × D or prescribed
– maximum amount whichever is lower

= Tax Payable

EXHIBIT 6.6 Personal assessment computation (married taxpayers – s.42(10))

Key Learning Point

The reduced total income of a married taxpayer and his/her spouse is to be computed
separately prior to aggregation in computing the combined reduced total income under
personal assessment.

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Knowledge Check Questions

Question 7
Identify which of the following is to be aggregated in computing a Hong Kong resident
taxpayer’s total income under personal assessment.
(I) Rent received from letting out a storage warehouse.
(II) Housing allowances received from the taxpayer’s employer.
(III) The taxpayer’s share of partnership income.
(IV) Severance pay made to a taxpayer in accordance with the Employment Ordinance.
A I, II and III
B I, III and IV
C II, III and IV
D I, II and IV

Question 8
In computing the reduced total income of each married taxpayer, identify which of the
following items are deductible from the total income of each taxpayer.
A Mortgage interest incurred on borrowings used to finance the purchase of a
rental property.
B Fees paid by an accountant to HKICPA for studying the Financial Controllership
Programme.
C Payment of HK$92,000 to a nursing home in Macau for the care of the taxpayer’s
grandmother.
D Home loan interest paid to the taxpayer’s wealthy retired uncle.

Question 9
Identify which of the following statements is correct in computing the tax payable under
personal assessment.
A A married taxpayer would first set-off against his total income the business losses
brought forward from his spouse’s business in the year for which personal assessment
was elected.
B Any excess concessionary deductions from the taxpayer’s spouse would first be set off
against the taxpayer’s total income to arrive at his/her reduced total income.
C Any excess mortgage interest of a taxpayer’s spouse would be used to offset the net
assessable value of the taxpayer in computing the combined reduced total income.
D For the year of assessment 2019/20, a taxpayer is eligible for HK$20,000 tax reduction
under personal assessment in any circumstances.

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SUMMARY

• Personal assessment is an alternative method of charging the income of an individual from

all Hong Kong sources to a single tax. Under personal assessment, all taxable rental, business
and salary income of the taxpayer are subject to tax in one assessment.

• To be eligible for personal assessment, the individual taxpayer must meet both the age
(18 years and above unless both parents are deceased) and residence tests (ordinary resident
or temporary resident of Hong Kong). The term ‘ordinarily reside’ is not defined in the IRO and
is a question of facts to be determined on a case by case basis. A temporary resident is an
individual who stays in Hong Kong for a period or periods totalling more than 180 days during
the tax year concerned; or 300 days in two consecutive tax years, one of which relates to the
tax year concerned.

• Married taxpayers, where both the taxpayer and his/her spouse live together and have
income chargeable to tax, may elect for personal assessment individually or jointly.

• A married taxpayer who fails the residency test may elect for personal assessment jointly with
his/her spouse if his/her spouse meets the residency requirement.

• An election must be made in writing within the stipulated time limit under s.41(3), that is, the
later of two years after the end of the year of assessment concerned or two months after
the issue of the relevant notice of assessment or such a period as the commissioner deemed
reasonable.

• There is no benefit from electing for personal assessment to a taxpayer whose only income
source is subject to salaries tax.

• Tax savings may arise under personal assessment because of the availability of deductions,
that is, mortgage interest, concessionary deductions (approved charitable donations, elderly
residential care expenses, home loan interest, contributions to recognised retirement
schemes, qualifying premiums paid under voluntary health insurance scheme, qualifying
annuity premiums paid under a qualifying deferred annuity policy, and tax deductible MPF
voluntary contributions), loss set-off and allowances otherwise not permissible under profits
tax and property tax assessments.

• Tax is computed by applying the progressive tax rates on net chargeable income or
the standard tax rate on the reduced total income whichever is lower, under personal
assessment.

• Tax payable is allocated to the taxpayer and his/her spouse based on the ratio of the taxpayer
and his/her spouse’s reduced total income to the combined reduced total income.

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MIND MAP

SCOPE BENEFITS
Not a separate tax levy May lower the taxpayer’s effective tax rate
An alternative method of subjecting under the progressive tax rates and
a resident taxpayer’s income to taxation availability of the one-time tax reduction
• by aggregating all rental, business and salary Mortgage interest deduction
income, and Concessionary deductions available
• in a single assessment
Business losses set off (current and prior year)
No effect on a taxpayer with income subject
Eligible for personal allowances
to salaries tax only
Offset spouse’s excess concessionary
May benefit some taxpayers, especially taxpayers
deductions and business losses
whose only incomes are from property rental
and taxpayers with trading/business losses APPLICATION PROCEDURES AND
FILING DEADLINE
ELIGIBILITY CRITERIA
Application:
An individual
• Complete Part 6 of tax return; or
• age 18 or above or when both parents
• Lodge Form IR76C
are dead; and
• ordinary or temporary Hong Kong Filing deadline: the later of
resident, or if married, spouse is ordinary • 2 years after the end of year of assessment
or temporary Hong Kong resident (YA), e.g. for YA 2016/17 must be filed by
PERSONAL 31 March 2019
Note: executor of eligible deceased taxpayer ASSESSMENT • 2 months after the assessment notice is
has the same right as deceased taxpayer (PA) issued in respect of the YA concerned
• Such further period as the commissioner
A MARRIED COUPLE deemed reasonable
May elect for joint or separate personal
assessment CALCULATION OF CHARGEABLE
INCOME – INDIVIDUAL TAXPAYER
Taxpayer whose spouse has no taxable
income may elect on his own Aggregate net assessable value, net
Taxpayer whose spouse is ineligible may assessable income and assessable profits
elect an his own Deduct mortgage interest applicable and
concessionary deductions under Part 4A
CALCULATION OF CHARGEABLE Less current year’s business loss, and
INCOME – MARRIED COUPLE brought forward loss under PA, if any, to
Calculate the reduced total income of each of the taxpayer arrive at reduced total income
and his/her spouse before aggregation (see steps 1 to 3 of Deduct personal allowances under Part 5
Calculation of Chargeable Income – Individual Taxpayer) to get the net chargeable income
Combine the reduced total income of the married couple
Deduct personal allowances under Part 5 to arrive at net
chargeable income
Taxpayers married during the YA are deemed married for the COMPUTE TAX PAYABLE
whole year when computing the combined/joint income
Tax payable is the lower of:
Prior year’s losses brought forward under PA only available to • Progressive tax rates on net chargeable
set off against total income of a taxpayer when PA elected for income; and
current year • Standard tax rate on reduced total income
Taxpayer who elects for PA on his/her own as his/her spouse Less tax reduced; i.e. prescribed% of the
has no taxable income is able to utilise his/her spouse's above or the prescribed maximum amount
loss brought forward

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Mr. and Mrs. Yang met the criteria of s.41(1) and thus can elect for
personal assessment.
Answer B is incorrect. Mr. Lai has lived in Hong Kong for two years now. Although he is
under 18, his parents are dead, thus he meets the requirements under s.41(1).

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Answer C is incorrect. Since his wife has no income assessable to tax and, in fact, under
s.42(6), Mr. Wong can set off the loss brought forward as if there was an aggregation.
Answer D is correct. James is a permanent resident of China. Under s.41(2), his executor would
have the same right as James but given that James did not meet the residence test under
s.41(1)(b), the executor would also not be eligible for personal assessment on his behalf.

Question 2
(a) Under s.43(2B) the additional assessment shall be issued to Mr. Yun since the
adjustment relates to Mr. Yun’s income.

(b) Yes, both David and his wife can elect for personal assessment jointly under s.41(1A).

(c) Yes, as Ms. Li and her husband are not living together, he can elect for personal
assessment as long as he does not claim married person’s allowance. Note: If he were
to claim married person’s allowance, they must be jointly assessed under personal
assessment.

(d) Mr. Tam returned to Hong Kong in February 2019. He was only in Hong Kong for a
short visit in 2017/18 and would not meet the residence requirement. For the year
of assessment 2018/19, he was in Hong Kong for two months and did not meet the
residence test either. However, if Mr. Tam continued to stay in Hong Kong and his
total stay for the years of assessment 2018/19 and 2019/20 were to exceed 300 days,
he would be considered a temporary resident of Hong Kong. As a temporary resident,
Mr. Tam would be able to elect for personal assessment for the year of assessment
2018/19 at that time.

Question 3
Under s.41(3) the election must be in writing and submitted no later than two years after
the end of the year of assessment in respect of which an election is made or one month
after an assessment becomes finalised. Given that the notice of amended assessment for
year 2017/18 was issued last month, this assessment would be finalised two months from
that date. See Section 6.3.2 for further illustration. Therefore, the election is available for
the year of assessment 2017/18.

Question 4
Miss Tsui cannot object as she has one month to object to her property tax assessment
issued in January 2020. The assessment becomes finalised one month therefrom; that is, in
February 2020. Any subsequent assessment issued under personal assessment would not
extend this objection time limit – see s.64(7)(c).

Question 5
Answer A is incorrect. Being taxed under the progressive tax rate table for a sole proprietor
is a benefit of personal assessment.
Answer B is correct. No deduction is allowed as the interest was not incurred in generating
assessable income in Hong Kong.

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Answer C is incorrect. A benefit of personal assessment is the eligibility for s.100 tax
reduction in the case of a property income taxpayer.
Answer D is incorrect. The ability to claim married person’s allowance for a partner of a
firm is a benefit of personal assessment.

Question 6
Answer A is incorrect. There are benefits to high property income taxpayers. See
Illustrative Example 13. Income is taxed at the lower of the progressive rates on net
chargeable income and the standard rate on reduced total income.
Answer B is incorrect. See Illustrative Example 13. Income is taxed at the lower of
the progressive rates on net chargeable income and the standard rate on reduced
total income.
Answer C is correct. See Section 6.4.2. It is always beneficial because of the s.100 tax
reduction which is not granted under a property tax assessment. In addition, the taxpayer
would be able to claim mortgage interest incurred on acquiring the property, if applicable.
Answer D is incorrect.

Question 7
Answer A is correct because rent received from letting out a storage warehouse,
a housing allowance from an employer and a share of partnership income are all
assessable incomes.
Answers B, C and D are incorrect. Severance pay made to a taxpayer in accordance with
the Employment Ordinance is not assessable under salaries tax.

Question 8
Answer A is correct. Mortgage interest incurred on borrowings used to finance the
purchase of a rental property is deductible under s.42(1).
Answer B is incorrect. The fee for studying the Financial Controllership Programme is
deducted from assessable income to arrive at net assessable income (s.12(1)(e)).
Answer C is incorrect. Elderly residential care home is defined to be a care home located in
Hong Kong – see s.26D(5).
Answer D is incorrect. Home loan interest is only deductible when paid to an organisation
prescribed under s.26E(9).

Question 9
Answer A is incorrect. The reduced total income of the married taxpayer must first be
computed individually before the loss set-off from his/her spouse. See Section 6.5.3.
Answer B is correct. See s.42(5)(c)(ii)).
Answer C is incorrect. Excess mortgage interest is not deductible (s.42(1)).
Answer D is incorrect. The tax reduction under s.100(4) is 100% of the tax payable up
to a prescribed amount (e.g. HK$20,000 for the year of assessment 2019/20) and not
HK$20,000 under all circumstances.

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EXAM PRACTICE

QUESTION 1
Martin Sum’s family migrated to Australia when he was in high school. He is an IT consulting
manager with a US company and was transferred from Melbourne to Hong Kong on 1 April
2019. His employer has agreed to pay for his first year tax consultation and preparation fee.
He has provided you with the following information:

Mr. Martin Sum: Information provided for the year ended 31 March 2020.

1. His annual salary is HK$650,000 and he is exempted from the local provident fund scheme.

2. He was granted the following stock award under the US parent company employees’
stock award scheme since he joined the company (see table).

  Share price Number of shares – vest equally over a four-year period

  Nasdaq at
1 December 1 December 1 December 1 December 1 December
Grant date date of Grant
2019 2020 2021 2022 2023
US$
1 December 2016 20.70 100 100
1 December 2017 19.60 120 120 120
1 December 2018 23.30 150 150 150 150
1 December 2019 40.20 300 300 300 300
370 670 570 450 300

Martin sold the 370 shares shortly after they vested.

3. To ease his relocation, his employer organised and provided him with a serviced
apartment in Central for six months from March to August 2019. He moved into the
apartment he bought thereafter (see item 8 below).

4. Martin was given a one-time home trip (business class ticket) to Australia during the
year. In December 2019, he had to go to Melbourne for a business meeting. He claimed
his home leave entitlement and had the air ticket issued for Catherine so that both of
them could travel together to Melbourne. The company paid HK$30,000 for the ticket.

5. He signed up to study for an MBA with HKU and has paid a tuition fee of HK$184,000.
As part of the company’s career development programme for senior staff, his employer
reimbursed 50% of his tuition fee.

6. All employees of the company can book the yacht owned by the company for staff
recreational purposes, but company policy is that at no time can an employee lease
or allow non-employees to use the boat in return for payments of any form. Martin
booked the boat for three days and proposed to Catherine Wong. Similar boats were let
out for HK$12,000 a day. Martin married Catherine in May 2019.

7. Martin has an apartment in Melbourne that was rented out for AU$23,400 in the year
(AU$450 a week). Almost all the rent went toward servicing his mortgage. He also
invested in some shares in Australia and received dividends amounting to AU$12,500
during the year.

8. He borrowed from a Hong Kong bank to partially finance the purchase of his residence
in Mid-Levels. He paid mortgage interest of HK$140,000 during the year.

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9. Catherine is a sole proprietor. She is a fashion designer specialising in modern Qipao

and has her own shop in Central. Her business profits computed in accordance with
Part 4 of the IRO were HK$450,000. She donated HK$50,000 to the Salvation Army, an
approved charitable organisation in Hong Kong.

10. Catherine owns an apartment in Kowloon Tong that she bought and financed partially
from a bank loan. It has since been rented out to a couple under a corporate lease.
She received an annual rent of HK$360,000 and paid mortgage interest of HK$290,000.
Catherine also paid rates of HK$8,000.

11. Catherine pays HK$130,000 to a local nursing home for the care of her father who is
suffering from Alzheimer’s disease and she gave her 70-year-old mother a monthly
allowance of HK$12,000.

Required:

(a) Compute Martin’s (i) assessable income and (ii) net assessable income for the year of
assessment 2019/20 under salaries tax assessment. Comments should be made on
your basis of treating the share awards as well as the perquisites with reference to the
IRO and DIPNs.

(b) Compute the net assessable value of Catherine’s property at Kowloon Tong.

(c) Assuming that neither Martin nor Catherine have paid any taxes for the year ended
31 March 2020, advise them on the taxes they are liable to pay and the amounts
payable. State whether there is any alternative way in which they could reduce their
total tax bill. If so, present your answer by illustrating the amount of tax savings.

QUESTION 2
Mr. Lum jointly or individually owned four properties in Hong Kong. Properties A, B and C
are wholly owned by Mr. Lum and Property D is owned by Mr. and Mrs. Lum jointly. They
would like to downsize after their grown-up daughter moved into her own apartment.
Mr. Lum purchased the fourth property, Property D, in June 2019 by mortgaging the family
residence, Property A. Mr. and Mrs. Lum moved into the smaller Property D after renovating
the apartment in August 2019. Property A was then rented out in September 2019. Property
B and C were rented out at all times. The following are the details of income received and
the interest paid by Mr. and Mrs. Lum on the mortgages:

Year ended 31 March 2020

Property Monthly Total Rental Mortgage Rates

Rental Income Income Interest
HK$ HK$ HK$ HK$
A 30,000 210,000 170,000 18,000
B 20,000 240,000 120,000 Nil
C 32,000 384,000 320,000 14,000

After retiring from his last position as a financial controller, Mr. Lum works part-time in
the finance department of a Chinese property company in Hong Kong, under a job share
arrangement. Mr. Lum opted for an annual salary of HK$230,000 and was given the use

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of a fully maintained company car. His job-sharing colleague earned an annual salary of
HK$270,000 for the year ended 31 March 2020.

Mrs. Lum does not work, and she takes care of her 77-year-old mother who is living
with them.

Required:

(a) Compute and explain by applying the relevant provisions of the IRO the amount of
interest deductible to Mr. Lum under personal assessment. Answer on the basis that
Mr. Lum would not be eligible for home loan interest deduction.

(b) Compute Mr. Lum’s (i) net assessable income, (ii) net assessable value of each
properties, and (iii) tax payable for the year of assessment 2019/20 under personal
assessment. Comment on the basis that you have taken in each of the computations.

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Martin Sum

(i) Computation of assessable income

HK$ Comments
Salary 650,000
Home leave 30,000 s.9(2A) (c)/DIPN 41
Share Award a
51,018 s.11D(a) and DIPN 38(Revised)
Housing benefitb 34,000 s.9(1)(b)/s.9(2)
Assessable incomec,d 765,018 s.2

a
 nder s.11D (a) and DIPN 38 (Revised), the share award would only be assessable
U
at the time it is vested free of conditions. However, most of the share awards
were granted to Martin when he was an employee of the Australian company.
The IRD has expressed its view on how such circumstances will be dealt
with and the following is how the taxable amount would be calculated:

Total days Martin was in Hong Kong from 1 April 2019 to vesting date (30 November 2019) = 244 days.

Period from Share Value No. of Days in Amount

grant to vest awards US$ (A) days HK (C) assessable US$
to vest (B) C ÷ B × A
1/12/16 to 30/11/19 100 4,020 1,095 244 895.78
1/12/17 to 30/11/19 120 4,824 730 244 1,612.41
1/12/18 to 30/11/19 150 6,030 365 244 4,031.01
6,539.20
a 
The assessable amount converted at the average buying exchange rate of 7.8018 is HK$51,018.
b
 he assessable value of the housing provided is equal to 10% of the income from employment less
T
expenses deductible under s.12(1)(a) and (1)(b) during the period when the accommodation was pro-
vided. Martin is only given the accommodation for six months, thus the assessable value is computed
as follows:

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 P ersonal A ssessment

HK$

Salary 650,000
Home leave  30,000
680,000
Apportioned to 6 months = 340,000
10% × HK$340,000 = HK$34,000

c
 iven that Martin is not able to convert the use of the yacht benefit to cash, the benefit is not an assess-
G
able benefit (s.9(2A)(a)(ii)).
d
 he MBA tuition fee is deductible by Martin under self-education expenses subject to the capped limit.
T
Given that his employer reimbursed him 50% of the fee, he would be able to claim the other 50%. The
amount reimbursed is not an assessable benefit.

(ii) Martin’s net assessable income

HK$
Assessable income in (i) 765,018
Less: Self-education expensesa (92,000) s.12(1)(e)/Schedule 3A
Net assessable income 673,018
a
 chedule 3A capped the deduction at HK$100,000 for the year of assessment 2019/20. Martin paid
S
HK$184,000 but 50% was reimbursed by his employer. Thus, the amount deductible is HK$92,000.

(b) Net assessable value of property at Kowloon Tong:

HK$
Rental income 360,000
Less: Rates paid (8,000) s.5(1A) (b)(i)
Less: Statutory allowance for repairs    
and outgoings (20% of assessable (70,400) s.5(1A) (b)(ii)
value after deduction of rates paid)
Net assessable value 281,600

(c) Martin’s income chargeable to tax in Hong Kong related to his employment, thus he
would be liable for salaries tax (s.8(1)).

Catherine has business profit that would fall under the profits tax net (s.14(1)).
In addition, she derived rental income, which would be assessed under property
tax (s.5(1)).

Assuming they fulfilled the conditions as prescribed in s.41(1A), they may jointly
elect for personal assessment, which may reduce their total tax bill for the year of
assessment 2019/20. Under s.42A(2), Martin and Catherine are deemed to be married
from the commencement of the year for the purpose of ascertaining their joint
total income.

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Martin Sum
Salaries Tax Computation
Year of Assessment 2019/20

HK$ HK$
Net assessable income (item (a)(ii) above) 673,018
Less: Concessionary deductions
 
– Home loan interest (s.26E/
Schedule 3D) (100,000)
Net income A 573,018
Less: Married person allowance (264,000)
Less: Dependent parent allowancea (50,000)
Net chargeable income 259,018

Tax at progressive rates:

 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$59,018 17% 10,033
B 26,033
OR
Tax at standard rate (A × 15%) C 85,953

Tax payable (lower of B and C) 26,033

Less: 100% tax reduction (s.100(1)) (20,000)
capped at HK$20,000
Net tax payable 6,033
a
 s Catherine is unable to claim the dependent parent allowance in respect of her
A
mother under profits tax or property tax assessments, Martin can claim the
allowance instead.

Catherine Wong
Profits Tax
Year of Assessment 2019/20

HK$
Net business profit/Assessable profit a
450,000
Tax @ 7.5% 33,750
Less: 100% tax reduction (s.100(2)) (20,000)
Net tax payable 13,750
a
 er business profit computed in accordance with Part 4
H
before the approved charitable donations = HK$500,000.
35% thereof is HK$175,000. Thus, the donation of
HK$50,000 is fully deductible under s.16D and
no adjustment is required for tax purposes.

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Catherine Wong
Property Tax
Year of Assessment 2019/20

HK$
Net assessable value (from above) 281,600
Tax @ 15% 42,240

Martin Sum and Catherine Wong

Year of Assessment 2019/20

Personal Assessment
Martin Catherine Total
HK$ HK$ HK$
Net assessable income 673,018
Net assessable value of property 281,600
Assessable profit 450,000
673,018 731,600
Less: Mortgage interesta (281,600)
Less: Concessionary deductions  
Home loan interest (100,000)
Elderly residential care expenses (100,000)
Reduced total income 573,018 350,000
Combined reduced total income A 923,018
Less: Married person’s allowance (264,000)
Less: Dependent parent (50,000)
allowanceb
Net chargeable income 609,018

Tax at progressive rates

 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
 On next HK$50,000 10% 5,000
 On next HK$50,000 14% 7,000
HK$200,000 16,000
Balance HK$409,018 17% 69,533
B 85,533
OR
Tax at standard rate (A × 15%) C 138,453

Tax payable (lower of B and C) 85,533

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Personal Assessment
Martin Catherine Total
HK$ HK$ HK$
Less: 100% tax reduction capped (20,000)
at HK$20,000
Net tax payablec 40,683 24,850 65,533

a
The deduction is limited to the net assessable value of the property (s.42(1)).
b
The dependent parent allowance can be claimed by Martin in respect of the allowance paid to Catherine’s
mother.
c
The tax payable by Martin and Catherine would be allocated based on the following:
Martin: HK$(573,018 ÷ 923,018) × HK$65,533 = HK$40,683;
Catherine: HK$(350,000 ÷ 923,018) × HK$65,533 = HK$24,850.

Martin and Catherine should not elect for personal assessment for the
year of assessment 2019/20 as there would be an additional tax of HK$3,510
(HK$6,033 + HK$13,750 + HK$42,240 − HK$65,533).

QUESTION 2
(a) Under s.42(1) loan interest incurred on moneys borrowed for the purpose of financing
the purchase of an income-generating property is deductible by a taxpayer under
personal assessment. The wording of s.42(1) – for the purpose of producing ‘that part’
of the total income – means that the amount deductible is limited to the net assessable
value of the said property and any excess cannot be used to set off against other
income of the taxpayer.

The mortgage interest must be directly related to the rental income. Any interest
incurred in period(s) where the property was not let out; that is, no rental income
produced, is not deductible. Similarly, any interest incurred that is not for the purpose
of the income-generating property would not be deductible either.

Mr. Lum purchased the fourth property by mortgaging the family residence, Property
A. Although the interest incurred relates to Property A, the purpose of the loan was not
to acquire Property A but to purchase Property D, which is home to Mr. and Mrs. Lum. In
view of this, the interest incurred on Property A would not be deductible under s.42(1).

The interest deductible and the net assessable value of each property are as below:

Property Rental Loan Rates (B) 20% deduction (ii) Net Interest
Income (A) Interest C = 20% × (A – B) assessable Value deductiblea
A–B–C
HK$ HK$ HK$ HK$ HK$ HK$
A 210,000 170,000 10,500 b
39,900 159,600 Nil
B 240,000 120,000 Nil 48,000 192,000 120,000
C 384,000 320,000 14,000 74,000 296,000 296,000
647,600 416,000

a
Limited to the net assessable value of the property except for Property A, which is not deductible as explained above.
b
Rates of HK$18,000 is for the whole year and is to be prorated to the months the property was rented out, that is,
seven months.

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(b) Mr. Lum

(i) Computation of net assessable income

HK$ Comments
Salary 230,000
Car benefit   DIPN 16 (Revised) para. 22, given the salary
40,000 would have been HK$270,000 if the employee
did not opt for the car benefit, thus the value
of the benefit assessed = HK$40,000
Net assessable income 270,000

(ii) Net Assessable value of each properties (see above)

(iii) Mr. Lum: Tax computation for the year of assessment 2019/20

Personal Assessment
HK$ HK$ HK$
Net assessable income 270,000
Net assessable value of property 647,600
917,600
Less: Mortgage interest (416,000)
Reduced total income A 501,600
Less: Married person’s allowance (264,000)
Less: Dependent parent allowancea (100,000)
Net chargeable income 137,600

Tax at progressive rates

 On first HK$50,000 2% 1,000
 On next HK$50,000 6% 3,000
4,000
 Balance HK$37,600 10% 3,760
B 7,760
OR
Tax at standard rate (A × 15%) C 75,240

Tax payable (lower of B and C) 7,760

Less: 100% tax reduction (7,760)
Net tax payable Nil

a
 r. Lum could claim both the dependent parent and additional dependent parent allowances as
M
Mrs. Lum’s mother is living with them.

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 7
Stamp Duty

CHAPTER TOPIC LIST

7.1 Stamp Duty Overview 7.4 Bearer Instruments

7.1.1 Chargeable Instruments
7.5 Duplicates and Counterparts
7.1.2 Substance over Form
7.1.3 Stampable Consideration 7.6 Voluntary Disposition
Inter Vivos
7.2 Immovable Property
in Hong Kong 7.7 Exemptions and Reliefs
7.2.1 Introduction to Property Law
7.8 Stamp Duty Administration
in Hong Kong
7.8.1 Methods of Stamping
7.2.2 Conveyance
7.8.2 Time Limit and Persons Liable
7.2.3 Agreement for Sale
for Stamping
7.2.4 The Charge to Ad Valorem
7.8.3 Penalty for Late Stamping
Stamp Duty
7.8.4 Penalty for Failure to Disclose
7.2.5 Rates of Ad Valorem Stamp Duty
Relevant Information
7.2.6 Multiple Properties and Multiple
7.8.5 Adjudication
Agreements
7.8.6 Appeal against Stamp Duty
7.2.7 Special Stamp Duty
Assessment
7.2.8 Buyer’s Stamp Duty
7.8.7 Effect of Non-stamping
7.2.9 Lease
7.9 Ramsay Principle
7.3 Hong Kong Stock
7.3.1 Hong Kong Stock versus 7.10 Alternative Bond Schemes
Non-Hong Kong Stock
7.11 Stamp Duty Planning

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LEARNING OUTCOMES

PRINCIPAL LO2: APPLY TAX RULES AND PRINCIPLES AND CALCULATE TAX LIABILITIES FOR
PROPERTY TAX, SALARIES TAX, PROFITS TAX, PERSONAL ASSESSMENT AND
STAMP DUTY IN HONG KONG
LO2.33: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Scope of stamp duty charge
2.33.01 Explain the relevant heads of stamp duty charge
LO2.34: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Conveyance on sale of immovable
property
2.34.01 Apply the stamping requirements and practices in relation to a conveyance on sale of
immovable property in Hong Kong
2.34.02 Apply SOIPN 1, 3, 5, 7 and 8
LO2.35: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Agreement for sale of immovable
property
2.35.01 Apply the stamping requirements and practices in relation to an agreement for sale of
immovable property in Hong Kong
2.35.02 Apply SOIPN 1, 3, 5, 7 and 8
LO2.36: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Lease of immovable property
2.36.01 Apply the stamping requirements and practices in relation to a lease of immovable property
in Hong Kong
LO2.37: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Hong Kong stock
2.37.01 Apply the stamping requirements and practices in relation to Hong Kong stock
2.37.02 Contrast Hong Kong stock and non-Hong Kong stock
LO2.38: D
 escribe, explain and analyse the following tax issues as they impact and interact
on transactions, individuals and entities: Stamp duty: Hong Kong bearer instrument,
duplicate and counterpart
2.38.01 Apply the stamping requirements and practices in relation to Hong Kong bearer instrument,
duplicate and counterpart
LO2.39: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Voluntary disposition inter vivos
2.39.01 Explain and apply the stamp duty implications for voluntary disposition inter vivos

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LO2.40: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Alternative bond schemes
2.40.01 Explain the stamp duty implications for alternative bond schemes
2.40.02 Apply SOIPN 6
LO2.41: D
 escribe, explain and analyse the following tax issues as they impact and interact on
transactions, individuals and entities: Stamp duty: Exemptions and reliefs
2.41.01 Explain and apply the exemptions and reliefs available under the SDO
2.41.02 Describe and apply the Arrowtown case and explain its significance
2.41.03 Apply SOIPN 2 and 6
LO2.42: D
 escribe, explain and analyse the following tax issues as they impact and interact
on transactions, individuals and entities: Stamp duty: Adjudication, assessment
and administration
2.42.01 Describe the administration issues concerning stamp duty
2.42.02 Explain the adjudication and appeal procedures for stamp duty assessment
2.42.03 Describe stamp duty offences and penalty provisions under the SDO
2.42.04 Describe the recovery of outstanding stamp duty and penalty
LO2.47: C
 alculate the following tax liabilities for transactions, individuals and entities:
Stamp duty: Ascertainment of stamp duty liability
2.47.01 Calculate the stamp duty payable under the relevant heads of stamp duty charge
PRINCIPAL LO5: ADVISE ON HONG KONG TAX PLANNING IDEAS AND STRATEGIES TO ENHANCE
TAX EFFICIENCY
LO5.05: A
 dvise on Hong Kong tax planning opportunities
5.05.07 Advise on stamp duty planning opportunities for individuals or corporations

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OPENING CASE

M r. Schwarz Zokosta (hereafter Mr. Zokosta) is a German national who wishes to move
to Hong Kong for business. By profession he is an investor: he identifies companies
with long-term growth potential and invests in them by acquiring shares. He is particularly
interested in acquiring a 50% shareholding in Golden Dragon Gate Ltd (hereafter Golden
Dragon), a company incorporated in Hong Kong that has developed a promising business
line in the package tours industry. For those purposes, he agrees with the current 100%
shareholder of Golden Dragon, Johnson Wang, to a purchase price of HK$25 million for a
50% stake in the company. Because Mr. Zokosta wishes to settle in Hong Kong in the long
term, he begins viewing apartments in Repulse Bay with a view to acquiring one instead of
renting. Although Mr. Zokosta is generally pleased with the fact that Hong Kong is a low tax
jurisdiction, which does not tax capital gains, he is concerned about stamp duty. In particular,
he has been advised that he will have to pay ad valorem stamp duty on the acquisition of the
Golden Dragon shares and on any residential property he acquires for himself. The rate of ad
valorem stamp duty on shares of a company incorporated in Hong Kong is 0.2% on the value or
price of the shares, whichever is the higher. Further, because Mr. Zokosta is not a Hong Kong
permanent resident, he is advised that he may be liable to additional stamp duty when he buys
an apartment: specifically, he will be chargeable to ad valorem stamp duties at a higher rate of
15% since he is not a Hong Kong permanent resident first-time buyer, and will further have to
bear buyer’s stamp duty for a further 15% on the higher of the value or purchase price of the
property. In this chapter we consider the implications of Mr. Zokosta’s proposed investments in
Hong Kong from the perspective of stamp duty.

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OVERVIEW

This chapter introduces the law and practice of stamp duty in Hong Kong. Stamp duty is a tax
on instruments – specifically on instruments for the transfer of Hong Kong stock and Hong
Kong immovable property. Stamp duty is computed by reference to the consideration given for
or the value of a transferred asset, whichever is the higher. Rates of stamp duty for residential
property in particular can be very high; accordingly, tax practitioners should be familiar with
the fundamental rules governing the charge to stamp duty and solutions available to mitigate
or avoid stamp duty. This chapter begin by illustrating the first principles of stamp duty, and
then considers its application in the context of immovable property, Hong Kong stock, bearer
instruments, and duplicates and counterparts. It also discusses the principal reliefs from
stamp duty.

7 . 1
STAMP DUTY OVERVIEW

Stamp duty is a tax on instruments – that is, documents in writing – and not on transactions.

It is one of the oldest taxes currently charged in Hong Kong. In general, a stampable instrument
must be duly stamped in order to be admissible as evidence in court. There was, therefore,
historically an incentive for stampable documents to be assessed to the correct amount of
duty, and duly stamped. In Hong Kong, however, stamp duty is a compulsory tax: That means
that there are documents which are, by their very nature, required to be stamped, and failure
to do so can give rise to administrative and, in some cases, criminal penalties. As with other
forms of taxation in Hong Kong, stamp duty is ultimately derived from the United Kingdom
model. Many other common law jurisdictions also have stamp duty legislation, which means
that practitioners and the courts in Hong Kong can refer to the jurisprudence in comparator
jurisdictions, though it is important to remember that the analytical focus must always be on
the Stamp Duty Ordinance (SDO) (Cap.117) itself; foreign decisions are relevant only to the
extent that they were applied to the same or similar statutory drafting. For the same reasons,
while the Hong Kong Inland Revenue Department’s (IRD) guidance on stamp duty matters is
of interest in the sense that it illustrates the assessing practice and policies of the IRD, it is not
law and should not be treated as legislation. As tax practitioners, you will be required to refer
directly to the statute and to the Hong Kong case law on point.

Stamp duty has two bases of computation:

1. Ad valorem stamp duty is charged as a percentage of the value or consideration given

(e.g. 15% of the consideration given or the value of the property transferred under the
dutiable instrument); or

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2. At a fixed rate (e.g. HK$100 for conveyance on sale of immovable property executed in
conformity with a duly stamped agreement for sale or up to HK$5 for a duplicate or
counterpart).

Stamp duty is administered by the Stamp Office, which is a subdivision of the IRD. The
Commissioner of Inland Revenue is also the Collector of Stamp Revenue (the Collector). The
Stamp Office is the statutory body charged with the assessment and collection of stamp duty in
Hong Kong.

It is crucial for you to acquire a good working knowledge of stamp duty. As a practical
matter, it is the tax levied at the highest rate in Hong Kong and, in certain transactions involving
the sale and purchase of residential property in Hong Kong, can reach aggregate rates of 50%
of the gross consideration or value of the transfer.

The Stamp Office has useful guidance on its assessing policies. These may be accessed on
the IRD’s website. The guidance notes are as follows in Exhibit 7.1.

No. Stamp office interpretation and practice notes Date issued

1. Stamping of agreements for sale and purchase of immovable property November 2018
2. Relief for stock borrowing and lending transactions February 2011
3. Deemed consideration under s.24 of the Stamp Duty Ordinance, Cap.117 September 1998
4. Deemed sale and purchase under s.19(1E) of the Stamp Duty 25 January 2000
Ordinance, Cap.117
5. Special stamp duty July 2014
6. Alternative bond schemes August 2014
7. Buyer’s stamp duty July 2014
8. Ad valorem stamp duty November 2018

EXHIBIT 7.1 Guidance notes for assessing stamp duty

These make good introductory reading, but they are not a substitute for the statute and
the case law. Stamp Office guidance is in and of itself incapable of creating legal rights or
obligations: in other words, it is not law, and is not even persuasive in adjudicating stamp duty
disputes. Candidates should therefore read these with a critical eye, together with the primary
sources of law.

7.1.1 Chargeable Instruments

Although stamp duty is a tax on instruments, the instruments it charges to tax (referred to in
both case law and commentary variously as stampable instruments, chargeable instruments or
dutiable instruments) are, in general, instruments denoting a transfer or other transaction.

S.4 of the SDO is the general charging provision. It provides that stamp duty is charged on
the instruments listed in the First Schedule, which comprise four broad types of instruments:

1. Instruments for the conveyance on sale or other transfer or assignment of beneficial

interest in immovable property situated in Hong Kong, including an agreement for
a lease (Head 1; broken down into Head 1 for the assignment and Head 1A for the
agreement for sale).

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2. Instrument for the sale and purchase or other transfer of beneficial interest of Hong
Kong stock (Head 2).

3. Issue of Hong Kong bearer instruments (Head 3).

4. Duplicates and counterparts of the documents in Heads 1 to 3 (Head 4).

The heads of charge to stamp duty are contained in the First Schedule of the SDO. Heads
of charge describe classes of stampable instruments; where an instrument falls within the
description of a given head of charge, it is, unless otherwise exempt, stampable under that
head. Different heads of charge may entail different rates of stamp duty. Stamp duty is a
schedular tax: That means that if an instrument does not fall within any of the heads of charge
it is not stampable. Instruments cannot be stampable by omission or by default: they must
correspond to a description of a stampable instrument. This is the so-called rule of ‘strict
construction’ – when interpreting a taxing statute and, specifically, a stamp duty statute, one
has to apply the clear words of the statute in a technically correct and precise manner: There
is no presumption about a tax and nothing is to be read in and nothing is to be implied – one
can only look fairly at the language used (Cape Brandy Syndicate v IRC (1921) 1 KB 64). That being
said, it is equally important to understand what the legislature actually meant in enacting a
given statute – that is the so-called rule of ‘purposive construction’. The clear words of a statute
do not exist in a vacuum, but were presumably introduced as a means to a particular end and it
is legitimate for the courts to construe the words of the legislature in that context (Mangin v IRC
(1971) AC 739).

Because Hong Kong has a territorial system of taxation, and stamp duty is by its very
nature a territorial tax, Heads 1–4 are charged on instruments that document the transfer
of either securities situated in Hong Kong (such as Hong Kong stock or bearer instruments
issued in Hong Kong) or Hong Kong situate immovable property (i.e. land, buildings, etc. in
Hong Kong).

S.2 of the SDO provides that an instrument is not duly stamped unless it bears a stamp
for the correct amount of stamp duty. S.15 of the SDO provides that an instrument not duly
stamped cannot be produced as evidence in civil proceedings. In practice, that sanction for
failure to stamp an instrument can have serious implications in a contentious scenario, with a
person asserting ownership of Hong Kong stock or immovable property in effect being unable
to produce, respectively, transfer or conveyancing evidence to support his or her claim.

S.15(2) of the SDO prevents a company secretary from registering a change in the
ownership of shares of a company incorporated in Hong Kong or otherwise listed on Hong
Kong Stock Exchange if the instrument of transfer has not been duly stamped and likewise
prevents the Land Registry from effecting a transfer of legal title pursuant to a conveyance of
immovable property.

For the liability of paying stamp duty, the general rule is that the transferor and transferee
are jointly and severally liable, though in some cases, such as that of buyer’s stamp duty, the
liability is borne by the transferee alone. In practice, the transferor and the transferee are
free to allocate the liability for accounting for stamp duty with respect to a given instrument
contractually in whatever proportions they see fit, for example, by way of a tax indemnity or
stamp duty clause inserted in the instrument of transfer. At law, however, the IRD may seek to
recover stamp duty from both parties.

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7.1.2 Substance over Form

Stamp duty looks to the substance of an instrument over its form. An instrument that in reality
operates to transfer a beneficial interest in Hong Kong immovable property will be chargeable
under Head 1 even if it is labelled as a licence, or as some other kind of instrument. The legal
rule is that the real nature and meaning of the instrument is to be ascertained and that the
description of it given in the instrument itself by the parties is immaterial, even though they
may have believed that its effect and operation was something other than what it in substance
was at law (Limmer Asphalte Paving Co v IRC (1872) LR 7 Ex 211). The charge to stamp duty will
depend on the circumstances existing at the time that the document was executed (i.e. when
a given instrument was signed and came into force between the parties thereto – see William
Cory & Son Ltd v IRC (1965) AC 1088).

7.1.3 Stampable Consideration

Ad valorem stamp duty is computed as a percentage of the greater of the consideration for
the transaction or the value of the property transferred by virtue of the transaction (Heads
1–3 of the First Schedule and ss.27(4) and 29F of the SDO). Thus, while stamp duty will in the
first instance be charged by reference to the stated consideration in the instrument, in the
event the consideration were not expressed (e.g. gift) or otherwise not ascertained at the
time of its execution, or if the consideration as ascertained were less than the market value of
the property, stamp duty would be charged on the value of the property transferred. These
sections serve the purpose of addressing tax avoidance, curbing the underpayment of stamp
duty by stating nil or inadequate consideration in the stampable instruments. As regards
immovable property, the Commissioner of Rating and Valuation, if necessary, will be requested
to provide expert advice as to the adequacy of the stated consideration. Conversely, as regards
shares, the listed price of shares listed on a stock exchange will be used to determine their
value; otherwise, for unlisted shares, reference will be made to the audited financial statements
of the company in question, with net asset value (also known as NAV) generally utilised
as a proxy.

It would follow that if a company (C) gifts a property (P) to a subsidiary (S), then the value
of the transfer for the purposes of computing the charge to ad valorem stamp duty on the
transfer of P will be its market value at the time of the transfer.

Note that ‘consideration’ for the purposes of computing ad valorem stamp duty may be
consideration either in cash or in kind. If C transfers P to S in exchange for the issue of 1 million
shares in S, the open market value of such shares will be taken to be the consideration given
for the transfer of P for stamp duty purposes. Therefore, the stamp duty will be calculated
based on the higher of the market value of 1 million shares in S or the market value of P at the
time of the transfer. By way of illustration, assume that the 1 million shares in S were, according
to its audited financial statements and most recent management accounts, worth HK$50
million, that means the consideration given will be treated as equivalent to that amount. Thus,
if P were actually worth HK$100 million, then stamp duty would be assessed on the basis of
HK$100 million of value and not HK$50 million of consideration.

If the sum payable under an instrument is unascertainable as at the time of execution, no

duty can be assessed; however, where the sum is merely uncertain, duty is assessed on the
maximum which might become payable and which can be calculated in advance as at the time
of execution. This is the so-called ‘contingency principle’.

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Illustrative Example 1
If C were to transfer P to S for a fixed consideration of HK$25 million, and a variable
consideration that is stated in the sale and purchase agreement will be between
HK$1 million and HK$10 million, the maximum HK$10 million of variable consideration
will be assumed for stamp duty purposes, such that ad valorem duty would be charged
on the basis of an aggregate consideration of HK$35 million (assuming, of course,
this were at least equal to the market value of P). Because of the application of the
contingency principle, most lawyers suggest that, where possible, variable consideration
clauses should not be included in agreements for the transfer of Hong Kong immovable
property or of Hong Kong stock, or at least that the maximum amount would not be set
as ceiling where variable consideration is essential and necessary.

Consideration sometimes may not be just in the form of cash. If the consideration is not in
cash, the stamp duty is charged in the following manner:

• If stock is the consideration:

°° Stamp duty is charged by reference to the value of the stock on the date of
conveyance – s.22(1).

• If security other than stock is the consideration:

°° Stamp duty is calculated on the amount due on the date of conveyance for principal
and interest on the security – s.22(2).

• For the transfer of Hong Kong immovable property or Hong Kong stock, if debt due to
the transferee is the consideration (i.e. debt waived):

°° Stamp duty is calculated on the amount of the debt waived – s.24(1).

°° By way of relief, there is a limitation on the effect of s.24(1) in that ad valorem

stamp duty may be charged on the value of the property upon adjudication by the
Collector, if the debt waived exceeds the value of the property – s.24(2).

• For transfer of Hong Kong shares, if guaranteed debt is the consideration:

°° Under s.24(3), if the transferee has to guarantee the repayment of the debts owed
by the transferred company after the transfer of shares, the amount of the debt so
guaranteed by the transferee will be regarded as part of the consideration for the
transfer of shares.

Where the stamp duty calculated includes a fraction of HK$1, round up the duty to the
nearest HK$1 (s.18A).

S.24 of the SDO is an anti-avoidance provision that deems certain debts discharged,
payments of money, transfers of stock and indebtedness incurred to be the whole or part of
the consideration for the sale of property or the passing of a beneficial interest in Hong Kong
stock in relation to the assessment of stamp duty on conveyances on sale and chargeable
agreements for sale and purchase of immovable property, and on any transaction whereby a
beneficial interest in Hong Kong stock passes. Thus, where consideration includes any debt due
to the transferee or the payment or transfer of any money or stock, such debt, money or stock

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is considered to be part of the transfer consideration, and ad valorem duty is to be charged

accordingly.

For exchange of property, stamp duty is charged on the difference of the values of the
properties exchanged, that is, the equality money.

Illustrative Example 2
A Ltd assigned an immovable property located in Hong Kong to B Ltd for a cash
consideration of HK$10 million and B Ltd’s agreement to waive a debt owed by A Ltd to
B Ltd. The outstanding amount of the debt so waived by B Ltd is HK$5 million.

The total amount of consideration subject to stamp duty is HK$15 million (i.e. HK$10
million + HK$5 million) under s.24(1).

If the market value of the property is only HK$12 million, the companies can apply to
the Collector for using HK$12 million for computation of stamp duty payable under s.24(2).

An agreement to exchange immovable properties is in the ordinary course chargeable

with stamp duty as if it were two separate chargeable agreements for sale (s.10(2)), unless any
relief applies. S.29C(10) nevertheless provides that stamp duty is to be computed by reference
to an agreement to exchange on the basis of the ‘equality money’, that is, the money paid
for the difference in value of the properties instead of on the value of each of the respective
properties. This rule is subject to the adequacy of consideration requirement in s.29F – if
the properties are exchanged without equality money or the equality money is less than
the difference in values of the properties, stamp duty will subsequently be charged on the
difference in values of the properties. In other words, stamp duty will be charged on the higher
of the difference between the market values of the properties exchange or the equality money
flowing between the parties of the exchange.

Illustrative Example 3
Mr. Hungus enters into an agreement with Mr. Zokosta to exchange a residential property
owned by Mr. Hungus for a residential property owned by Mr. Zokosta. Mr. Hungus’s
property in North Point has been valued at HK$15 million by the Commissioner of Rating
and Valuation, while Mr. Zokosta’s property in Sai Kung has been valued at HK$25 million
by the same. They agree to an equality money cash payment of HK$10 million. Pursuant
to s.29C(10), ad valorem stamp duty will be charged on the HK$10 million. If, however,
only HK$5 million of equality money had been paid, then s.29F would operate to deem
the equality money to be HK$10 million for stamp duty purposes.

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Key Learning Point

Stamp duty is a tax on instruments – that is, documents – and not on transactions.

There are four principal heads of charge for stamp duty, listed in the First Schedule of
the SDO, they are, immovable property in Hong Kong, Hong Kong stock, Hong Kong bearer
instrument, and duplicates and counterparts.

Key Learning Point

In assessing whether a document is dutiable, one looks to the substance and not the form
or label of the document.

In construing stamp duty legislation, the orthodox contemporary doctrine of statutory

construction is a purposive approach that seeks to interpret the plain meaning of the
statute in its appropriate legislative context.

Knowledge Check Question

Question 1
Gary wishes to lease a property to Dave for a period of six years in consideration for a
premium of HK$1 million and a monthly rent of HK$35,000. To avoid stamp duty on the
lease, he enters into an agreement with Dave which is titled a ‘licence’. Identify which of the
following statements is the most accurate.
A One looks to the strict legal designation of the instrument: because it is labelled a
licence, it is not stampable.
B Because the licence includes a lease premium, it is in substance a lease, and is therefore
stampable.
C The Stamp Office is not competent to adjudicate this matter and it must be referred to
the courts.
D Although the instrument is labelled a licence, it is by reference to its terms and the
legal relations it is intended to bring about as between Dave, Gary and the property, in
substance, a lease; accordingly, the instrument is stampable.

7 . 2
IMMOVABLE PROPERTY IN HONG KONG

Ad valorem stamp duty is charged on either the sale and purchase agreement for the transfer
of Hong Kong immovable property or on the conveyance for the transfer of Hong Kong
immovable property. Separately, ad valorem stamp duty is also chargeable on an agreement

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for a lease. The conveyancing and property holding regimes in Hong Kong are complex.
Generally, a sale and purchase agreement, which operates to transfer beneficial interest
in a property, precedes the assignment of the property, which is a separate instrument
that operates to perfect the transfer and to convey legal ownership of the property to the
transferee. Historically, the assignment was the stampable instrument; however, the preferred
contemporary approach is to procure the stamping of the sale and purchase agreement.

In everyday parlance, ‘immovable property’ in general refers to lands and buildings, but s.3
of the Interpretation and General Clauses Ordinance (Cap.1) defines the term as meaning:

1. Land, whether covered by water or not;

2. Any estate, right, interest or easement in or over land; and

3. Things attached to land or permanently fastened to anything attached to land.

Accordingly, options to acquire immovable property and certain easements are ‘immovable
property’ for the purposes of the SDO (George Wimpey & Co Ltd v IRC (1975) 2 All ER 45).

The transfer of immovable property in Hong Kong by way of gift gives rise to a charge to ad
valorem stamp duty on the value of the property so transferred. There are certain exceptions
to this general rule, which will be discussed in further detail in this chapter.

Most importantly, the assent by an executor or administrator to a beneficiary under a

will does not give rise to stamp duty, because the will itself does not transfer the property to
the beneficiary; it is, instead, the operation of the general law of probate and succession in
Hong Kong. A mortgage, which technically involves the transfer of property by the mortgagor
(the person who takes out the mortgage) to the mortgagee (the bank or financial institution
making the loan) subject to the equity of redemption is also not treated as a conveyance on
sale and does not give rise to a charge to stamp duty because it is not a conveyance on sale: in
essence, it is security for the repayment of a loan (see also s.27(5) of the SDO).

Generally, conveyances of property between closely related persons are treated

preferentially for stamp duty purposes. A closely related person is defined in s.29AD of the SDO
as, in the case of two persons, if one of them is the parent, spouse, child, brother or sister of
the other and in the case of three or more persons if each of them is a parent, spouse, child,
brother or sister of each of the others.

Note that the stamp duty code distinguishes between residential and non-residential
property. In response to increasing property speculation and unaffordable house prices, the
Hong Kong government has introduced fiscal measures to discourage speculation in and
stockpiling of residential property, especially by those who are not resident in Hong Kong.

S.29A(1) defines residential property as any property other than non-residential property.
Non-residential property is defined in the same section as immovable property which, under
the existing conditions of:

a. A government lease or an agreement for a government lease;

b. A deed of mutual covenant, within the meaning of s.2 of the Building Management
Ordinance (Cap.344);

c. An occupation permit issued under s.21 of the Buildings Ordinance (Cap.123); or

d. Any other instrument which the Collector is satisfied effectively restricts the permitted
user of the property;

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may not be used, at any time during the term of the government lease in respect of the
property or during the term of the government lease that has been agreed on in respect of the
property (as is appropriate) wholly or partly for residential purposes.

There are three kinds of stamp duty that may emerge from the conveyance on sale of
Hong Kong immovable property: ad valorem stamp duty (AVD), special stamp duty (SSD), and
buyer’s stamp duty (BSD). The last two apply only to residential property.

7.2.1 Introduction to Property Law in Hong Kong

As a preliminary comment, there are in general two legal documents that govern the
transfer of immovable property in Hong Kong: the agreement for sale and the conveyance.
Land is a particular kind of property which requires certain formalities in order to be
transferred. Unlike other forms of property that can be transferred by negotiation – like
cash, which ownership is transferred when it changes hands – or by way of a sale and
purchase agreement – like shares or other intangibles – immovable property must at law,
in general, be transferred by deed. Most sales and purchases of immovable property in
Hong Kong are governed by a sale and purchase agreement, which sets out the principal
commercial terms of the bargain between vendor and purchaser. Once executed, however,
performance of the sale and purchase agreement only transfers beneficial interest in the
property to the purchaser, who may thereafter sue for specific performance (i.e. to get the
property itself rather than cash compensation in the event of a breach of contract on the
part of the vendor). The agreement for sale is, however, not sufficient to transfer legal title
in the property. For those purposes, the assignment, which is technically designated as
‘conveyance’ in the SDO, is required.

The assignment is executed as a deed: That means that it needs to be signed, sealed,
and delivered as a deed. The formalities for executing a deed are more stringent than those
for executing a simple contract for the sale of property, which may be executed by simple
signature, and does not need to be sealed or delivered as a deed.

A sample transaction flow of a Hong Kong conveyancing transaction is as shown in

Exhibit 7.2.

Provisional agreement Sale and purchase

Assignment (legally
(heads of terms, will agreement (legally
binding – transfers legal Registration in the Land
generally be superseded by binding – transfers
interest in the property to Registry
the formal agreement for beneficial interest in the
the purchaser)
sale) property to the purchaser)

EXHIBIT 7.2 Conveyancing transaction in Hong Kong

Note that unlike many other common law jurisdictions, Hong Kong does not have freehold
land. All title to land is held under a government lease – also known as leasehold. The duration
of the lease will depend on the location of the property in question. The government, therefore,
is the ultimate owner (freeholder) of all land in Hong Kong, save for St John’s Cathedral, which is
held by the Anglican Church on a conditional freehold.

The head leaseholder is, in common parlance, treated as the ‘owner’ of the land. The
leaseholder may, subject to the terms of the government lease and any restrictive covenant

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binding them, in turn, sublet the property to other persons. Such subleases are simply called
‘leases’. References to a ‘lease’ in the context of stamp duty generally refer to relatively short-
term leases of property from the head leaseholder.

7.2.2 Conveyance
Head 1(1) of the First Schedule of the SDO provides that a conveyance on sale of Hong
Kong immovable property is stampable. S.2(1) of the SDO provides that a ‘conveyance’ is:
every instrument (including a surrender) and every decree or order of any court whereby any
immovable property is transferred or vested in any person. ‘Conveyance on sale’ means: every
conveyance whereby any immovable property, upon the sale thereof, is transferred to or
vested in a purchaser or any other person on his or her behalf or by his or her direction, and
includes a foreclosure order. It is not possible to avoid ad valorem stamp duty by seeking to
transfer the property orally or otherwise without an instrument of transfer. Historically, only
the assignment was chargeable to stamp duty under Head 1(1). But now in most cases, the AVD
is charged on the agreement for sale under Head 1(1A). Where AVD is paid on the agreement
for sale, only a fixed HK$100 duty is charged on the assignment. The reason for this change
is historic. In the past, property speculation would be effected on a confirmation basis. That
means that a person could acquire property under a sale and purchase agreement free from
AVD – bearing in mind that at that time duty was only charged on the assignment – and thereby
acquire beneficial interest in it. The speculator could then ‘flip’ the property to another buyer
at a mark-up, but it was the original vendor and the new purchaser who paid the stamp duty
on the assignment, and not the speculator acting as confirmor. The introduction of Head 1(1A)
closed that loophole.

As summarised above, Hong Kong conveyancing law is complex. In general, the agreement
for sale is executed prior to the assignment, which may take place a month or more after the
agreement for sale is signed. That is because both the agreement for sale and the assignment
are required in order to perfect the sale and purchase of Hong Kong immovable property from
vendor to purchaser. Once executed, the agreement for sale operates to transfer beneficial
interest in the property, subject to the payment of the transfer consideration, to the transferee.
The assignment, conversely, operates to transfer legal title in the property to the transferee. In
practice, therefore, ad valorem stamp duty, together with BSD and SSD where relevant, are now
paid on the agreement for sale and not the assignment.

7.2.3 Agreement for Sale

S.29A(1) of the SDO provides that a chargeable agreement for sale includes:

• An instrument in which a person contracts to sell or purchase immovable property;

• An instrument in which a person confers, or has conferred on them, an option or a right

to purchase immovable property or a right of pre-emption in respect of immovable
property, other than a specified option or right (i.e. an option);

• An instrument in which a declaration of trust in respect of immovable property is

made, other than a declaration of trust under which no beneficial interest passes in the
property subject to the declaration;

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• An instrument that, if implemented, would be implemented by a conveyance on sale; or

• An instrument that constitutes a memorandum, note or other evidence of an unwritten

sale agreement.

Generally, therefore, any contractual agreement for sale or purchase of land and buildings
in Hong Kong will come within the terms of the definition. In this regard, the part of the
definition most likely to be applicable is that which encompasses ‘an instrument in which
a person contracts to sell or purchase immovable property’. That said, unless specifically
excluded, a nomination made or a direction given by a purchaser of an immovable property
to another person to take up an assignment of the property is an agreement for sale under the
definition of ‘agreement for sale’ in s.29A(1) of the SDO. In this context, a nomination occurs
where a person acquires a property and thereafter nominates another person to take up the
assignment. The nominee nominated to take up the assignment will in general be the person
who will actually be the transferee. Under those circumstances, the nominee is in effect a bare
trustee or agent of the transferee: He or she will effect the agreement for sale and purchase,
but will turn over the property legally and, in the ordinary course, beneficially to the nominee.
Nominee arrangements are not uncommon in family contexts: parents may acquire a property
and nominate one or more of their children to take up the assignment.

The definition does not cover what might be called a usual mortgage (or charge – i.e.
security taken over immovable property other than a mortgage). A mortgage in ordinary
circumstances is, put simply, security given to the lender for a loan to acquire the property
whereby legal and equitable title to the property is vested in the lender, subject to the
mortgagor’s (i.e. the borrower’s) equity of redemption. A mortgage has to be in writing, and is
therefore an instrument in principle capable of attracting stamp duty. That said, a mortgage
confers no immediate or automatic right of sale of the property in the lender (in other words,
such a right is exercisable if and only if there is a default on the part of the mortgagor).
Consequently, a mortgage does not qualify as an agreement for sale as defined in the SDO and
is therefore not chargeable with duty. Alternatively, an agreement for sale or other instrument
that is simply disguised as a mortgage and that incorporates a provision, such as an irrevocable
power of attorney, that has the practical effect of granting the mortgagee an absolute right to
the property is not a true mortgage for stamp duty purposes. Such an instrument is not merely
security for the loan advanced by the mortgagee but gives, expressly or implicitly, an immediate
and automatic right of disposal of a property that is stampable.

In so far as head 1(1A) in the First Schedule is concerned, s.29AB(1)–(2) provides that a
nomination or direction is excluded from the definition of ‘agreement for sale’, and thus not
chargeable with AVD if the relevant property is a residential property and it is shown to the
satisfaction of the Collector that each of the following conditions apply:

1. It is made or given in favour of one, or more than one, person (whether or not also in
favour of the purchaser);

2. On the date of the nomination or direction that person, or each of those persons, is
closely related to the purchaser, or to each of the purchasers and where there is more
than one person, those persons are also closely related;

3. That person, or each of those persons, is acting on his or her own behalf; and

4. That person, or each of those persons, is not a beneficial owner of any other residential
property in Hong Kong.

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Illustrative Example 4
Consider the following cases. Mr. Karl Hungus is a Hong Kong permanent resident who
does not own any other residential property in Hong Kong. He acquires a property,
Blackacre, in Sai Kung and:

1. Nominates his wife, Bunny Lee, a Hong Kong permanent resident not owning any
other property in Hong Kong, to take up the assignment. His wife is treated as a
close relative and, accordingly, no AVD is chargeable on the nomination.

2. Nominates his daughter, Ilse, to take up the assignment. Ilse owns a flat in Mid-
Levels. As she is already the owner of a residential property in Hong Kong, the
nomination is chargeable with AVD at the lower Scale 2 rates. That is because
Ilse is closely related to Mr. Hungus, but already owns a residential property in
Hong Kong.

3. Nominate Ilse’s fiancée, Hilde, who owns a town house on Lantau Island. That
nomination is charged with AVD at the higher Part 1 of Scale 1 rates. That is
because Hilde is not closely related to Mr. Hungus, and already owns a residential
property in Hong Kong.

S.29A(2) specifies that a stampable agreement for sale and an unwritten sale agreement
may be enforceable or unenforceable, absolute or conditional, formal or informal, temporary
or permanent, provisional or non-provisional. This is to avoid any assertion on the part of the
duty payer that an agreement does not fall within the definition of a stampable agreement
for sale and so to discourage aggressive stamp duty planning. In Hong Kong conveyancing
practice, it is conventional for the purchaser and the seller of immovable property to execute
a so-called provisional or preliminary agreement. The buyer will usually provide a deposit
(typically 5% of the purchase price) when signing the provisional agreement to indicate his or
her willingness to progress the transaction to completion. In the event that the buyer chooses
not to proceed to a formal agreement for sale and purchase and to assignment, he or she
would forfeit the deposit. The deposit is, in effect, security for the buyer’s undertaking to
acquire the property. Despite being labelled ‘provisional’ such agreements fall within the s.29A
definition of agreement for sale and purchase and are therefore stampable, unless superseded
by a formal agreement for sale. On the same footing, an instruction for sale or a memorandum
of sale signed at a developer’s sale office falls within the definition. To prevent the use of
frivolous conditions as a means of circumventing the provisions whenever a property is resold,
conditional agreements are also covered by the definition. In order to ensure that stamp duty is
not avoided by the vendor and purchaser of immovable property simply by declining to execute
an agreement for sale.

Unless superseded by a definitive agreement for sale, a merely provisional agreement for
sale which is de facto final because it is performed and not superseded is therefore stampable
as an agreement for sale within the meaning of s.29A. S.29B of the SDO further creates a
requirement for the purchaser and vendor under an unwritten sale agreement within 30 days
after the relevant date of the agreement (being in practice the date when an unwritten

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agreement for the sale and purchase of the property was made or, in other words, when the
agreement was in principle reached to buy and sell – s.29B(3)), if they have not already done so,
to execute a written agreement for sale. Note, however, that if the provisional agreement and
the sale and purchase agreement are executed more than 14 days apart, the first agreement
should be presented for stamping within 30 days after the relevant date (as defined in the
preceding text). After the first agreement is stamped, the second agreement is chargeable with
fixed stamp duty of HK$100 and the time for stamping is within 30 days after its execution
and on the relevant date. Under those circumstances, it is the provisional sale and purchase
agreement that is the instrument that in practice bears AVD.

The charge to stamp duty is not, however, intended to catch non-binding agreements.
Therefore, where an agreement for sale is made ‘subject to contract’, it does not fall within the
definitional ambit of an agreement for sale. In this regard, it is relevant that the definition of
‘agreement for sale’ expressly requires the agreement to be one in which ‘a person contracts to
sell or purchase immovable property’.

The following matters must be specified in the required agreement for sale (S.29B(5)):

1. Names, addresses and ‘identification numbers’ of the vendor and purchaser. If

the vendor or purchaser is not an individual but is registered under the Business
Registration Ordinance (Cap.310), the business registration number of the vendor or
purchaser;

2. Location of the property;

3. Whether the property is residential or non-residential;

4. Date on which the agreement for sale was made;

5. If the agreement for sale was preceded by an unwritten sale agreement or another
agreement for sale, made between the same parties and on the same terms, the date
on which the first such agreement was made;

6. Whether a date has been agreed for the conveyance on sale, and if so, that date;

7. Whether there is an agreed consideration for the conveyance on sale, and if so, the
amount or value of the consideration;

8. The amount or value of any ‘other consideration’ paid or given in relation to the
agreement for sale or conveyance on sale pursuant to that agreement, such as
confirmor fees, and the names, addresses and identification numbers or business
registration numbers of the recipients; and

9. If the purchaser has not executed the agreement, a statement by each person
executing the agreement as to whether the purchaser knows that the agreement
affects them.

As summarised in Section 7.1.3, s.29C(10) provides that ad valorem stamp duty on an

agreement to exchange immovable properties will be computed by reference to the ‘equality
money’. This section also applies to a chargeable agreement to partition an immovable
property. Property is partitioned when an existing property is separated into multiple, smaller
properties. S.29C(10) applies to a case where both of the properties to be exchanged are

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residential properties, which are, in general, subject to stamp duty at much higher rates
relative to commercial property and which further entails a potential charge to SSD and
BSD. Stamp Office Interpretation and Practice Notes (SOIPN) No. 1 sets out the Collector’s
view that the section also applies to a case where a residential property is exchanged for
a non-residential property or vice versa. Thus, the exchange of a residential property for a
non-residential property may be subject to BSD computed by reference to the value of the
residential property.

If an agreement for sale is cancelled, annulled or rescinded, or is otherwise not performed,

it will not be treated as a chargeable agreement for sale (s.29C(5A)(a)). An exception to that
general rule is where the cancellation, annulment, rescission or non-performance, as the case
may be, results from the occurrence of a specified event described in s.29C(5AA), such as a
resale or disposal of the property by way of nomination or direction by the first purchaser.
Under those circumstances, the agreement will continue to be treated as a chargeable
agreement for sale (s.29C(5A)(b)).

Illustrative Example 5
(Adapted from SOIPN no. 1)

If A purchases a property from Developer X and later resells it to B, the agreement

for sale made between X and A is chargeable even though the agreement, in line with
common market practice, is subsequently cancelled by consent of the parties and
replaced by a new chargeable agreement made between X and B. For the avoidance of
doubt, s.29C(4)(b) provides that the new agreement made between X and B is chargeable
with stamp duty by reference to the consideration (which includes any confirmor fee)
required to be stated in the new agreement. A document that is used for the purpose
of cancelling an agreement for sale will not itself be regarded by the Collector as an
agreement for sale chargeable to duty.

If stamp duty has been paid for an agreement for sale which, pursuant to s.29C(5A)
(a) of the Ordinance, is not regarded as a chargeable agreement, an application for refund
may be made to the Collector within two years after the cancellation, annulment or
rescission of the agreement, or in the case where the agreement is not performed, two
years after the agreed date of completion of the transaction (s.29C(5B)).

7.2.4 The Charge to Ad Valorem Stamp Duty

AVD is the base duty payable in all circumstances on transfer of beneficial interest of
immovable property in Hong Kong. SSD is payable on stampable instruments for the sale or
transfer of residential property acquired on or after 20 November 2010 and subsequently
disposed of within a specific period of time. BSD is payable by the purchaser of a residential
property if that purchaser is not a Hong Kong permanent resident (HKPR) acting on his or her
own behalf. SSD and BSD, where he or she is charged, are payable in addition to AVD. Thus, a
given property transaction can in practice give rise to a charge to AVD, SSD, and BSD – each is
computed and charged separately.

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AVD is charged either at Scale 1 or Scale 2 rates (the lower rates) (see Section 7.2.5).
Scale 1 rates are further divided into Part 1 (a flat rate of 15%) and Part 2. Scale 1 (Part 1) is for
residential property, while Scale 1 (Part 2) is for non-residential property.

Scale 1 rates are applicable by default, unless Scale 2 applies (s.29BA). For example,
an agreement for sale of residential property is chargeable with AVD at Scale 2 rates if the
purchaser is a HKPR acting on his or her own behalf and is not a beneficial owner of any other
residential property in Hong Kong (s.29BB) or the agreement for sale of residential property is
between closely related persons (s.29BD).

According to s.29AC(1) and (2), the beneficial owner of a residential property includes
a purchaser under an agreement for sale of the property even if the transaction has not
been completed, unless the agreement for sale has been cancelled, annulled or rescinded,
or otherwise not performed. For example, suppose you are not a beneficial owner of any
residential property in Hong Kong and you acquire two residential properties from a developer
on the same day by signing two separate agreements for sale. The second agreements for
sale you sign will be chargeable with AVD at Scale 1 (Part 1) rates because you are already
a beneficial owner of the first property after you had signed the first agreement for sale,
thus s.29BB is not applicable. Likewise, a vendor under an agreement for sale of residential
property will not be regarded as the beneficial owner of the property being disposed of.
S.29AC(3) also states that a beneficial owner of a residential property includes a beneficial
owner of part of the property. That means that even if a person is a tenant-in-common
who owns only 10% of a residential property, this person is a beneficial owner of a
residential property.

Furthermore, under a property holding trust (e.g. a person [trustee] holds a property for
another person [beneficiary] under a trust arrangement), although the trustee is the legal
owner, the beneficial owner is the beneficiary. However, it may not be known by other people
not involved in the trust. Therefore, in practice, the Stamp Office requires all the purchasers
who apply AVD to be charged at Scale 2 rates under ss.29BB to 29BD to submit a statutory
declaration to declare that they are not a beneficial owner of any other residential property in
Hong Kong.

Additionally, to prevent taxpayers using an HKPR as their agent or trustee to avoid paying
AVD at higher rates, the purchaser or transferee has to make statutory declaration that he or
she is acting on his or her own behalf in order for Scale 2 rates to be applied.

There is circumstance that a HKPR would like to change his or her only residential property
to a new one, however, the HKPR will be subject to AVD at Scale 1 rates when acquiring the new
residential property as he or she is already a beneficial owner of another residential property in
Hong Kong (i.e. his or her original property). The original intention of introducing the two-scale
AVD rates was to curb short-term speculative activities and to address the overheated property
market, but not to affect the normal needs in Hong Kong. Therefore, s.29DF provides a refund
mechanism for any HKPR who is acting on his or her own behalf in acquiring a residential
property (and a car parking space, if applicable) (‘the subject property’) to replace his or
her only residential property (and a car parking space, if applicable) (‘the previously owned
property’) to apply for partial refund of AVD paid. The amount of partial refund will be equal to
the difference between the AVD paid and the AVD calculated at Scale 2 rates. The HKPR needs
to prove that the previously owned property has been disposed of by an agreement for sale or

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conveyance on sale within 12 months from the date of assignment of the subject property if
the subject property is acquired on or after 5 November 2016. It should be noted that where at
the time of acquisition of the subject property, the purchaser owned more than one property,
he or she will not be entitled to a partial refund even if all properties are disposed of within
12 months (Ho Kwok Tai v CSR (2016) 5 HKLRD 713).

Specifically, Scale 2 rates apply to the following situations:

• Acquisition of a residential property (together with a car parking space) by a HKPR(s)

acting on their own behalf who is not a beneficial owner of any other residential
property or car parking space in Hong Kong at the time of acquisition;

• Acquisition of a residential property by a HKPR(s) jointly with close relative/s (i.e.

spouse, parents, children, brothers and/or sisters) who is not a HKPR, and each of the
purchasers is acting on his or her own behalf and not a beneficial owner of any other
residential property in Hong Kong at the time of acquisition;

• Transfer of residential properties between close relatives;

• Nomination of a close relative(s) to take up assignment of a residential property;

• Acquisition or transfer of a property (residential or non-residential) by a court order,

which includes a foreclosure order obtained by a mortgagee (whether financial
institution or not);

• Transfer/vesting of a mortgaged property under a conveyance to its mortgagee that is a

financial institution; and

• Replacement property – acquisition of a property to replace another property that was

owned by the purchaser and the original property has been acquired by the Urban
Renewal Authority or resumed by an order (i.e. property re-acquired by the government
for public use).

Exemption from AVD applies to the following situations:

• Nomination of a close relative(s) (be they HKPRs or not) to take up assignment of

residential property who do(es) not own any other residential property in Hong Kong at
the time of nomination;

• Transfer of a property to a beneficiary of the estate of a deceased person pursuant to

a will or in accordance with the law of intestacy or acquired the property by the right of
survivorship;

• Transfer of a property to a body corporate from an associated body corporate;

• Transfer of properties to the government; and

• Gift of properties received by charitable institutions exempted from tax under s.88 of
the Inland Revenue Ordinance (IRO).

Partial refund for residential property can be obtained if:

• A HKPR who is acquiring a residential Property B to replace his or her only other
residential property A can apply for partial refund of AVD;

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• Subject to AVD at Scale 1 as usual in the first instance;

• Refund of the stamp duty paid in excess (computed under Scale 2) if Property A has
been disposed of within six months (if Property B was acquired before 5 November
2016) or 12 months (if Property B was acquired on or after 5 November 2016) from the
date Property B was assigned to him or her; and

• General time limit: within two years after the date of the chargeable instrument
(i.e. normal sale and purchase) for acquisition of Property B or not later than two months
after the date of the assignment for the disposal of Property A, whichever is the later.

Parking spaces for cars are a special case, and one that is particularly relevant in
Hong Kong, since the availability of a parking space can materially impact the relative
commercial attractiveness of a residential property.

A car parking space is, technically speaking, not residential property and is in general
a tenement separate from any residential property to which it is attached. Where a HKPR
acquires residential property together with a car parking space under a single agreement
for sale or a conveyance on sale, the instrument in question is chargeable to AVD at the
lower Scale 2 rates provided that the HKPR is acting on his or her own behalf in acquiring the
properties concerned and on the date of acquisition, he or she is neither a beneficial owner of
any other residential property nor a beneficial owner of any other car parking space in Hong
Kong. This arrangement specifically covering scenarios where a parking space is acquired
together with residential property is only applicable where the relevant residential property is
a single residential property (ss.29AK and 29BC). Thus, the lower Scale 2 rates of AVD are only
applicable for a HKPR acquiring one residential property together with one car parking space
(i.e. parking space for one motor vehicle, only).

If a single instrument involves more than one car parking space, all of which are separable
from the residential property purchased under the same instrument, all the car parking spaces
will be chargeable with AVD at Part 2 of Scale 1 rates.

Below are some examples extracted from SOIPN No.8:

Example 1

Mr. A entered into an agreement for sale on 1 January 2018 to acquire a single residential
property and a car parking space at the respective prices of HK$5 million and HK$1 million.
Mr. A was a HKPR acting on his own behalf in acquiring the properties and did not own any
other residential property or car parking space in Hong Kong on the date of acquisition.

AVD payable

The agreement for sale will be chargeable with AVD at Scale 2 rates. The applicable duty rates
are determined by reference to the total consideration of HK$6 million. The total amount of
AVD payable is HK$180,000 (HK$6,000,000 × 3%).

Example 2

Mr. A entered into an agreement for sale on 1 January 2018 to acquire a single residential
property and a car parking space, both of which are separable from each other, at the

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respective prices of HK$5 million and HK$1 million. Mr. A was a HKPR acting on his own behalf
in acquiring the properties and did not own any other residential property but owned another
car parking space in Hong Kong on the date of acquisition.

AVD payable

The acquisition of the residential property and the car parking space will be regarded as
separate and distinct matters. Scale 2 rates will apply to the acquisition of the residential
property whereas Part 2 of Scale 1 rates will apply to the acquisition of the car parking
space. The applicable duty rates are determined by reference to the total consideration
of HK$6 million. The total amount of AVD payable on the chargeable agreement for sale is
HK$210,000 which is computed as follows:

(a) AVD payable on the residential property: HK$5,000,000 × 3% = HK$150,000

(b) AVD payable on the car parking space: HK$1,000,000 × 6% = HK$60,000

7.2.5 Rates of Ad Valorem Stamp Duty

The current rates of AVD are as in Exhibits 7.3 and 7.4

Amount or value of the consideration Rates at Scale 1 (Part 1): Applicable to

(whichever is the higher) instruments of residential property
executed on or after 5 November 2016
15%

Amount or value of the Rates at Scale 1 (Part 2): Applicable to instruments

consideration (whichever is the  of non-residential property executed on or
Exceeds Does not exceed after 23 February 2013 and certain instruments
HK$ HK$ of residential property executed on or after
23 February 2013 but before 5 November 2016
2,000,000 1.5%
2,000,000 2,176,470 HK$30,000 + 20% of excess over HK$2,000,000
2,176,470 3,000,000 3%
3,000,000 3,290,330 HK$90,000 + 20% of excess over HK$3,000,000
3,290,330 4,000,000 4.5%
4,000,000 4,428,580 HK$180,000 + 20% of excess over HK$4,000,000
4,428,580 6,000,000 6%
6,000,000 6,720,000 HK$360,000 + 20% of excess over HK$6,000,000
6,720,000 20,000,000 7.5%
HK$20,000,000 HK$21,739,130 HK$1,500,000 + 20% of excess over HK$20,000,000
HK$21,739,130 8.5%

EXHIBIT 7.3 Current rates of AVD – rates at Scale 1

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Amount or value of the consideration

(whichever is the higher)
Exceeds Does not exceed
HK$ HK$ Rates at Scale 2
2,000,000 HK$100
2,000,000 2,351,760 HK$100 + 10% of excess over HK$2,000,000
2,351,760 3,000,000 1.5%
3,000,000 3,290,320 HK$45,000 + 10% of excess over HK$3,000,000
3,290,320 4,000,000 2.25%
4,000,000 4,428,570 HK$90,000 + 10% of excess over HK$4,000,000
4,428,570 6,000,000 3%
6,000,000 6,720,000 HK$180,000 + 10% of excess over HK$6,000,000
6,720,000 20,000,000 3.75%
20,000,000 21,739,120 HK$750,000 + 10% of excess over HK$20,000,000
21,739,120 4.25%

EXHIBIT 7.4 Current rates of AVD – rates at Scale 2

AVD is usually payable within 30 days after the execution of the stampable agreement
(s.29B(3) of the SDO). As stated before, technically, AVD can be charged on either the sale
and purchase agreement or the assignment (i.e. under either Head 1 or Head 1A). If, as is
the usual contemporary practice in Hong Kong, AVD is charged on the sale and purchase
agreement, then the assignment that serves to complete the conveyance of the immovable
property in question bears a nominal fixed duty of HK$100, provided always that it be executed
in conformity with the stamped agreement for sale (s.29D(2)(a) and First Schedule of the SDO,
Head 1(1A), note 3(b)). A conveyance on sale is not executed ‘in conformity with’ an agreement
for sale unless it is in favour of exactly the same person(s) named in the agreement for sale as
the purchaser(s) and the conveyance is of the whole or part of the immovable property which is
the subject matter of the agreement for sale (s.29D(6)(c)).

AVD is the gateway tax to SSD and BSD. Where no AVD is chargeable, neither are
SSD or BSD.

Illustrative Example 6 – Scale 2 Rates – Nomination

(Adapted from SOIPN No. 1)

Mr. A entered into a provisional agreement for sale and purchase (PASP) to acquire a
residential property on 1 January 2018. On 10 January 2018, he made a nomination to
nominate his wife, Ms. B, to take up the entire assignment of the property. Ms. B was
acting on her own behalf in the nomination and she owned a residential property in
Hong Kong on the date of nomination.

The said PASP on 1 January 2018 is chargeable with AVD. In addition, the nomination is
chargeable with AVD again at Scale 2 rates as Ms. B is a closely related person to Mr. A. If
Ms. B is not a closely related person, Scale 1 Part 1 rate will apply.

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Illustrative Example 7 – Exemption from AVD – Nomination

Mr. A entered into a PASP to acquire a residential property on 1 January 2018. On
10 January 2018, he formally nominated his wife, Ms. B, to take up the assignment of the
property. Ms. B was acting on her own behalf in the nomination and she did not own any
residential property in Hong Kong on the date of nomination.

Again the said PASP on 1 January 2018 is chargeable with AVD, yet the nomination is
not an agreement for sale and thus is not chargeable with AVD. That is because the PASP
is for the purposes of s.29A an agreement for sale, which was not superseded by any
other agreement. Conversely, the nomination is an instrument that may specifically be
exempted, and would have been so exempt if Ms. B had not owned any other residential
property in Hong Kong. However, she did in Illustrative Example 6, and so her case did not
fall within the terms of exemption and AVD was payable with respect to the nomination as
well as with respect to the PASP as two separate agreements for sale.

Illustrative Example 8
(Adapted from SOIPN No.1)

A sells a property to B. B, in turn, sells the property to C. A conveyance on sale of the

property is made directly by A to C with B joining as the confirmor and there is no
independent agreement for sale concluded between B and C. The stamp duty position
would be as follows:

1. The conveyance on sale is charged with stamp duty of HK$100 only if C can
produce a stamped agreement for sale under which he is named as the purchaser,
that is, the sub-sale agreement made between B and C. The first agreement for
sale between A and B should also be stamped with AVD.

2. If the chargeable agreement between B and C is not stamped, the conveyance

on sale is chargeable to AVD under Head 1(1) in the First Schedule, plus a penalty
(if any) calculated by reference to the date by which the chargeable agreement
for sale should have been stamped. After the conveyance is so stamped, the
agreement for sale will then become chargeable with stamp duty of HK$100
(s.29D(2)(b)). That is because in the absence of an agreement for sale the
assignment (i.e. the conveyance) is the instrument that bears AVD.

7.2.6 Multiple Properties and Multiple Agreements

Subject to any exemptions or reliefs, AVD at the higher Part 1 of Scale 1 rate of 15% is charged
on agreement for the sale and purchase of more than one residential property even if the
purchaser or transferee is a HKPR acting on his or her own behalf and is not a beneficial owner
of any other residential property in Hong Kong at the time of acquisition of the properties
concerned.

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If a single instrument involves both residential and non-residential properties which are
inseparable for sale and purchase, the instrument will be treated as an instrument for the
sale and purchase of residential property for AVD purposes. SOIPN No. 1 provides that in
ascertaining whether residential property and non-residential property transferred under the
same instrument are separable or inseparable for AVD purposes, the Stamp Office may take
into account various documents, including approved building plans, deed of mutual covenant,
occupation permit and any other document that it considers relevant. An instrument that is of
particular relevance in that regard is the deed of mutual covenant. A deed of mutual covenant
is an instrument regulating the use of spaces within a building. Each unit, apartment or space
is allocated a certain number of notional ‘undivided shares’. Such undivided shares betoken
a right to exclusive use to certain parts of the building. Thus, if the relevant deed of mutual
covenant specifies that the residential and non-residential properties have certain undivided
shares in common (i.e. the residential and non-residential properties concerned do not have
their respective undivided shares), the properties concerned will be regarded as inseparable
for sale and purchase. If, however, the residential and non-residential properties forming
the subject matter of the transfer are separable, the Stamp Office will regard the properties
as separate and distinct and charge them to AVD accordingly by apportioning the aggregate
consideration between them. Where progressive rates of AVD apply, however, the applicable
AVD rates for each property will be determined by reference to the total consideration
of the entire instrument (i.e. aggregating the consideration for both the residential and
non-residential property).

Illustrative Example 9
Mr. Schwarz Zokosta owns a ‘tong lau’ building in Sai Ying Pun. On the ground floor,
there is a dried seafood shop and on the upper three floors there are two residential
flats per floor. He decides to sell this to a property developer, Billion Dragon Profit Ltd,
for HK$60 million. According to the reference on the building plans and the occupation
permit, it was established that the shop and the flats are separable. The shop had a
market value of HK$15 million and that the six flats were worth HK$7.5 million each.
The building was sold at market value under a single sale and purchase agreement.
Accordingly, AVD was charged at Part 2 of Scale 1 rates on the shop, and at Part 1 of
Scale 1 rates for the flats, the buyer being a body corporate.

Thus:

1 shop (commercial property): 15,000,000 at 8.5% = 1,275,000 plus

6 flats (residential property): 45,000,000 at 15% = 6,750,000, yielding HK$8,025,000 of

AVD (note that BSD, discussed in greater detail in Section 7.2.8, would also be chargeable
in this case).

Where two agreements for sale are made in respect of the same property and both
agreements involve a common purchaser, stamp duty will be charged as shown in Illustrative
Example 10 (s.29C(5)).

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Illustrative Example 10
Under an agreement for the sale and purchase of a residential property in Sha Tin,
Agreement 1, Mr. Karl Hungus as the vendor and Mr. H.L. Fook and Mr. S.T. Wong are
the purchasers. Under a subsequent agreement, Agreement 2, Mr. Fook and Mr. Wong
were joined by W.T. Lo as the third joint purchaser for the same property. The sale
price was HK$80 million, Mr. Fook, Mr. Wong and Mr. Lo are all HKPRs and do not have
any residential property in Hong Kong. In this scenario, Agreement 1 would bear ad
valorem stamp duty at the standard Scale 2 rate of 4.25%, yielding stamp duty payable
of HK$3.4 million. Subsequently, the joining of Mr. Lo as a third buyer amounts to a
conveyance on sale of one-third of the interest held jointly by Mr. Wong and Mr. Fook
to Mr. Lo. By reference to the one-third devolving to Mr. Lo, a further HK$1,133,334 of
AVD would be payable on Agreement 2 representing AVD charged on the disposal of a
one-third interest in the property acquired under Agreement 1.

Similarly, if Mr. Hungus executed an instrument in which he contracted to sell a

property to Mr. Fook and to Mr. Wong jointly, but does not assign the property to Mr. Lo,
and upon their request, executed another instrument in which he contracted to sell the
property to Mr. Wong, Mr. Fook, and Mr. Lo as a third buyer, the same reasoning would
apply. Both instruments are chargeable with AVD; however, if the first agreement is
stamped, the AVD on the second agreement will be reduced by two-thirds representing the
interests Mr. Fook and Mr. Wong acquired under the first agreement (applying s.29D(4)).

Contrast a scenario where Mr. Hungus agrees in writing to sell a property to

Mr. Fook, Mr. Wong and Mr. Lo; and subsequently that agreement is superseded by a
second agreement, under which the sole purchaser is Mr. Fook, with Mr. Wong and Mr. Lo
no longer being interested in acquiring the property. In that scenario, Mr. Hungus would in
practice no longer be selling to multiple buyers, but to a sole buyer, being Mr. Fook. Both
agreements are chargeable with AVD as agreements for sale and purchase. If, however, the
first agreement was duly stamped, the AVD on the second agreement will be reduced by
one-third representing the one-third interest Mr. Fook acquired under the first agreement,
with the remaining two-third interest transferred by Mr. Wong and Mr. Lo to be under the
second agreement remaining assessable for AVD purposes (applying s.29D(5)).

7.2.7 Special Stamp Duty

SSD was introduced to discourage property speculation in Hong Kong. It is an additional
charge to stamp duty that applies to transactions whereby the immovable residential
property is disposed of (i.e. resold or otherwise transferred) within 36 months from the date
of its acquisition. Such short-term purchases and sales are considered by the Hong Kong
government to be inconsistent with its stated policy aim to reduce increased pricing pressure
on the property market. Accordingly, such transactions attract higher rates of duty.

With effect from 20 November 2010, any residential property acquired on or after
20 November 2010, either by an individual or a company (regardless of where it is
incorporated), and resold within 24 months (the property was acquired on or after
20 November 2010 and before 27 October 2012) or 36 months (the property was acquired
on or after 27 October 2012), will be subject to SSD (Heads 1(1AA) and 1(1B)).

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It is worth noting that even some rare cases may attract SSD. For example, an agreement
for exchange or partition of residential property may give rise to a charge to SSD if there is a
change in beneficial interest with 36 months of its acquisition.

SSD is calculated by reference to the stated consideration or the market value of the
property (whichever is the higher) at the rates for different holding periods of the property by
the seller or transferor before disposal (Exhibit 7.5).

Holding period The property was acquired on or after

27 October 2012
6 months or less 20%
More than 6 months but for 12 months or less 15%
More than 12 months but for 36 months or less 10%

EXHIBIT 7.5 Current rates for different holding periods

SSD is in effect parasitic on AVD: it is charged together with AVD and computed on the
basis of the same transfer consideration or value, as the case may be. In general, it will be
charged on the same instrument and at the same time as AVD: thus, either on the agreement
for sale and purchase or on the assignment of the property in question (ss.29CA and 29DA
of the SDO).

As summarised in SOIPN No.1, SSD is not payable in the following cases:

a. Nomination of a close relative(s) (that is, spouse, parents, children, brothers or sisters)
of the original purchaser(s) to take up the assignment of the residential property. If
there is more than one nominee, the nominees must also be close relatives; and sale or
transfer of the residential property to a close relative(s).

b. Addition/deletion of name(s) to/from a chargeable agreement for sale or a conveyance

on sale in respect of the residential property if the person(s) is/are the close relative(s)
of the original purchaser(s).

c. Sale or transfer of residential properties by a court order or pursuant to a court order.

The exemption covers a compulsory sale of residential property under a compulsory
sale order granted under the Land (Compulsory Sale for Redevelopment) Ordinance
(Cap.545), and also any sale of residential property where the residential property was
transferred to or vested in the vendor by or pursuant to any decree or order of any
court, including a foreclosure order obtained by the mortgagee whether or not it falls
under the definition of a financial institution within the meaning of s.2 of the IRO. For
this purpose, ‘court’ means any court of the Hong Kong Special Administrative Region of
competent jurisdiction.

d. Sale of the estate of a deceased person, which involves a residential property, by the
executor or personal representative and sale or transfer of a residential property by a
person whose property is inherited from a deceased person’s estate or passed to that
person under a will, the law of intestacy or right of survivorship.

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e. The residential property sold relates solely to a bankrupt estate or the property of a
company that is being wound down by the court by reason of its inability to pay debts.

f. Sale of mortgaged residential properties in various forms by a mortgagee that is a

financial institution within the meaning of s.2 of the IRO, or by a receiver appointed by
such a mortgagee.

g. Sale or transfer of residential properties to the government.

h. Sale or transfer of residential properties between associated bodies corporate (i.e.

stamp duty relieved under s.45).

7.2.7.1 Reckoning of Holding Period

For the purposes of determining the duration of the holding period in computing the charge to
SSD, the acquisition date is taken to be the date a person enters into a chargeable agreement
for sale as purchaser to purchase the property (i.e. the date of the provisional agreement
for sale and purchase in most cases). If no such agreement is executed, then the date of
conveyance is taken to be the date of acquisition.

The fundamental unit of reckoning a holding period is the calendar month. The period from
a certain day in a month to the preceding day in the following calendar month is counted as
one month and if there is no corresponding day in the following month, then the last available
day is taken to amount to the span of a calendar month.

For example, 10 January 2017 to 9 February 2017 = 1 month

30 January 2017 to 28 February 2017 = 1 month

31 August 2016 to 1 March 2017 = 6 months and 1 day

Illustrative Example 11
Mr. Ho acquired a residential property by way of an agreement for sale on 10 September
2017 (conveyance executed on 10 November 2017) at HK$5 million and sold it for HK$6.5
million by way of an agreement of sale signed on 10 March 2018, with the conveyance
executed on 31 May 2018. Identify the rate for SSD and calculate the amount of
SSD payable.

Holding period from 10 September 2017 to 10 March 2018 is six months and one day,
the applicable SSD rate is 15%.

SSD payable is 15% × HK$6.5 million = HK$975,000

7.2.8 Buyer’s Stamp Duty

BSD was likewise introduced to cool down the Hong Kong residential property market and
discourage excessive property speculation and stockpiling. Unlike SSD, BSD does not target
speculators generally, but in effect imposes an additional charge to stamp duty where the
purchaser of the property is not a HKPR individual acting on his or her own behalf. In other

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words, the purpose of BSD is to impose a fiscal penalty on companies generally and individuals
who are not HKPRs.

With effect from 27 October 2012, unless specifically exempted, BSD is payable on an
agreement for sale or a conveyance on sale executed for the acquisition of any residential
property. BSD is charged at a flat rate of 15% on the transfer consideration or the market
value of the property, whichever is the higher, and is in addition to any other duty payable:
(Head 1(1AAB) and Head 1(1C) in the First Schedule). BSD is in effect parasitic on AVD: it is
charged together with AVD and computed on the basis of the same transfer consideration
or value, as the case may be. Agreements to exchange property are, as we have discussed,
chargeable agreements for sale for stamp duty purposes. Thus where a non-residential
property is exchanged for a residential property (whether or not any consideration is paid or
given for equality), BSD computed by reference to the value of the residential property will
be payable on the instrument and the person acquiring the residential property under the
exchange is treated as the transferee or acquirer for those purposes. They, therefore, are
the person(s) who will be liable for the BSD arising from the exchange. That general rule is
subject to the usual exemption from BSD: thus, if the person receiving the residential property
pursuant to the exchange is a HKPR acting on his or her own behalf, the instrument effecting
the exchange will be exempt from BSD. By the same token, where there is an exchange of
residential property for a non-residential property plus a residential property, the transaction
will be regarded as an exchange of residential property for residential property for the
BSD purposes.

As regards car parking spaces in the context of BSD, the general rule is if the car parking
space is not separate and distinct from the residential property (i.e. if the car parking space
and the residential property cannot be separately sold), the instrument for the sale and
purchase of the residential property will be chargeable with BSD by reference to the total
value of the whole transaction, including the car parking space. If, however, the car parking
space is a separate and independent property from the residential unit, the value of the car
parking space will be deducted from the total value of the whole transaction for computing the
BSD payable.

BSD is not payable if, among other things:

• The instrument in question is not chargeable to AVD;

• The purchaser, or each of the purchasers, is a HKPR acting on his or her own behalf
(e.g. not as trustee or agent);

• S.45 relief applies;

• Under the conveyance, a mortgaged residential property is transferred to or vested

in its mortgagee that is a financial institution within the meaning of s.2 of the IRO
(Cap.112) (i.e. broadly speaking, a bank);

• Any purchaser or transferee under a chargeable agreement for sale or conveyance on

sale is acting in the transaction as a trustee or guardian for another person who is a
HKPR and is a mentally incapacitated person;

• It is a gift to a charitable institution (S.44 of the SDO);

• The instrument was made pursuant to any decree or order of any court in Hong Kong,
including a foreclosure order obtained by a mortgagee;

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• The property is purchased jointly and one purchaser is a HKPR and the other purchaser(s)
is/are closely related;

• Acquisition/transfer of a residential property between close relatives; or

• The purchaser or transferee is acting on his or her own behalf and the residential
property (‘replacement property’) is acquired by the purchaser or transferee to replace
another residential property (‘original property’) that was owned by the purchaser or
transferee alone or jointly with any other person(s) and that has been:

°° Acquired by the Urban Renewal Authority;

°° Resumed under an order made under s.3 of the Lands Resumption Ordinance
(Cap.124) or purchased under s.4A of that ordinance;

°° Sold pursuant to an order for sale made by the Lands Tribunal under s.4(1)(b)(i) of
the Land (Compulsory Sale for Redevelopment) Ordinance (Cap.545);

°° Resumed under an order made under s.4(1) of the Mass Transit Railway (Land
Resumption and Related Provisions) Ordinance (Cap.276);

°° Resumed under an order made under s.13(1) of the Roads (Works, Use and
Compensation) Ordinance (Cap.370);

°° Resumed under an order made under s.16 or 28(1) of the Railways Ordinance
(Cap.519);

°° Acquired under an acquisition order made under s.3(1) or (2) of the Land
Acquisition (Possessory Title) Ordinance (Cap.130); or

°° Resumed under an order made under s.37(2) of the Land Drainage Ordinance
(Cap.446).

Illustrative Example 12
Mr. A sold a residential property in Hong Kong to Ms. B, who is ordinarily resident in
Hong Kong under a dependent spouse visa, but not a HKPR, for a consideration of
HK$10 million by an agreement for sale and purchase.

Although Ms. B is ordinarily resident in Hong Kong, she is not a HKPR. From BSD
perspective, because she is not a HKPR, the agreement for sale and purchase of
the residential property will be chargeable to BSD, which will in this case amount to
HK$1.5 million (i.e. HK$10 million × 15%).

Illustrative Example 13 – AVD, SSD and BSD

Mr. X sold and conveyed a residential flat (being held for five years) to Mr. Y, a HKPR,
for a consideration of HK$10 million. Mr. Y will occupy the flat as his place of residence.
The agreement of sale was signed on 1 May 2018 and the deed of assignment was signed
on 2 July 2018.

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Illustrative Example 13 (continued)

AVD on the agreement of sale:

 ither 15% × HK$10 million = HK$1,500,000 (assuming Y owns another residential

E
property in Hong Kong, hence Scale 1, Part 1 applies)

Or 3.75% × HK$10 million = HK$375,000 (if Y did not own any residential property in
Hong Kong at time of acquisition, hence Scale 2 applies).

The deed of assignment is subject to stamp duty of HK$100.

No BSD is charged as Mr. Y is a HKPR acting on his own behalf, regardless of whether
Mr. Y holds another residential property in Hong Kong.

No SSD is charged as the property has been held for five years by Mr. X.

Illustrative Example 14
Mr. Schwarz Zokosta is a German national, present in Hong Kong on an employment visa.
In December 2018, he viewed a flat in Repulse Bay he rather liked. The owner of the flat,
Montgomery H. Withnail, QC, is a retired British lawyer who wishes to return to London.
He first acquired the flat in June 1986. Because he wants to dispose of the property
quickly, he agrees to sell it to Mr. Zokosta for HK$50 million. The latest market valuation
of the flat shows that it is worth HK$60 million. Mr. Zokosta owns no other property in
Hong Kong.

To compute the aggregate stamp duty payable with respect to the conveyance of
the flat, consider that because market value is higher than consideration, the market
value (i.e. HK$60 million) is taken to be the computational basis of AVD. The property is
residential and Mr. Zokosta is not a HKPR, accordingly AVD is charged at Part 1 of Scale
1: 15%. SSD is not chargeable because Mr. Withnail has acquired the flat over 30 years
prior to its disposal. BSD is, however, chargeable at 15% because Mr. Zokosta is not a
HKPR. Accordingly, aggregate stamp duty will be HK$18 million on the sale and purchase
agreement, plus HK$100 duty on the assignment.

Apply and Analyse 1
Mr. Wolf Muller is a private investigator who has recently become a Hong Kong permanent
resident. He decides to purchase a residential flat near Chunking Mansions where his
office is located. In February 2019, he signed an agreement for the sale and purchase
of a residential property in Tsim Sha Tsui for HK$15 million, which his estate agent told
him is a reasonable sum, since the bank valuation of the property also came in at around
HK$15 million. The vendor inherited the property from his late mother in November
2018 according to the will. Mr. Muller owns one other residential property – a town
house in Roswell, New Mexico, in the United States of America. Following completion of

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Apply and Analyse 1 (continued)

the purchase, Mr. Muller is advised by his solicitors that he is now the registered owner
of the property. Mr. Muller has a paranoid disposition and three months later decided
to envelop the property into a company incorporated in the Marshall Islands, X Limited,
which is wholly owned by him. In order to do so, he transferred the property for a notional
consideration of HK$100 to X Limited under a separate instrument he called a ‘Deed of
Contribution’. Compute the stamp duty liability for these two transactions.

Analysis

Mr. Muller is a HKPR buying his first residential property in Hong Kong, accordingly the
agreement for sale and purchase will be chargeable with AVD at Scale 2 rates of 3.75%.
No BSD is chargeable as Mr. Muller is a HKPR acting on his own behalf and SSD is not
applicable as the vendor inherited the property according to the will. AVD is therefore
HK$562,500. Subsequently, the property is sold to X Limited. Because the market value
exceeds the consideration of HK$100, HK$15 million is treated as the dutiable amount.
AVD at 15% is payable because the purchaser is a company; likewise with BSD at a further
15%. Because Mr. Muller is not a body corporate, s.45 cannot apply to exempt the transfer
from stamp duty. SSD is also payable at a rate of 20% because the property was sold within
six months. Stamp duty on the second leg of the transaction is HK$7.5 million. HK$100
fixed duty would be chargeable on both assignments, assuming the relevant agreements
for sale and purchase were duly stamped.

7.2.9 Lease
A lease of immovable property situated in Hong Kong is chargeable to AVD under Head 1(2) of
the First Schedule. A lease is not exhaustively defined in the SDO and reference must therefore
be made to the general law of property in Hong Kong. A lease is distinguishable from a licence
in the sense that a lease is a proprietary right (that is, the lessee has rights to the property
itself) and can enjoy and occupy the property to the exclusion of all others, including the lessor.
This is in contrast to a licence, where the licencee’s right is merely contractual to be enforced
against the licensor as a personal right: the licencee has no rights to the licenced property itself
(Street v Mountford (1985) UKHL 4). Note that a lease includes a sublease.

As is the case with conveyances of immovable property generally, the stampable

instrument is technically the lease itself; however, an agreement for a lease is chargeable with
AVD as if it were a lease (s.16(2) of the SDO), and a lease subsequently executed pursuant
to a duly stamped agreement for a lease is chargeable with a nominal fixed duty of HK$3
(Head 1(2)(c) of the First Schedule).

Applying the substance-over-form rule of statutory construction, an instrument that

takes effect as a licence, even though described as a lease, is not dutiable because it does not
transfer any proprietary interest in land. It is therefore vital first to establish the true nature of
a given instrument at common law to determine whether it is dutiable (Guoji Transport Co Ltd v
CSR (1997) HKLRD 1168).

Although a lease is technically a conveyance for stamp duty purposes (Littlewoods Mail
Order Stores Ltd v IRC (1963) AC 135), it is separately charged to different AVD rates under

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Head 1(2) of the First Schedule on the principle of general statutory construction that a
special law derogates from the general law. The rates of ad valorem duty on leases are as in
Exhibit 7.6.

Term Rate
Not defined or uncertain 0.25% of the yearly or average yearly renta
Term ≤ 1 Year 0.25% of the total rent payable over the term of the leasea
1 year < Term ≤ 3 years 0.5% of the yearly or average yearly renta
Term > 3 years 1% of the yearly or average yearly renta
Key money, construction fee, etc. 4.25% of the consideration if rent is also payable
mentioned in the lease under the lease. Otherwise, same duty as for a sale of
immovable property
Duplicate or counterpart The same stamp duty as on the original, capped at HK$5 each
a
The yearly rent/average yearly rent/total rent has to be rounded-up to the nearest HK$100.
Note: Any deposit that may be mentioned in the lease will not be taken into account in assessing the stamp duty.
EXHIBIT 7.6 AVD rates for different terms

Under Head 1(2)(a), any consideration or any part of the consideration moving either
to the lessor or to any other person consisting of money, stock or security is dutiable at
the same rate as a conveyance on sale (or at the rate of 4.25% if rent is also payable on
the lease). In practice, this consideration means consideration apart from the obligation
periodically to pay rent. In commercial practice, such consideration is called a ‘premium’.
Again, the substance-over-form rule applies. For example, in Miramar Hotel & Investment Co
Ltd v CSR (1961) 1 HKTC 755, the relevant lease agreement provided for certain amounts to
be paid by the lessee as ‘rent in advance’. The Court of Appeal held that having regard for
the quantum and capital nature of the payments labelled ‘rent in advance’ such amounts
were in reality premiums for entering into the lease, as distinct from payments of rent and
were accordingly dutiable under the predecessor head of charge to Head 1(2)(a) of the
First Schedule.

A deed of variation varying the amount of rent payable with respect to a lease that has
been already stamped may give rise to additional AVD where the rent is increased by virtue of
the deed of variation, but only in respect of the additional rent (s.17 of the SDO). The dutiable
instrument is the deed of variation itself, with stamp duty computed by reference to the
additional rent provided for in the deed of variation. Where the amount of the rent is variable,
or subject to some contingency, the contingency principle will apply and stamp duty will be
assessed by reference to the maximum additional rent payable under the deed of variation.
Where, however, there is no tenable means of ascertaining the rent payable, the lease will not
be stampable.

An oral lease for a term not exceeding three years at market rent within the meaning
of s.6(2) of the Conveyancing and Property Ordinance (Cap.219) does not give rise to
any charge to stamp duty. That is because such a lease takes effect at law by parol
(i.e. is binding on lessor and lessee and does not need to be reduced to writing) and, on
that footing, there is no stampable instrument, nor is there any requirement that one
should be produced.

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Illustrative Example 15
Mr. A signed a tenancy agreement with Ms. B in respect of a residential property in Hong
Kong. The lease agreement was for a fixed term of two years commencing on 1 March
2018, renewable for another two years. Monthly rent is HK$10,000, with a two-month
rent-free period. Rental deposit is HK$30,000.

Stamp duty payable 0.5% (HK$10,000 22 2) HK$550

(Considering the two-month rent-free period that is to be discounted for AVD

purposes, the total rent for the two-year lease is HK$220,000, the average yearly rent is
HK$110,000)

Lease – contingency principle

A retail shop is let under a three-year lease. The monthly rental is HK$10,000 plus 4% of
the tenant’s monthly turnover (subject to a maximum of HK$20,000)

Amount of stamp duty payable for the lease, applying contingency principle:

(HK$10,000 HK$20,000) 12×0.5% HK$1,800

Key Learning Point

The following instruments with respect to Hong Kong immovable property are dutiable: an
agreement for sale, an assignment and a lease. AVD is charged at variable rates depending
on the consideration or value given, and at higher rates for residential property. SSD is
charged when a residential property is sold within 36 months of acquisition. Generally,
BSD is charged when the purchaser of a residential property is anyone other than a HKPR
acting on his or her own behalf.

Knowledge Check Questions

Question 2
On 4 January 2019, Dobermann Properties GmbH, a company incorporated in Germany,
but tax resident in Hong Kong, buys its first residential property in Hong Kong, an
apartment at 14 Old Peak Road, from Anderson Gao for HK$75 million. Anderson bought
the property on 17 September 2017. Identify which of the following statements is true.
A Dobermann Properties GmbH will not have to pay buyer’s stamp duty because it is
resident in Hong Kong and owns no other residential property in Hong Kong.
B Special stamp duty will be charged on the agreement for sale or assignment at a
rate of 15%.
C Stamp duty may be avoided entirely by orally transferring the property to Dobermann
Properties GmbH.
D AVD will necessarily be charged at 15% of the higher of the transfer consideration or the
value of the property.

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Knowledge Check Questions (continued)

Question 3
Identify which of the following instruments bears AVD.
A A deed of mortgage between a bank and an individual for the acquisition of a
commercial property in Happy Valley
B An assignment for the conveyance of residential property in Mongkok, following a duly
stamped agreement for sale and purchase
C An occupation permit for a property on the Peak to be used as a social club and drinking
establishment
D A contractual option for the purchase of residential property in Sha Tin

7 . 3
HONG KONG STOCK

The sale and purchase or otherwise the transfer in beneficial interest in Hong Kong stock gives
rise to a charge of ad valorem stamp duty at the aggregate rate of 0.2% on the higher of the
transfer consideration or the value of the Hong Kong stock transferred. Technically speaking,
0.1% is borne by the transferor and 0.1% is borne by the transferee, though both are jointly
liable for the recovery of any unpaid or underpaid duty.

Although the headline rate of duty is much lower than for immovable property, on
sufficiently large corporate transactions stamp duty can be a material commercial concern.
Because it is now relatively straightforward to transfer stocks and shares in a dematerialised
manner without a hard copy instrument of transfer, s.19 of the SDO requires that contract
notes be produced upon the sale and purchase of Hong Kong stock, i.e. bought note and sold
note. Each is a separate instrument bearing 0.1% AVD, yielding an aggregate of 0.2% on the
transfer as a whole. Contract notes are in essence simplified instruments for the sale and
purchase of Hong Kong stock: These are the instruments that are stamped for stamp duty
purposes, together with the instrument of transfer (IoT), another pro-forma instrument that
documents the transaction and sets out the relevant commercial details of the same.

The value of shares is usually determined as follows: For listed shares, the listed value
is used; however, for shares in an unlisted company, the net asset value of the company as
shown in its most recent audited financial statements is used as a proxy for value. For example,
if half the issued share capital of a company with a net asset value of HK$10 million were
transferred, ad valorem duty at a rate of 0.2% would be computed on the higher of the transfer
consideration or HK$5 million, being the estimated value of the shares. When determining
the net asset value of a company that holds properties in Hong Kong, the market value of the
properties will be used instead of the carry amounts stated in the state of financial position
because the carrying amount under cost model does not reflect the market value of the
properties and thus the shares.

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The issue of shares is not dutiable. Similarly, where shares are either redeemed or
cancelled pursuant to a reduction of capital, those operations do not give rise to stamp duty
because they do not involve the transfer of the share in question, but merely its extinction.

Ad valorem stamp duty is charged under Head 2(1) on the contract notes for the sale
and purchase of Hong Kong stock, with the IoT bearing a nominal and fixed HK$5 duty.
An instrument for the transfer of Hong Kong stock otherwise than on a sale and purchase
is dutiable at the same rate as a sale and purchase under Head 2(3). Thus, the gratuitous
donation of Hong Kong stock would likewise give rise to a charge to stamp duty. The dutiable
instrument under Head 2(3) is the instrument of transfer in question (e.g. the deed of gift).
Under the Companies Ordinance, it is not possible to transfer legal title to shares otherwise
than by an IoT. That requirement, in turn, ensures symmetry with the stamp duty provisions by
requiring that there always be a relevant IoT to bear duty.

7.3.1 Hong Kong Stock versus Non-Hong Kong Stock

S.2 defines ‘stock’ as follows:

a. Any shares, stocks, debentures, loan stocks, funds, bonds or notes of or issued by any
body, whether corporate or unincorporate, or any government or local government
authority, or any other similar investment of any description;

b. Any units under a unit trust scheme;

c. Any right, option or interest in or in respect of any stock referred to in paragraph (a) or
(b), other than any such right, option or interest under an employees’ share purchase or
share option scheme;

But in general does not include any loan capital, or any bill of exchange or promissory
note, or any certificate of deposit within the meaning of s.2 of the Inland Revenue
Ordinance (Cap.112) or any Exchange Fund debt instrument or Hong Kong dollar
denominated multilateral agency debt instrument within the meaning of that
ordinance, or any bond issued under the Loans Ordinance (Cap.61), or any debentures,
loan stocks, funds, bonds or notes denominated otherwise than in the currency of
Hong Kong except to the extent that the same shall be redeemable, or may at the
option of any person be redeemed, in the currency of Hong Kong.

It is important to note that loan instruments, relevantly including debentures and bonds,
are generally exempt unless denominated in Hong Kong dollars. The exception to this general
rule is bearer instruments, the transfer of which is dutiable under Head 3.

Hong Kong stock is defined in s.2 specifically as ‘stock the transfer of which is required to be
registered in Hong Kong’. In practice, that means:

• Shares in a company incorporated in Hong Kong, since the Companies Ordinance

(Cap.622) requires that the transfer of shares in a Hong Kong incorporated company be
recorded in the company’s share register;

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• Shares in a company otherwise listed on the Hong Kong Stock Exchange (HKSE) because
the rules of the HKSE require that the transfer of shares listed thereon be recorded in a
register in Hong Kong.

• Units in a unit trust of which a register is required to be kept in Hong Kong.

Note that as a matter of corporate law, s.15(2) of the SDO provides that a company
secretary in Hong Kong cannot register a change in ownership of shares unless the instrument
of transfer is duly stamped.

S.21 of the SDO further provides that, with limited exceptions, a company cannot pay
interest or dividends on Hong Kong stock unless the recipient is the registered owner of the
stock. This prevents the stamp duty avoidance tactic of transferring the right to receive income
in connection with Hong Kong stock to another person, without transferring the underlying
stock itself. That would, in turn, render certain derivative instruments, such as equity
derivatives, difficult to structure to the extent that they relate to Hong Kong stock.

A unit trust is a specific kind of trust utilised principally for commercial purposes. A unit
trust is a trust, and the trustee of that trust issues units to unit holders. Units in a unit trust
represent a notional, undivided interest in the trust property, subject to the terms of the
trust instrument. In practice, that makes unit trusts somewhat akin to companies and units
somewhat akin to shares in such companies, though it must be borne in mind that trusts are
not separate legal persons and units in a unit trust typically do not carry rights, such as voting
rights, normally associated with shares. In practice, unit trusts are often used to structure
pension schemes or collective investment schemes in that they allow third parties to participate
in a trust structure as investors. Units in a unit trust are stock within the meaning of the SDO.
It would follow that where the register of units is required to be kept in Hong Kong, the units
of that unit trust will be Hong Kong stock and the transfer thereof will therefore give rise to a
charge of ad valorem stamp duty under Head 2(1) or 2(3) of the First Schedule. The trustees
or managers under the scheme may not register a transfer of units thereunder unless an
instrument of transfer has been delivered to them (S.36).

Where stamp duty is paid under head 2(1) in the First Schedule in respect of a sale or
purchase of a unit under a unit trust scheme effected by the managers under such a scheme,
the stamp duty shall be refunded to the managers upon application to the Stamp Office if the
managers and trustees under such a scheme, before the expiration of two months from the
date on which the sale or purchase is effected, jointly certifying that:

a. The certificate, if any, in respect of the unit has been cancelled;

b. As a consequence of the sale or purchase, a proportionate part of the trust property

has been realised, and the trust property diminished accordingly; and

c. The unit is extinguished and the managers have no power to transfer any other unit in
lieu thereof.

An exception to the general rule that the sale and purchase or other transfer of beneficial
in Hong Kong stock gives rise to a charge to ad valorem stamp duty is in the context of

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exchange-traded funds (ETFs). ETFs are broadly speaking bundled investment products, which
enable investors to access a basket of underlying securities or other assets through a single
umbrella security, which is usually stock in the ETF itself. Investors hold units in the ETF (if it is a
unit trust) or shares (if it is a body corporate), but do not themselves own the underlying assets,
which are held by the ETF. They thereby participate in the gains (and losses) arising from the
holding by the ETF of those underlying assets. This is a growing sector in Hong Kong; hence, the
decision of the Government to implement concessionary stamp duty regulations with respect
to ETF activities. Thus, pursuant to the Stamp Duty Ordinance (Amendment of Schedule 8)
Regulation 2020:

1. The purchase of Hong Kong stock made for the allotment of a share or unit in an
ETF and the sale of Hong Kong stock made for the redemption of a share or unit in
the ETF; and

2. The sale and purchase of Hong Kong stock between a market maker of an ETF and
a participating dealer of the ETF for the allotment or redemption of a share or unit
of the ETF,

are both exempt from the stamping requirements in section 19(1) and Head 2 of the First
Schedule of the SDO. The objective of this regime for ETFs is to reduce the transaction
costs relating to ETFs, which in turn may narrow the bid-ask spreads of the shares or units
of exchange traded funds. For those ETF-related purposes, a market maker is a person
approved by or registered with the Stock Exchange Company for performing, in accordance
with rules made by the Stock Exchange Company, market making or liquidity providing
activities in respect of the shares or units of the ETF.

Key Learning Point

The sale and purchase or transfer of beneficial interest in Hong Kong stock give rise to
a charge to stamp duty. Hong Kong stock is defined as ‘stock the transfer of which is
required to be registered in Hong Kong’. The rate of stamp duty is 0.2% of the higher of the
transfer consideration or the value of the Hong Kong stock transferred.

Knowledge Check Question

Question 4
Dobermann Properties GmbH is a company incorporated in Germany. On 1 January 2019,
it lists on the main board of the Hong Kong Stock Exchange. Identify which of the following
statements is true.
A When Dobermann Properties GmbH is listed on the Hong Kong Stock Exchange, its place
of incorporation is deemed to be Hong Kong, such that its shares are Hong Kong stock
within the meaning of s.2 of the SDO.

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Knowledge Check Questions (continued)

B The issue of 10,000 shares in Dobermann Properties GmbH gives rise to an obligation to
stamp an instrument of transfer and account for ad valorem duty upon the issue of the
shares to the shareholder because its shares are Hong Kong stock.
C The rules of the Hong Kong Stock Exchange require that transfers of shares listed on
the exchange be registered in Hong Kong; accordingly, shares in Dobermann Properties
GmbH are Hong Kong stock.
D The transfer of shares effected in Hong Kong or relating to anything done or to be done
in Hong Kong give rise to a charge to stamp duty; accordingly, if shares in Dobermann
Properties GmbH are transferred pursuant to an agreement for sale and purchase
effected in Hong Kong, the purchaser and vendor must produce contract notes and
cause these to be duly stamped.

7 . 4
BEARER INSTRUMENTS

A bearer instrument is a debenture wherein capital and interest are payable to the bearer
(i.e. the person physically in possession of the bond instrument) and which passes from hand
to hand free from any equities which might have attached to it as between the issuer and
the original holder (Re Imperial Land Co. of Marseilles Ex parte Colborne and Strawbridge (1870)
L.R. 11 Eq. 478). Thus, a bearer instrument is negotiable upon delivery: in order to effect a
transfer all one needs to do is hand the debenture or bond certificate as the case may be to
the transferee.

Head 3 of the First Schedule imposes ad valorem duty of 3% on the issue of Hong Kong
bearer instruments. Both ‘bearer instrument’ and ‘Hong Kong bearer instrument’ are fairly
narrowly defined in s.2(1) as meaning any instrument to bearer by delivery of which any
stock can be transferred, but does not include an instrument relating to stock which consists
of a loan expressed in terms other than in the currency of Hong Kong except to the extent
that the loan is repayable, or may at the option of any person be repaid, in the currency of
Hong Kong.

The stampable instrument is the debenture or bond certificate itself. No duty is charged on
the sale and purchase or other transfer of a bearer bond. Note that under the new Companies
Ordinance (Cap.622), it is no longer possible for Hong Kong companies to issue bearer shares
or share warrants on a bearer basis.

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7 . 5
DUPLICATES AND COUNTERPARTS

Duplicates and counterparts are originally signed instruments, they do not mean
photocopies. For example, in a case of lease, it is usual in Hong Kong that the landlord
would keep a piece of tenancy agreement and the tenant keeps another piece. The contents
of the two pieces of tenancy agreement are exactly the same, the landlord and the tenant
have signed on both pieces. In this case, one piece is the original and the other one is the
duplicate. If the landlord only signed on one piece and the tenant only signed on the other
(i.e. each piece only has one signature), the tenancy agreement will only be effective if the
two pieces are read together, then in this case, one of them will be the original, the other one
will be the counterpart.

Under Head 4 of the First Schedule of the SDO, duplicates and counterparts of any
instrument chargeable with any stamp duty are chargeable with stamp duty, the amount of
stamp duty will be the same amount as on the original, subject to a HK$5 cap. For stamp duty
purposes, the instrument bearing ad valorem duty will be treated as the original, and the stamp
on the duplicates and counterparts will indicate that they are duplicate or counterpart and
state the amount of AVD paid on the original, serving as cross referencing. Note that a duplicate
or counterpart is only treated as duly stamped if the original of the duplicate or counterpart in
question was duly stamped.

7 . 6
VOLUNTARY DISPOSITION INTER VIVOS

Voluntary dispositions inter vivos are transfers either at an undervalue or for no consideration
at all made between two persons. Ss.27(1) and 27(4) of the SDO states that any conveyance
or transfer (not being a disposition made in favour of a purchaser or incumbrancer or other
person in good faith and for valuable consideration) shall be deemed to be a conveyance
or transfer operating as a voluntary disposition inter vivos (except where marriage is the
consideration). Accordingly, such transfers at an undervalue or gratuitous transfers give rise
to a charge to stamp duty computed by reference to the market value of the asset transferred,
irrespective of the commercial terms of the transfer.

For example, assume that an individual (I) owns: (1) the leasehold to a property (P); and
(2) 100,000 shares in a company (C). If I transfers P to a purchaser at half its market valuation
and/or gifts the 100,000 shares in C to his wife, the instruments denoting the conveyance
and transfer will be dutiable and the amount of stamp duty payable and in each case will be
computed by reference to the actual market value of the property conveyed or transferred, as
the case may be.

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It is apparent that s.27 is an anti-avoidance provision. It prevents stamp duty avoidance

by simply gifting or transferring property for consideration below its real market value. There
are certain important exceptions to this general rule in s.27(5), which relate to conveyances or
transfers under which no beneficial interest passes. Important examples of such conveyances
and transfers include:

• Transfer or conveyance for the purpose of effecting the appointment of a new trustee;

• Distribution of property by operation of law pursuant to a liquidation or dissolution

(Ayerst v C & K (Construction) Ltd (1976) AC 167);

• Conveyance or transfer from a trustee to a beneficiary under a trust; and

• A conveyance or transfer made for nominal consideration for the purpose of securing
the repayment of an advance or loan (hence, mortgages are not dutiable).

Note that a settlement on trust is a transfer of beneficial interest and the relevant transfer
or conveyance will accordingly be dutiable at normal rates. The same property, once distributed
out of trust to the beneficiaries of the trust, however, will be exempt from stamp duty by virtue
of s.27(5). Similarly, a distribution in specie of Hong Kong stock or Hong Kong immovable
property on a liquidation of a company in proportion to the shareholders’ shareholding
percentage will also be exempt from stamp duty by virtue of s.27(5).

A transfer of an immovable property under an estate of a deceased person to the

beneficiaries of the estate pursuant to a will or in accordance with the law of intestacy or by the
right of survivorship is not chargeable with stamp duty because there is no change in beneficial
interest (s.27(5)). However, if the beneficiaries of the estate agree as between themselves to
vary the provisions of the will or the outcome of the distribution of the estate as it would have
been under the law of intestacy and so redistribute their entitlements to the property, the
excess distribution over the original entitlement will be subject to AVD as a deed of gift at Scale
1 rates or Scale 2 rates, as the case may be (BSD may apply, depending on the circumstances)
(Tan Kay Thye v Commissioner of Stamp Duties (1991) 3 MLJ 150).
At Hong Kong contract law, marriage is a good consideration – that is, an agreement to
marry is something of value that can be given in consideration such as to render a contract
enforceable. S.27(4) expressly exempts from the deeming provision cases where marriage
is the consideration. That is a necessary concession since it is in practice almost impossible
to quantify the money value of marriage. It would follow, for example, that where property
is conveyed in consideration of marriage, the deeming provision in s.27 will not apply
and therefore ad valorem duty will not be charged with respect thereto (Inland Revenue
Commissioners v Rennell (1964) AC 173).

Key Learning Point

Stamp duty cannot be avoided simply by gifting Hong Kong stock or Hong Kong immovable
property to the transferee, or transferring it under its value (i.e. below market value). S.27
operates as an anti-avoidance provision, deeming such transfers to be transfers at full
market value for stamp duty purposes.

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Knowledge Check Question

Question 5
Identify which of the following statements is true.
A The issue of a bond is always exempt from stamp duty because it is loan capital and
therefore excluded from being Hong Kong stock within the meaning of s.2 of the SDO.
B A duplicate agreement for sale and purchase may be duly stamped as a duplicate and
shown as evidence in court notwithstanding that the original is in the process of being
adjudicated by the Collector of Stamp Revenue.
C Tanis settles his town house in Sai Kung on trust with himself as trustee and his wife,
Laurana, as beneficiary; that transaction does not give rise to a charge to stamp duty by
virtue of s.27(5) of the SDO.
D The trustees of The Lord Soth Trust assign 10,000 shares in Neraka Pty Ltd, a company
incorporated in Singapore but listed on the Hong Kong Stock Exchange, to a beneficiary
of that trust; that trust distribution does not give rise to charge to stamp duty by virtue
of s.27(5) of the SDO as there is no change in beneficial interest.

7 . 7
EXEMPTIONS AND RELIEFS

Notable exemptions and reliefs include the following:

• S.39 of the SDO provides for, among others, the following specific exemptions:

°° All instruments duly stamped under the stamp regulations enforced by the
Japanese in Hong Kong during the Second World War;

°° All conveyances on sale, and agreements for sale of immovable property (s.29H(1)
(a)), to the government or an incorporated public officer;

°° All grants by the government and all government leases and all surrenders of such
grants and leases; and

°° All instruments exempted under s.125 of the Bankruptcy Ordinance (Cap.6) or s.281
of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap.32)
(i.e. transfers and conveyances subject in liquidation/bankruptcy scenarios);

• S.40 of the SDO exempts all instruments with respect to which, by virtue of s.41 or
43(1), no person is liable for stamping;

• S.43 of the SDO exempts the lease of consular and quasi-consular premises; and

• S.44 of the SDO exempts charitable donations.

In practice, the most important relief is relief under s.45, which in essence is a group relief
provision exempting from stamp duty conveyances of Hong Kong immovable property or
transfers of Hong Kong stock between associated corporations. S.45 relief cannot be claimed
by individuals or persons other than bodies corporate, though there are no incorporation or

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registration requirements for bodies corporate seeking relief; for example, it is not necessary
that any of the transferor or the transferee be incorporated in Hong Kong or carry on a trade or
business in Hong Kong. Relief under s.45 entails total exemption from all forms of stamp duty,
including AVD, SSD, and BSD.

It does not, however, apply to the grant of a lease unless the lease is deemed to be a
conveyance on sale by virtue of being a voluntary disposition inter vivos on the terms of s.27.
The nominal fixed duties of HK$100 on conveyance and HK$5 on the instrument of transfer
(as the case maybe) are not exempted by s.45.

The bodies corporate are associated if either:

• One of the bodies corporate must be the beneficial owner of not less than 90% of the
issued share capital of the other; or

• A third body corporate must be the beneficial owner of not less than 90% of the issued
share capital of each of the transferee and the transferor.

The ownership criteria set forth in the preceding text may be traced through multiple
corporate layers.

Illustrative Example 16
If the transferor (A Ltd) and the transferee (B Ltd) are each 100% subsidiaries of different
companies (C Ltd and D Ltd, respectively), but both C Ltd and D Ltd are, in turn, 100%
subsidiaries of a single body corporate (TopCo Ltd), the association condition as between
A Ltd and B Ltd is met by virtue of the fact that they are both indirect 100% subsidiaries
of TopCo. Similarly, if E Ltd were the owner of 100% of the issued share capital of F Ltd,
and F Ltd, in turn, owned 95% of the issued share capital of G Ltd, the association
condition would be met as between E Ltd and G Ltd, because G Ltd is in effect the
95% indirect subsidiary of E Ltd.

Contrast a scenario where the transferor (X Ltd) and the transferee (Y Ltd) are 100%
subsidiaries of, respectively, A Ltd and B Ltd. A Ltd and B Ltd are, in turn, 75% subsidiaries
of Z Ltd, with the remaining 25% of their issued share capital held by various third parties.
Under those circumstances, s.45 relief is incapable of applying. That is because although
X and Y as transferor and transferee are associated in the loose sense of the term, they
are not associated within the meaning of s.45(2). They would be so associated if, however,
A Ltd and B Ltd were both at least 90% subsidiaries of Z Ltd.

Ownership must be beneficial: The relief will not apply where the share capital of either
party is held on trust for an unrelated third party.

There are also important anti-avoidance provisions. Notably, the conveyance or transfer in
question must not have been executed in connection with an arrangement under which:

• Any part of the consideration was to be provided or received directly or indirectly by a

person other than an associated corporation of the transferor or the transferee (s.45(4)(a));

• The beneficial interest in the immovable property or Hong Kong stock was previously
transferred directly or indirectly by a person other than an associated body corporate
of the transferor or the transferee (s.45(4)(b)); or

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• The transferor and the transferee were to cease to be associated (as summarised in the
preceding text) by reason of a change in the percentage of the issued share capital of
the transferee in the beneficial ownership of the transferor or a third corporation within
two years after the date of execution of the instrument (s.45(4)(c)).

An ‘arrangement’ means a plan or scheme under which any of the so-called disqualifying
events referred to in the preceding text have been or are to be done (Shop and Store
Developments Ltd v IRC (1967) 1 AC 472). Where the transferor and transferee cease to be
associated within the meaning of s.45 within two years after the date of execution of the
instrument, stamp duty would thereby become chargeable at the rate it would have been
charged on the date of execution of the instrument.

An important limitation of s.45 relief is a de-grouping charge that arises when, for whatever
reason, the transferor and the transferee cease to be associated within the meaning of s.45(2)
within two years of the execution of the relevant instrument that would, but for s.45 relief,
have been chargeable with stamp duty. The de-grouping charge in substance amounts to a
withdrawal of relief and gives rise to an immediate charge to stamp duty on the amounts that
would, but for s.45 relief, have been chargeable with respect to the transfer in question. The
purpose of the de-grouping charge is to prevent aggressive tax avoidance whereby corporate
structuring solutions are applied to engineer a scenario whereby s.45 relief applies with the
sole or dominant purpose of exempting a given transaction from stamp duty and, immediately
thereafter, the structure is unwound.

However, s.45(4)(c) should be read carefully in that ‘the transferor and the transferee
were to cease to be associated by reason of a change in the percentage of the issued share
capital of the transferee in the beneficial ownership of the transferor or a third corporation’.
That means if a group undergoes restructuring, the transferor is liquidated after transferring
its property to another associate body corporate (the transferee), then s.45 relief would still
apply if there is no change in the percentage of the issued share capital of the transferee in the
beneficial ownership of a third corporation, because in this case the change only happens to
the transferor. Similarly, s.45(4)(c) would not apply if the transferee is the holding company of
not less than 90% of the issued share capital of the transferor.

Thus, in the event that the transferor and transferee cease to be associated within the
meaning of s.45(2) by reason of a change in the percentage of the issued share capital of the
transferee in the beneficial ownership of the transferor or a third body corporate (s.45(4)(c)),
then s.45(5A) provides that:

a. The transferor and transferee must notify the Stamp Office of that fact and of the date
of the cessation within 30 days after the date of the cessation;

b. If any relief from stamp duty has been granted under s.45, the relief is deemed to be
withdrawn and the transferor and transferee are liable or jointly and severally liable,
as the case may be, to pay within 30 days after the date of the de-grouping, by way of
stamp duty an amount equal to the stamp duty that would have been chargeable on
the instrument had relief not been granted under s.45;

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c. If such stamp duty charged by virtue of the withdrawal of s.45 relief is not paid within
the 30 days:

(i) The transferor and transferee are liable or jointly and severally liable (as the case
requires) to a penalty; and

(ii) The amount of the penalty payable after a lapse of a period of time after the
30 days is the same as that calculated under s.9 for an instrument chargeable with
stamp duty that is not stamped before or within the time for stamping it and is
stamped after the lapse of the same period of time after the time for stamping it.

S.45 relief is not self-executing. The transferor and transferee must apply to the Collector
for adjudication (for which see further Section 7.8.5) under s.13 of the SDO. The conveyance or
transfer will therefore not be duly stamped until adjudicated by the Collector as exempt under
s.45. The process of application requires that a statutory declaration be sworn affirming that all
the conditions for the application of s.45 apply and it is the applicant(s) who have the burden
of proving that s.45 relief applies to a given transaction (Littlewoods Mail Order Stores Ltd v IRC
(1963) AC 135).

Illustrative Example 17
The transferor, A Ltd, transfers a residential property in Yuen Long to B Ltd as
transferee. Both A Ltd and B Ltd are 100% subsidiaries of a Cayman Islands company,
TopCo Ltd. At the date of the transfer, A Ltd and B Ltd qualify for s.45 relief because
they are associated within the meaning of s.45(2) and are so exempted from AVD
and, by extension, SSD and BSD, under s.45(1). Nine months after the execution of
the agreement for sale under which the property was transferred to B Ltd, TopCo Ltd
finds an interested buyer for B Ltd, and sells 50% of its shareholding. Under those
circumstances, the transferor and the transferee have ceased to be associated with
one another within the meaning of s.45(2) within two years of the transfer by reason
of a change in the percentage of the issued share capital of the transferee (B Ltd) in
the beneficial ownership of TopCo Ltd, as specified in s.45(4)(c). It would follow that
s.45(5A) would apply to disallow s.45 relief and trigger a clawback mechanism whereby
AVD and, if relevant, SSD and BSD, are chargeable with respect to the agreement for
sale. As required by s.45(5A), the transferor and the transferee are obliged to notify the
commissioner that the de-grouping has taken place, the relief will be deemed to have
been withdrawn, and A Ltd and B Ltd will be jointly and severally liable for any AVD, SSD,
and/or BSD that would have, but for the s.45 relief, been chargeable on the transfer.
Payment must be made within 30 days of the de-grouping.

Key Learning Point

There are a number of reliefs and exemptions available from stamp duty. In practice, the
most important of these is s.45 relief, which applies to transfers of Hong Kong stock or
Hong Kong immovable property made between two associated bodies corporate.

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Knowledge Check Question

Question 6
Rabid Rottweiler SA is a company incorporated in Luxembourg that wishes to transfer
the title it holds in Superrich Jumbo Profit House, a commercial block in North Point, to
an associated transferee. Identify under which of the following scenarios is s.45 relief
available.
A Rabid Rottweiler SA enters into an agreement for the sale and purchase of the property
with Mr. Schwarz Zokosta, a German resident and 100% beneficial owner of the entire
issued share capital of Rabid Rottweiler SA.
B Rabid Rottweiler SA leases the property to Doge Pty Ltd, a company incorporated in
Japan, for a term of 1 year at market rent. Rabid Rottweiler SA is the 100% beneficial
owner of the entire issued share capital of Doge Pty Ltd.
C Rabid Rottweiler SA enters into an agreement for the sale and purchase of the property
with Double Lucky Gold Dragon Inc, a company incorporated in China. A partnership
established under the Partnership Ordinance of which Rabid Rottweiler SA is a corporate
partner holds, as part of its partnership assets, 100% of the issued share capital of
Double Lucky Gold Dragon Inc.
D Rabid Rottweiler SA enters into an agreement for the sale and purchase of the property
with Pentex Inc, a company incorporated in the United States of America. Rabid
Rottweiler SA is the beneficial owner of 100% of the issued share capital of WhiteWolf
LLC, a Delaware limited liability corporation, which, in turn, is the beneficial owner of
90% of the issued share capital of Pentex Inc.

7 . 8
STAMP DUTY ADMINISTRATION

The IRD is charged with administering the SDO, for which it has a dedicated section, the Stamp
Office. The position of Collector is held by the Commissioner of Inland Revenue. Formally, all
requests for adjudication and all correspondence in matters of stamp duty are addressed to
the Collector.

7.8.1 Methods of Stamping

The permitted methods of stamping are set out in s.5 of the SDO. In general, stamped
instruments bear a physical stamp indicating the amount of duty paid and the date of
stamping. An instrument must bear such physical certification of stamping in order to be
treated as duly stamped under the SDO.

Stamping may be applied either in paper or electronic format for chargeable agreements
for sale, conveyances on sale and leases of immovable property under a computerised
‘Property Stamping System’. This system generates stamp certificate copies for these
instruments.

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The Stamp Office has a 24 hours e-Stamping service to submit electronic stamping
applications for

• Initial stamping of agreement or assignment with not more than four purchasers
(the e-Stamping service also does not apply to adjudication cases, stock transactions,
property transactions involving nomination or supplemental agreements, and tenancy
agreements for consideration other than rent);

• Payment of deferred stamp duty;

• Subsequent agreement or assignment; and

• Tenancy agreement with not more than four landlords and four tenants.

For all other dutiable instruments, the original instrument must be presented to the Stamp
Office with a stamping request and supporting documents. Upon receipt of a stamping request
with the required document(s) the Stamp Office will either issue a stamp certificate in respect
of the instrument or impress a stamp on the document. Payment of duty may be effected
immediately to the extent that duty may be computed immediately by the Stamp Office;
otherwise, the duty will need to be assessed, such that the documents will be provisionally
stamped subject to the final computation and payment of duty. Any delays on the basis
of computational matters occasioned by the Stamp Office do not result in a breach of the
statutory timing rules for stamping.

7.8.2 Time Limit and Persons Liable for Stamping

In general, both the transferor and the transferee are jointly and severally liable for the
payment of stamp duty. The principal exceptions to this rule are the cases of BSD, where only
the buyer is liable for payment of BSD, and stamp duty under Head 3 of the First Schedule,
where the issuer of the bearer instrument bears the duty.

As regards time limits, these are set forth in the First Schedule. Stamping as regards the
conveyance of immovable property or a dutiable agreement for sale and purchase must in
general take place within 30 days after the execution of the said instrument.

Conversely, the time limit for a contract note under Head 2(1) is 2 days after the sale
and purchase of Hong Kong stock if effected in Hong Kong or 30 days after the sale and
purchase if effected outside of Hong Kong. In the case of a voluntary disposition inter vivos of
Hong Kong stock chargeable under Head 2(3), the time limit is extended to 7 days if executed in
Hong Kong, and remains 30 days if executed outside of Hong Kong. Technically, an IoT should
be stamped under Head 2(4) prior to its execution or, if executed outside of Hong Kong, in any
event within 30 days of execution, though in practice such instruments, which are necessary
to effect a change in legal ownership of Hong Kong stock, are executed prior to stamping.
When duly stamped, the transferor or transferee will then send the instrument of transfer
to the company secretary of the company that shares were transferred, requesting that its
register of members be updated to reflect the transfer by entering the transferee’s name.

Bearer instruments dutiable under Head 3 are stampable prior to issue.

Duplicates and counterparts dutiable under Head 4 are stampable within seven days
after execution, or such longer period as the time for stamping the original instrument
would allow.

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7.8.3 Penalty for Late Stamping

Unlike taxes charged under the Inland Revenue Ordinance, failure to stamp is not itself an
offence. The penalties for delayed stamping are, however, potentially very severe. S.9 of the
SDO stipulates penalties for late stamping:

• If the instrument is so stamped not later than one month after the time for stamping,
the penalty shall be double the amount of the stamp duty;

• If the instrument is so stamped later than one month but not later than two months
after the time for stamping, the penalty shall be four times the amount of the
stamp duty; and

• In any other case, the penalty shall be 10 times the amount of the stamp duty.

The Collector is empowered to remit any part of a penalty chargeable under s.9. In its
published guidance, the Stamp Office has stated that in a voluntary disclosure case, if the delay
is not deliberate, it will normally adopt the following formula in calculating the reduced penalty,
subject to a minimum sum of HK$500:

Reduced penalty 14% Stamp duty payable No.of days delayed 365days

The penalty remission may be adjusted upward or downward depending on the special
circumstances of a case. For example, the above formula does not apply to late stamping cases
uncovered during inspection carried out by the Stamp Office (i.e. not a voluntary disclosure
case). In addition, the penalty for a second or subsequent delay uncovered will be more severe.

Duty payers should write to request for remission of penalty with explanations of the delay
and supporting evidence, where appropriate.

7.8.4 Penalty for Failure to Disclose Relevant Information

Penalties for late stamping under s.9 are administrative penalties and are in practice collected
as though they were additional stamp duty. In certain circumstances, however, criminal
penalties may also arise. S.11(2)(a) of the SDO provides that any person who, with intent to
defraud the government, executes any instrument in which all the facts and circumstances
affecting liability to stamp duty are not fully and truly set out commits an offence. S.11(2)(b)
provides that any person who, with intent to defraud the government, prepares a document
and omits to set out any relevant fact or circumstance affecting chargeability to stamp duty
commits an offence. This provision targets persons, such as accountants or lawyers, who may
be instructed to prepare stamp duty documentation.

All offences under the SDO are punished by the same sanctioning provision in s.60, which
provides that any person who commits or attempts to commit any offence under the SDO shall
be liable to a fine at level 6 (currently HK$100,000) or to imprisonment for one year.

It is important further to note that s.53 of the SDO provides that where an offence under
the SDO is committed by a body corporate, any officer thereof who failed to discharge the
obligation or liability imposed by the ordinance is also deemed to commit an offence and so
liable to the sanctions in s.60.

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In addition to the previously mentioned statutory offences, there is a common law offence
of cheating the IRD (which includes the Stamp Office).

Because the preceding offences are all criminal in nature, the guilt of the defendant must
be shown beyond reasonable doubt by the prosecution. This is distinct from the balance
of probabilities standard typically adopted in other cases for the recovery of tax claimed
by the IRD.

7.8.5 Adjudication
S.13 of the SDO provides that an executed instrument may be presented to the Collector,
together with supporting documentation where required, and the Collector’s opinion sought on
the amount of duty (if any) payable thereon. This is not the equivalent of an advance ruling or
other form of revenue clearance, where the IRD is contacted prior to the envisaged transaction.
Instead, it requires that the instrument first be executed, and only then the opinion of the
Collector may be sought. It therefore has more in common with a standard process of tax
assessment. S.45 relief is administered by way of adjudication. There is a flat adjudication fee of
HK$50, payable with respect to each application.

Certain instruments are required to be adjudicated and such instruments are expressly
exempted from the payment of adjudication fee:

• S.24(2) (conveyance or contract notes in consideration of debt);

• S.27(3) or 29F(2) (instruments operating as gifts);

• S.29H(3) or 45(3) (instruments qualifying for intra-group relief);

• S.44(3) (instruments effecting a gift to exempted institution); and

• First Schedule, Head 1(1), note 4 and Head 2(3), note 3 (foreclosure order).

The request for adjudication should be submitted together with the original instrument and
relevant supporting documents at the Stamp Office counter. There is no applicable electronic
submission.

If the Collector is of the opinion that the document is not chargeable with stamp duty, it
may be stamped with a stamp denoting that it is not chargeable with stamp duty and if the
Collector is of the opinion that the document is chargeable to stamp duty, the controller may
assess the amount of stamp duty or, if it already has been stamped under s.5 of the SDO
and all the stamp duty has been fully paid, it may be stamped with a stamp denoting that the
document is duly stamped.

Where the Collector, within seven days of making the assessment, serves notice of it by
post on the person who requested the adjudication or who is liable to stamp the document, the
assessment will become final and conclusive within one month of the date of the notice unless
an appeal, if lodged within time, is successful.

7.8.6 Appeal against Stamp Duty Assessment

Any person dissatisfied with the Collector’s assessment on adjudication may appeal to
the District Court, as set forth in s.14 of the SDO within one month from the date of the
assessment. The one-month time limit may be extended if the appellant was prevented from

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lodging an appeal before the time limit by virtue of illness, absence from Hong Kong or other
reasonable cause (s.14(5B)). The duty payer will in general be required to pay the stamp
duty claimed by the Collector first, notwithstanding having lodged an appeal under the IRD’s
customary ‘pay first, argue later’ approach to dispute resolution, unless the appellant provides
security to the satisfaction of the Collector for payment of the duty in dispute, in which case
the demand for payment of duty may be postponed for such period, to such extent and on
such terms as the Collector thinks fit (s.14(1A)). Separately, where the court on application
made by the appellant is satisfied that it would impose hardship (meaning more than mere
inconvenience) on the appellant to require them to pay all or part of the stamp duty claimed
by the Collector upfront, it may agree to hear the appeal without payment of stamp duty or the
part of the stamp duty or on security being given to the court (s.14(1B)).

Once a notice of appeal has been lodged by the appellant, the Collector will be required to
state a case, setting out the facts of the dispute and the specific questions of law for the District
Court to answer. The case stated by the Collector will in essence form the subject matter of the
dispute to be heard before the court. The Collector will deliver the case stated to the person
requesting it and the appellant has only seven days to set it down for hearing after serving it on
the Secretary for Justice, as set forth in s.14(2). This is a strict and statutory time limit. Neither
the Collector nor the court have any discretion to derogate from it (Bangkok Capital Antique Co
Ltd v CSR (1984) 2 HKTC 83). There are no exempting circumstances.

The District Court, as the court of first instance in stamp duty disputes, must determine
the relevant facts and adjudicate the dispute by applying the law to those facts. Any party
dissatisfied with the judgement of the District Court may appeal to the Court of Appeal,
provided that court grants leave to appeal and the appeal is on a point of law.

7.8.7 Effect of Non-stamping

S.15(1) provides that subject to the specific exceptions in s.15(1A) and s.15A, any chargeable
instrument which is not duly stamped is not admissible in evidence in any civil proceedings
whatsoever. Where failure duly to stamp is pleaded in civil proceedings, a document not
stamped will nonetheless be admissible if a solicitor personally undertakes that the document
will be lodged for stamping and that any duty and penalty assessed will be paid (s.15(1A)).
Where a document not duly stamped is admitted as evidence and the matter is subsequently
appealed, the appellate court must take custody of the instrument and submit it to the
Collector for stamping, though, under such circumstances, the document will in effect be
admitted and accepted as evidence (Sun Hing Co v Brilliant Investment Co Ltd (1966) HKLR 310).
In practice, note that it is considered a breach of court etiquette (albeit not necessarily in
and of itself objectionable) to seek to impugn an instrument on the basis that it has not been
duly stamped.

A purchaser of immovable property in Hong Kong will in the ordinary course conduct
searches and other due diligence to ensure that the vendor of the property can sell them a
good title – that is, the seller actually owns and can actually sell the property on the terms
that he or she has covenanted in the agreement for sale. Under s.15(2) the Land Registrar,
who is the person responsible for admitting and maintaining documents in the Land Registry,
which is Hong Kong’s registry of instruments relating to immovable property, is prohibited
from registering any chargeable instrument that is not duly stamped. The upshot of that is
that a vendor of immovable property will likely not be able to show and prove good title to the

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property he or she purports to sell until such time as the agreement for sale or conveyance,
as the case may be, are duly stamped. In practice, that will make it commercially almost
impossible for the vendor to sell the property to any third party until the relevant instrument
for transfer has been duly stamped.

As regards Hong Kong stock, s.19(3) of the SDO provides that no agent or other person has
any legal claim to any charge for brokerage, commission or agency with reference to the sale or
purchase of any Hong Kong stock if he or she fails to comply with the provisions of s.19 – being
the requirement forthwith to produce contract notes with respect to the sale and purchase of
Hong Kong stock and procure that these be duly stamped.

Similarly, where bought and sold notes and an instrument of transfer have not been duly
stamped, the company secretary of the company whose shares are being transferred will not
as a matter of corporate law be able to register the change in the registered ownership of the
shares. S.21 of the SDO provides that, under those circumstances, dividends cannot be paid to
the transferee and the transferee will not by extension be allowed to claim the payment of any
dividends.

Key Learning Point

It is crucial to ensure that dutiable instruments be duly stamped on time. Failure to
procure the due stamping of such documents may cause them to be inadmissible in civil
proceedings. Late stamping can give rise to penalties of up to 10 times the stamp duty
chargeable, which in immovable property transactions can be punitive.

Knowledge Check Question

Question 7
Dobermann Properties GmbH submitted an instrument for the Collector’s adjudication,
and the Collector has adjudged the instrument to bear ad valorem duty of HK$1.5 million
and issued an assessment to ad valorem duty on that basis. Dobermann Properties GmbH
was dissatisfied with the adjudication, and instructed the litigation specialist law firm Pitt &
Bull to lodge an appeal. Identify which of the following statements are correct.
I. Pitt & Bull should file a notice of appeal within one month of the date of the
assessment.
II. Pitt & Bull serve the case stated issued by the Collector on the Secretary of Justice
eight days after receipt of the same; it was physically prevented from doing so
because of a prolonged Category 10 typhoon, accordingly the District Court has
jurisdiction to extend the time limit for service.
III. Asuka, a legal director of Dobermann Properties GmbH, was responsible for filing
the original adjudication application. In preparing the supporting documents, she
decided that an opinion prepared by Montague H. Withnail QC on certain matters
of UK law was not relevant because it had no bearing on any matter of Hong Kong
stamp duty. It later emerged that the opinion clarified certain matters relating

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Knowledge Check Question (continued)

to the instrument to be adjudicated that would have increased ad valorem duty
chargeable on it by HK$500,000. Asuka is now liable to criminal sanctions under
s.11(2)(b) of the SDO.
IV. Dobermann Properties GmbH has cashflow difficulties, and will not be able to pay
the HK$1.5 million claimed because that would cause it to become insolvent – Pit
& Bull should therefore apply to the court under s.14(1B) to progress the appeal
without payment of stamp duty.
V. Gau DJ dismisses the appeal brought by Dobermann Properties GmbH and
upholds the Collector’s assessment in full. Pitt & Bull, in reviewing the judgement,
find that Gau DJ relied on the judgement of the Court of Final Appeal in Jarndyce
v Jarndyce, but misinterpreted the court’s reasoning in that case. Dobermann
Properties GmbH may therefore apply to the Court of Appeal for leave to appeal on
the basis of that error.
A I, II and III
B III, IV and V
C I, IV and V
D II and IV

7 . 9
RAMSAY PRINCIPLE

The so-called Ramsay principle is derived from the judgement of the House of Lords
in W.T. Ramsay Ltd v IRC (1982) AC 300. Although it is often labelled as an anti-avoidance
provision, it is, in reality a principle of statutory construction or, more broadly, of statutory
application. The House of Lords in Ramsay opined that tax legislation is intended to apply
to real-world business or commercial transactions and events. As we have already seen,
the current judicial orthodoxy is that statutes must be construed purposively – that is, with
a view to the mischief the legislation was intended to cure. Thus, where there is a pre-
ordained series of transactions or a single composite transaction, any steps in the series
or any components in the composite transaction that have no real commercial or business
purpose may be disregarded for all fiscal purposes. The relevant tax legislation would,
on that footing, focus on the commercial result of the transaction, disregarding the effect
of the uncommercial transactions or events. If the legal position is that tax is imposed by
reference to a commercial concept (such as profits, gains, etc.), then to have regard to the
business ‘substance’ of the matter is not to ignore the legal position but to give effect to it
(MacNiven v Westmoreland Investments Ltd (2001) STC 237).

Because stamp duty is a tax on instruments, and the charging provisions in s.4 and the First
Schedule depend on the strict legal understanding of the instruments concerned, there was at
one time a judicial and academic debate as to whether the Ramsay principle was applicable in a
stamp duty context. A transfer of shares and a conveyance on sale are not commercial terms,

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but, strictly speaking, legal, technical terms, such that it was arguable whether the logic of the
Ramsay could apply in a context that was purely legalistic.

In Hong Kong, that question was resolved by the Court of Final Appeal in CSR v Arrowtown
Assets Ltd (2004) 1 HKLRD 77. In that case, the dispute turned on an aggressive tax avoidance
scheme that had been entered into in order to obtain relief from stamp duty under s.45 of the
SDO. Economically worthless ‘B’ shares had been issued in order to secure formal compliance
with the 90% beneficial ownership test for the association condition in s.45 to be met. In
dismissing the taxpayer’s appeal and holding that the transaction, viewed realistically, did not
fall within the association condition required by s.45 read purposively (i.e. to provide stamp
duty relief to bona fide intra-group transfers), the court decided that the Ramsay principle
was therefore applicable to stamp duty matters. Thus, the Ramsay principle is in reality simply
the restatement of conventional principles of purposive statutory interpretation in a tax law
context. The court held that the ultimate question is whether the relevant statutory provisions,
construed purposively, were intended to apply to the transaction, viewed realistically. Where
schemes involve intermediate transactions having no commercial purpose inserted for the
sole purpose of tax avoidance, it is quite likely that a purposive interpretation will result in such
steps being disregarded for fiscal purposes.

Key Learning Point

The modern approach to statutory interpretation is to understand the plain words of
the statute specifically in the legislative context in which they were enacted. The Ramsay
principle applies to ensure that the provisions of a taxing statute are applied, as they were
intended, to a real-world commercial operation or transaction.

7 . 1 0
ALTERNATIVE BOND SCHEMES

Islam prohibits the charging of interest. Observant Muslims accordingly avoid charging interest
in financial transactions. This has led to the emergence of a specific Islamic financing sector,
which is based on the issue of Islamic financial instruments known as ‘sukuk’ that are usually
asset-backed and avoid the charging of interest by involving an element of profit participation,
or otherwise synthesise interest in the guise of lease or rental payments. With a view to
attracting Islamic finance to Hong Kong, the government has introduced ss.47C–47K of the SDO
to exempt ‘sukuk’ alternative bond schemes (ABS) and the asset transactions underlying such
schemes from stamp duty. Because the ABS replicate interest without there necessarily being
a loan relationship between the participants to the scheme, value is often derived from an
underlying asset, which may be Hong Kong immovable property or Hong Kong stock of which
the transfer would otherwise be dutiable.

Exemption from stamp duty is in general achieved by:

1. Treating bonds issued under ABS as conventional bonds for the purposes of the SDO
(s.47E). Bonds, being debentures and thus loan capital, are expressly excluded from the

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definition of Hong Kong stock in s.2 of the SDO, provided that they be denominated in a
currency other than Hong Kong dollars.

2. Instruments otherwise chargeable under Heads 1 and 2 of the First Schedule executed
in accordance with an underlying investment arrangement – through which the ABS
commercially derives its value – are exempt if the conditions in s.47F are satisfied:

a. The subject matter of the instrument is a specified asset transaction between

the originator and the bond-issuer (i.e. of the class of transactions specifically
contemplated as exempt from stamp duty under the ABS); and

Security must be provided for the payment of stamp duty and other amounts that
would otherwise be chargeable to duty, to ensure that in the event relief were to be
withdrawn from the ABS, the Collector would not be left out of pocket.

Key Learning Point

Alternative bond schemes (ABS) are instruments and/or legal arrangements that are
entered into with a view to complying with Islamic principles of finance, which prohibit the
charging of interest. ABS therefore ‘synthesise’ interest via income streams derived from
underlying asset transactions.

7 . 1 1
STAMP DUTY PLANNING

As with any other form of tax planning, stamp duty mitigation must be prepared with care and
pragmatism. In particular, the purposive approach to statutory interpretation as understood
in cases such as Ramsay and Arrowtown and the historic substance-over-form approach
in applying stamp duty legislation are obstacles to simplistic or overly aggressive stamp
duty planning.

Some important principles of stamp duty mitigation are as follows:

1. Perhaps the most common form of stamp duty planning is enveloping Hong Kong
immovable property in a company. That means that instead of holding the property
directly, the ultimate beneficial owner holds shares in an offshore company (often
incorporated in the British Virgin Islands, Bermuda, or the Cayman Islands), and the
offshore company, in turn, holds legal and beneficial title to the Hong Kong immovable
property. The advantage of this approach is that the transfer of shares in offshore
companies that are not listed on the HKSE are not dutiable. Thus, instead of buying the
underlying property, a potential acquirer would buy shares in the enveloping company,
thereby avoiding AVD, BSD and SSD. There are two main disadvantages with this
approach. First, the initial enveloping of the property (i.e. the transfer of the property

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to the corporate vehicle) is dutiable and, if the property is residential, will incur BSD at a
flat rate of 15% of the value or transfer consideration, whichever is the higher. Second,
a potential buyer will in general need to undertake more due diligence in buying a
company that may have debts or other liabilities that would be transferred to the buyer
along with the underlying property.

2. The issue and extinction of shares is not in and of itself stampable. That means that
it is always preferable, if possible, to cancel shares by way of a share redemption
or reduction of capital followed by a fresh issue of shares, instead of transferring
the shares outright. Consider the following scenario: A Co. wishes to transfer the
entire issued share capital of Target, a company incorporated in Hong Kong, to an
unrelated third party, B Co. S.45 relief cannot apply because the parties are not
associated within the meaning of that section. Instead of selling the shares in Target,
which would give rise to stamp duty, Target issues, say, 100 shares to B Co. for
consideration equivalent to the contemplated transfer consideration. The issue of
shares is not stampable. Subsequently, A Co. extinguishes its shareholding in Target
by way of a reduction of capital followed by cancellation of shares or otherwise by
converting its shareholding into redeemable shares and redeeming these for nominal
value. The cancellation or extinguishment of shares is not dutiable. Accordingly, the
transfer of Target is achieved by avoiding dutiable transactions, and substituting
these for non-dutiable operations. Note, however, that the Stamp Office considers
that a buyback of shares, as opposed to redemption or cancellation pursuant to a
reduction of capital, to be sale and purchase within the meaning of s.19 of the SDO
and accordingly dutiable.

3. An amalgamation of two companies under the Companies Ordinance (Cap.622) is

in practice a merger. Where Hong Kong immovable property or Hong Kong stock is
transferred pursuant to an amalgamation to the amalgamated (i.e. merged or surviving
entity), the Stamp Office is of the view that no stamp duty is payable, provided that an
application for relief under s.45 is made in connection with the amalgamation. Note,
however, that a recent decision Nomura Funds Ireland v CSR (2017) DCSA 4 suggests that
a merger whereby Hong Kong stock passes from the merging company to the merged
company does give rise to a charge for AVD, albeit that the case was decided in the
context of an EU law merger.

4. Transmissions by operation of law are not in general dutiable. When a person dies
and Hong Kong immovable property or Hong Kong stock devolves to his or her
beneficiaries or legatees pursuant either to his or her will or the laws of intestacy, such
transmission is not dutiable. Similarly, when a company is put into liquidation (whether
this be voluntary or insolvent) and property of which the transfer would otherwise
be dutiable is transmitted pursuant to the laws governing insolvency or liquidation,
such transmissions should not be dutiable. Where a foreign law is involved, however,
the Stamp Office will require detailed expert evidence – usually to be obtained from
counsel in the relevant jurisdiction – to support the proposition that the transmission is
indeed by operation of law.

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Apply and Analyse 2
Mr. Huang, who is not a HKPR, acquired a residential property in Hong Kong from Mr. Ho
at a consideration of HK$5 million. The dates of the relevant documents are as follows:

• 1 January 2019 – Provisional Sale and Purchase Agreement (PSPA)

• 12 January 2019 – Formal Sale and Purchase Agreement (FSPA)

• 15 February 2019 – Deed of Assignment (DA)

Mr. Huang nominated his wife as a joint tenant in the DA. Mrs. Huang is likewise not a
HKPR. Neither Mr. Huang nor Mrs. Huang owned any other residential property in Hong
Kong at any relevant times, though they both each owned a flat in Shenzhen.

On 1 April 2019, Mr. and Mrs. Huang let the property to Mr. Chan by signing a tenancy
agreement with detailed terms as below:

• Lease term: two years (renewable for two more years)

• Monthly rent: HK$10,000

• Lease premium: HK$200,000

• Rental deposit: HK$20,000

Mr. Ho acquired the property from the property developer at HK$4 million on
1 January 2018, with agreement for sale and conveyance on sale signed on 1 January 2018
and 31 January 2018, respectively. Mr. Ho is a Hong Kong permanent resident.

Analysis

The PSPA was superseded by the FSPA within 14 days. Hence the PSPA is not chargeable to
stamp duty. The FSPA is chargeable to AVD as an agreement for sale.

For AVD, Scale 1, Part 1 rate of 15% is used as Mr. Huang is not a HKPR

HK$5,000,000 15% HK$750,000

For the deed of assignment, AVD is HK$100 only if FSPA is duly stamped.

Nomination of Mrs. Huang as a joint owner in the DA is exempt from AVD because the
nomination is not regarded as an agreement for sale, as Mrs. Huang is a closely related
person of Mr. Huang and she did not own any residential property in Hong Kong at the
time of acquisition of the subject property.

Analysis for SSD

Mr. Ho acquired the property on 1 January 2018 and sold it on 1 January 2019. The holding
period is 12 months and 1 day. The applicable rate is 10%.

SSD payable HK$5,000,000 10% HK$500,000

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Apply and Analyse 2 (continued)

Analysis for BSD

Mr. Huang is not HKPR, hence BSD is chargeable:

BSD is payable:

HK$5,000,000 15% HK$750,000

Analysis for the Tenancy

The lease term is two years. Hence 0.5% applies to the yearly rent. The lease premium is
chargeable at 4.25%. No stamp duty is chargeable on the rental deposit.

Stamp duty for the lease agreement

((HK$10,000 12) 0.5%) (HK$200,000 4.25%) HK$9,100

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SUMMARY

• Stamp duty is a tax payable on instruments, not transactions. It is therefore important to

identify the appropriate dutiable instrument, and the rate at which it will bear duty.

• There are four broad classes of dutiable instruments in Hong Kong relating to the transfer
or lease of Hong Kong immovable property, transfer of Hong Kong stock, issue of bearer
instruments, and the duplicates and counterparts of the above.

• Hong Kong stock includes shares in a company incorporated in Hong Kong or otherwise listed
on the Hong Kong Stock Exchange.

• A conveyance on sale or agreement for sale of Hong Kong immovable property will bear ad
valorem stamp duty. The rate is a function of whether the buyer is a first-time HKPR individual
buyer or otherwise, and whether the property is residential or otherwise.

• It is contemporary practice that the agreement for sale will be the instrument bearing ad
valorem stamp duty. Where ad valorem stamp duty is paid, the assignment, which is formally
the conveyance of the property, will bear a nominal duty of HK$100.

• BSD and SSD are payable on residential property under certain circumstances. SSD is payable
with respect to residential property that is disposed of within 36 months of acquisition. BSD is
payable when the purchaser of the property is anyone other than a HKPR acting on his or her
own behalf.

• Stamp duty is charged based on the higher of the transfer consideration or the value of the
property transferred. One cannot therefore avoid stamp duty by transferring property at an
undervalue.

• The most important statutory relief from stamp duty is in s.45 of the Stamp Duty Ordinance,
which provides that transfers of Hong Kong stock or Hong Kong immovable property by one
body corporate to an associated body corporate are exempt from stamp duty.

• There is no objection mechanism under the Stamp Duty Ordinance: where a duty payer is
dissatisfied with the assessment of the Collector of Stamp Revenue, he or she may appeal
first to the District Court and subsequently to the Court of Appeal. There are specific time
constraints in this situation.

• The specific regime for alternative bond schemes (ABS) means that Hong Kong is a convenient
structuring jurisdiction for Islamic finance.

• There are ample opportunities for stamp duty planning, but care must be exercised in light
of the anti-avoidance principles in cases such as Ramsay and Arrowtown, which make clear
that artificial structures and transactions may in certain circumstances be disregarded for
tax purposes.

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MIND MAP

BASIC PRINCIPLES STAMP DUTY PLANNING

Tax on instruments, not transactions Beware Ramsay principle of statutory
Substance over form interpretation
Charged on the higher of the transfer Arrowtown key case on artificial stamp duty
consideration or value avoidance
Four main heads of charge Transmissions by operation of law are
• Hong Kong immovable property generally exempt from stamp duty
• Hong Kong stock Hong Kong immovable property is often held
• Bearer instruments by offshore corporations
• Duplicates and counterparts
EXEMPTIONS AND RELIEFS
Contingency principle
Charitable donations
Consideration can include a debt
Transfers/conveyances under winding-up or
Transferor and transferee jointly and
liquidation
severally liable to pay
S.45: transfers between associated bodies
IMMOVABLE PROPERTY corporate
STAMP DUTY
Conveyance on sale/agreement for sale Special regime for alternative bond
Lease schemes (ABS)
Ad valorem stamp duty (AVD) – rate depends ADMINISTRATION
on whether property is residential or Adjudication
non-residential
Appeal to District Court
Nominations are stampable, unless exempted
Late stamping penalties
Special stamp duty (SSD)
Effect of non-stamping: inadmissible in civil
Buyer’s stamp duty (BSD) proceedings
HONG KONG STOCK, BEARER INSTRUMENTS
VOLUNTARY DISPOSITIONS INTER VIVOS
AND DUPLICATES
Transferring assets at undervalue or by gift
The transfer of stock is required to be
cannot avoid stamp duty
registered in Hong Kong: (i) companies
incorporated in Hong Kong; (ii) listed on Deemed to be sale and purchase at market
the Hong Kong Stock Exchange; (iii) units value
in a unit trust S.27(5) exemption for transfers out of trust
Must produce contract notes (in the case or under which no beneficial interest passes
of sale) and instrument of transfer
Duty payable on bearer instruments on issue
Duplicates and counterparts of stampable
instruments bear nominal duty

Knowledge Check Questions

Question 1
Answer A is incorrect. One has to adopt a ‘substance-over-form’ approach.
Answer B is incorrect. The existence of a lease premium is a commercial term and is
not itself dispositive – the relevant question is what the instrument itself constitutes in
substance.
Answer C is incorrect. The Stamp Office is the statutory body charged with assessing and
collecting stamp duty.
Answer D is correct. One must adopt the ‘substance-over-form’ approach: Street v
Mountford applies.

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Question 2
Answer A is incorrect. The agreement for sale of the residential property will not be
chargeable with BSD only if the purchaser is an individual who is a HKPR acting on his or
her own behalf. Dobermann Properties GmbH is a company and thus the exemption does
not apply.
Answer B is incorrect. The rate of SSD is 10% as the property was held for more than
12 months but for 36 months or less.
Answer C is incorrect. S.29B requires that an unwritten agreement for sale and purchase
be memorialised in writing.
Answer D is correct. This is a residential property being transferred to a company, such
that the higher flat rate of AVD will apply.

Question 3
Answer A is incorrect. The deed of mortgage is not chargeable with stamp duty because it
is only for the purpose of securing the repayment of an advance or loan (s.27(5)).
Answer B is incorrect. The assignment will bear a nominal HK$100 – this is flat rate duty
and not ad valorem duty.
Answer C is incorrect. Occupation permits are not stampable instruments.
Answer D is correct. An option is treated as an agreement for sale under s.29A(1) of the SDO.

Question 4
Answer A is incorrect. The shares are Hong Kong stock, but not by reason of
re-domiciliation, but by virtue of being stock of which the transfer is required to be
registered in Hong Kong.
Answer B is incorrect. Stamp duty is charged on the transfer of Hong Kong stock but not
the issue or allotment of Hong Kong stock.
Answer C is correct. Hong Kong stock means stock of which the transfer is required to be
registered in Hong Kong.
Answer D is incorrect. Although the contract notes have to be stamped, it is because the
listed shares are Hong Kong stock. There is nothing to do with the territorial concept!
The place where the instrument itself is executed is irrelevant, it will only affect the time
of stamping.

Question 5
Answer A is incorrect. If the bond is a bearer instrument, the issue of it is chargeable with
stamp duty under Head 3; see also the conditions for the exemption of loan capital in s.2.
Answer B is incorrect. The original must be duly stamped for the instrument to be
admissible as evidence in court.
Answer C is incorrect. If there is a change in beneficiary, the settlement of a property on
trust is a voluntary disposition inter vivos under s.27 and accordingly give rise to a charge
to stamp duty which will be calculated based on the market value of the town house on the
date of settlement.
Answer D is correct. A transfer out of assets on trust to a beneficiary of the trust is
expressly exempt from stamp duty under s.27(5).

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Question 6
Answer A is incorrect. An individual is not eligible for s.45 relief; only a body corporate is.
Answer B is incorrect. Leases not deemed to be conveyances are not eligible for s.45 relief.
Answer C is incorrect. Association cannot be traced through an interposed partnership,
only an interposed body corporate.
Answer D is correct. Association for the purposes of s.45 relief can be traced through
multiple layers of bodies corporate. As a general rule, Delaware LLC is considered a
body corporate. It should be noted that the Stamp Office will adjudicate whether all the
companies involved are bodies corporate before granting the relief.

Question 7
Answer C is correct. Only I, IV and V are correct statements.
I. It is correct that Pitt & Bull should file a notice of appeal within one month of the
date of the assessment.

II. It is not correct because the 7-day time limit is strict, and non-derogable.

III. It is not correct because s.11(2)(b) requires intent to defraud and Asuka’s mistake
was apparently inadvertent.

IV. It is correct that under those circumstances, Pit & Bull should apply to the Court
under s.14(1B) to progress the appeal without payment of stamp duty.

V. It is correct that based on that situation, Dobermann Properties GmbH

may therefore apply to the Court of Appeal for leave to appeal on the basis of
that error.

EXAM PRACTICE

QUESTION 1
Ho Wong Ltd (HWL) is the holding company of the Ho Wong Group, which carried on
property development and investment business in Hong Kong. There were three companies
held by HWL directly or indirectly, namely Ah Fat Ltd (AFL), Bat Tat Ltd (BTL) and Oriental
Generation Ltd (OGL). All companies of the group are incorporated and carried on business
in Hong Kong. The shareholding structure of the group is depicted as below.

HWL

95% 85%

AFL BTL
15%

95%

OGL

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OGL was holding a bare site, which was permitted for residential development. The site
was bought from Cheung Fat Ltd (CFL), which carried on property development business
in Hong Kong and was unrelated to OGL. OGL has been holding the site for two years.
The Ho Wong group would form a joint venture with another unrelated party, namely
Durant Daily Ltd (DDL), to develop the site. There are two options now being considered by
the management:

Option 1: OGL would sell 10% interest in the site to DDL for a cash consideration of
HK$100 million.

Option 2: Steps are as follows:

Step A

 FL would transfer all its shares in OGL to BTL for a cash consideration of
A
HK$100 million plus a guarantee provided by BTL for a bank loan of HK$900 million
borrowed by OGL.

Step B

 TL would then issue 1,000,000 preference shares at HK$100 per share to DDL.
B
After the issue, the new preference shares would be equivalent to 10% of BTL’s
total issued share capital at par value (including all existing ordinary shares).
These preferences gave no voting right to DDL.

Required:

Discuss the Hong Kong stamp duty implications pertaining to Options (1) and (2) for the joint
venture project.

QUESTION 2
Angel King Ltd (AKL), Bee Queen Ltd (BQL) and Cat Prince Ltd (CPL) are all incorporated and
carried on business in Hong Kong. AKL is the holding company of BQL and CPL, with 90%
and 80% shareholding respectively. Mr. Chen, a mainland resident, is the sole shareholder
of AKL. Chen held 10% and 20% shareholding of BQL and CPL.

The following transactions were carried out among AKL, BQL and CPL:

(a) On 1 November 2018, by way of executing of a deed of assignment AKL

transferred a residential property located in Hong Kong (Property A) to BQL.
As consideration for the transfer of Property A, BQL paid HK$2 million cash to AKL
and agreed to waive the loan due from AKL. The outstanding amount of the loan
as at 1 November 2018 was HK$15 million. AKL bought Property A in 2015, the
relevant agreement for sale was signed on 1 November 2015 and the conveyance
for sale was signed on 1 December 2015. AKL applied the cash sales proceeds to
distribute dividends to Mr. Chen. The market value of the property as at the date
of conveyance was HK$16 million. AKL had been using Property A as staff quarters
since its acquisition.

(b) On 30 April 2019, BQL sold Property A to CPL by way of executing a memorandum
for sale at a cash consideration of HK$18,000,000. BQL and CPL then formally
signed a deed of assignment on 30 June 2019. The market value of Property
A increased from HK$18,000,000 as at 30 April 2019 to HK$20 million as at
30 June 2019. BQL had been using Property A as staff quarters throughout its
ownership period.

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(c) On 30 June 2019, CPL leased Property A back to AKL. Under the 4-year lease
agreement, there was a one-year rent-free period. AKL paid a sum of HK$300,000 as
lease premium. After the rent-free period, the monthly rental is HK$30,000.

Required:

Analyse the stamp duty, profits tax and property tax implications of the preceding
transactions.

QUESTION 3
Mr. Pat Miyagi is a Japanese entrepreneur who wishes to acquire a stake in a Hong Kong
corporate group.

Required: Analyse the stamp duty consequences of the following transactions, giving
reasons for your answers.

Transaction (1)

 n 4 May 2016, Mr. Miyagi acquired 100% of the issued share capital of Daniel Cosmetics
O
Limited (DCL), a company incorporated in Hong Kong, from an unrelated third party for
HK$50 million. The book value of the shares is HK$60 million, but Mr. Miyagi bargained
the seller down because the market in Hong Kong appeared to be turning, and the seller
was keen to exit its investments.

Transaction (2)
 n 29 December 2017, he subsequently incorporated another company in Hong Kong,
O
Cobra Cosmetics Limited (CCL), with 100 ordinary shares, being 100% of its issued share
capital, to DCL, such that CCL became a 100% subsidiary of DCL. CCL carried on the
separate business of managing martial arts gymnasiums.

Transaction (3)

In time, the business of CCL grew considerably. Wishing to consolidate his corporate
holdings, Mr. Miyagi decided to put CCL into voluntary liquidation on 4 October 2018
and for those purposes distributed in specie all of CCL’s assets to DCL after satisfying its
creditors, including the leasehold to three martial arts gymnasiums located in Kowloon,
and valued at approximately HK$20 million each.

Transaction (4)

 r. Miyagi died on 1 January 2019 and left all his assets, including 100% of the issued
M
share capital of DCL, to his heir, Ralph, under a Hong Kong will.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Option 1
Acquisition of a bare site, which is permitted for residential development, from a
property developer and subsequent disposal of the site is regarded as a disposal of
residential property (paragraph 26 of Stamp Office Interpretation and Practice Notes
No. 5 (Revised) refers). AVD would be chargeable at 15% as DDL is not a HKPR: HK$100
million × 15% = HK$15 million. SSD would also be chargeable at 10% (based on

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 TAXATION

24 months holding period): HK$100 million × 10% = HK$10 million. BSD would be

chargeable at 15%: HK$100 million × 15%= HK$15 million. That is, total stamp duty payable
for Option 1 is HK$40 million.

Option 2
• For transfer of Hong Kong stock, stamp duty is chargeable at 0.2% on the dutiable
value. The dutiable value is on the higher of the consideration or the market value/
the net asset value of the stock being transferred. Therefore, if the consideration is not
adequate, the Collector of Stamp Revenue (CSR) can replace the transfer value with a
fair market value of the relevant stock for stamp duty purpose. OGL is incorporated
in Hong Kong and hence its share register must be kept in Hong Kong. Accordingly,
shares in OGL are Hong Kong stock and transfer of such shares should be subject to
stamp duty.

• Step (A) involves the transfer of Hong Kong stock in OGL to BTL. The dutiable value
would be the total consideration of HK$1,000 million rather than just HK$100 million.
It is because under s.24(3), consideration for stamp duty purposes includes debts
guaranteed. In this case, BTL would provide a guarantee for the HK$900 million bank
loan. And such an amount is a consideration for the transfer notwithstanding it was not
received by AFL. It is worth to note that if the transfer consideration HK$1,000 million
was below the market value of the shares being transferred, the CSR could deem
it as a voluntary disposition and invoke s.27(1) to apply the market value for stamp
duty purpose.

• Stamp duty could be exempt for transfer of Hong Kong stock between associated
corporations (s.45). Two corporations are associated corporations under the following
situations:

°° One corporation beneficially owns at least 90% issued share capital of another
corporation; or

°° At least 90% issued share capital of two corporations is being beneficially owned by
a third corporation.

HWL had a direct shareholding of 95% in AFL. HWL also had a direct shareholding of
85% in BTL. HWL had an indirect shareholding of 14.25% (95% × 15%) in BTL via AFL. In total,
HWL had a shareholding of 99.25% in BTL. Therefore, AFL and BTL could be regarded as
associated corporations and the transfer of shares between these two corporations could be
exempt from stamp duty. Adjudication is required in this regard.

• S.45 exemption would not be available if in connection with the transfer of shares, the
transferor and transferee would cease to be associated corporations due to change
in shareholding of the transferee held by the transferor or a third-party corporation
(s.45(4)(c));

• S.45 exemption, if previously granted, would be ‘clawed back’ if the transferor and
transferee cease to be associated within two years after the transfer of the shares.
Under such circumstances, the transferor and transferee shall inform the CSR about the
cessation of associated relationship within 30 days after such cessation.

• For step (b), the issue of new preference shares (10% issued all share capital) to an
independent third party will result in cessation of the association relationship as BTL

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will be 89.325% (= 76.5% + 95% × 13.5%) held by HWL. All shares of BTL will be taken
into account in ascertaining if the ‘90%’ threshold is met. Hence, s.45(4)(c) is applicable
to deny exemption.

HWL

95% 76.5%
DDL

10%
AFL BTL
13.5%

95%

OGL

• There would be no s.45 exemption if the consideration of the transfer or any part of the
consideration was to be provided by a person, which was not an associated corporation
to the transferor and the transferee (s.45(4)(a)).

• DDL would provide part of the consideration by subscribing new shares of BTL. But
DDL was not an associated corporation to AFL and BTL. Hence, there would be no s.45
exemption by virtue of s.45(4)(a).

• Stamp Duty payable would be HK$2 million (=HK$1,000 million × 0.2%) (on the sold note
and bought note) plus HK$5 (on instrument of transfer).

QUESTION 2
Main points to be discussed:

Transaction (a)

 KL held 90% shares of BQL and hence AKL and BQL are associated companies in
A
terms of s.45(2) of the Stamp Duty Ordinance (SDO). However, the relief under s.45(1)
does not apply because it seems that the conveyance was made in connection with an
arrangement, under which the consideration was to be received by a person who is
not an associated corporation (s.45(4)(a)). Mr. Chen is not an associated corporation to
AKL and BQL, and the cash consideration received had been applied for distribution of
dividend to him.

Ad valorem duty (AVD) payable:

The total consideration is cash and loan waiver (s.24(1)):

HK$ (2 million 15 million) 15% HK$2.55 million

 owever, relief can be applied under s.24(2), which allows using the property value for
H
stamp duty purposes. The instrument must be adjudicated by the Collector of Stamp
Duty. If s.24(2) applies, AVD payable is:

HK$16 million 15% HK$2.4 million

 art 1 of Scale 1 rates applies as the property is not acquired by a Hong Kong permanent
P
resident (HKPR).

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 TAXATION

 pecial stamp duty (SSD) is not applicable as the property was acquired by AKL
S
on 1 November 2015 and it was as assigned on 1 November 2018, that is, 36 months
and 1 day.

Buyer’s stamp duty (BSD) is payable as the property is not acquired by HKPR.

BSD payable : HK$16 million 15% HK$2.4 million

 he disposal gain should be capital in nature as AKL has been using Property A as staff
T
quarters for about three years since acquisition, and should have claimed commercial
building allowances thereof. Applying the test of ‘badges of trade’, the gain is likely to be
capital in nature and not taxable under s.14 of the IRO. Balancing adjustment needs to
be made for disposal of the property.

Transaction (b)

 KL held 90% and 80% shares of BQL and CPL. BQL and CPL are not associated
A
companies in terms of s.45(2) of the SDO. The relief under s.45(1) does not apply.

AVD payable on the sale agreement: HK$18 million × 15% = HK$2.7 million.

AVD payable on the deed of assignment: HK$100

 he consideration of HK$18,000,000 will be used for charging AVD, instead of the market
T
value of Property A on date of conveyance of HK$20 million.

SSD would be chargeable: HK$18 million × 20% = HK$3,6 million

 he holding period was six months (1 November 2018 to 30 April 2019). The property
T
was acquired and disposed on date of agreement for sale. If no agreement for sale is
available, the date of conveyance will be applied.

BSD payable: HK$18 million × 15% = HK$2.7 million

 QL is very likely to be challenged by the Inland Revenue Department (IRD) being subject
B
to profits tax in respect of the disposal gain of HK$1 million in view of short period of
ownership. Although the property had been used as staff quarters, it would be difficult
to convince the IRD that BQL intended to hold the property for long-term purpose.

Transaction (c)

The tenancy agreement is subject to stamp duty under Head 1(2). The amount of duty is:

((HK$30,000 36/4 ) 1%) (HK$300,000 4.25%) HK$15,450.

 PL would be subject to property tax and profits tax in Hong Kong in respect of the
C
rental income derived from leasing out the property. It can apply for s.5(2)(a) exemption.
If the application is accepted by the IRD, it would be exempted from property tax and
subject to profits tax only.

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QUESTION 3
Transaction 1

This is a sale and purchase of Hong Kong stock. Contract notes must be produced,
bearing ad valorem duty at an aggregate rate of 0.2%. Mr. Miyagi and Seller are jointly
and severally liable for ad valorem duty. An instrument of transfer bearing notional HK$5
duty will also need to be produced. The stamp duty will be assessed based on the higher
of the consideration or the value of the stock. Therefore, the ad valorem duty payable will
be HK$120,000 (i.e. HK$60,000,000 × 0.2%).

Transaction 2

There is no stamp duty on the issue of shares.

Transaction 3

The transmission of immovable property by operation of law under liquidation (in this case
by virtue of the operation of the Companies (Winding up and Miscellaneous Provisions)
Ordinance) is specifically exempt from stamp duty under s.27(5). Accordingly, no charge to
AVD, SSD or BSD will arise in this case.

Transaction 4

As above. The transmission of assets under a will does not give rise to any charge to
stamp duty.

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 Part C
 rofits Tax Rules, Principles and
P
Calculations of Profits Tax Liabilities
for Cross-border Transactions

Chapter 8 Profits Tax Liabilities for Cross-border Transactions

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 8
Profits Tax Liabilities
for Cross-border
Transactions

CHAPTER TOPIC LIST

8.1 Tax Implications of Residence 8.2.3 Deemed Trading Receipts of

and Non-residence Non-resident Persons
8.1.1 Permanent Establishment 8.3 Withholding Tax
8.2 Provisions Concerning 8.3.1 Withholding Obligations on
Non-resident Persons Hong Kong Agents
8.2.1 Assessing Liability of a 8.3.2 Withholding Obligations on
Non-resident Person with Resident Persons Paying or
Permanent Establishment Crediting Certain Payments to
in Hong Kong Non-resident Persons
8.2.2 Non-resident Persons Selling 8.3.3 Amount of Tax to Be Withheld
Goods in Hong Kong 8.3.4 Refund of Tax Overpaid

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LEARNING OUTCOMES

PRINCIPAL LO3: A
 PPLY PROFITS TAX RULES AND PRINCIPLES AND CALCULATE PROFITS TAX
LIABILITIES FOR CROSS-BORDER TRANSACTIONS
LO3.01: E
 xplain and analyse the tax implications and calculate the tax liabilities for cross-border
transactions
3.01.01 Analyse the relevant issues in relation to residents and non-residents
3.01.02 Compare and contrast the tax treatments for residents and non-residents
3.01.03 Explain the methods used by the IRD in assessing a non-resident person to tax in Hong Kong
3.01.04 Explain what is meant by an agent of a non-resident person
3.01.05 Calculate the amount of tax which is to be withheld by a Hong Kong resident from payments
made to non-residents
3.01.06 Apply DIPN No. 17 and 30

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OPENING CASE

BERRYBEST

B B Canada Ltd started manufacturing wireless handheld devices in Canada with a trademark
name, BerryBest, in 2017. Due to its sleek design and sophisticated security system,
BerryBest was well received amongst corporate customers in North America.

In January 2018, as part of its global expansion initiatives, BB Canada Ltd appoints Chatty
HK Ltd as its distribution agent. Chatty HK Ltd is in the business of promoting and marketing
wireless devices for several global suppliers as they understand the Asia market well,
particularly in Hong Kong, China and Singapore.

Due to the growing demand among corporate customers in the Asia region, Chatty HK Ltd
leases a warehouse to keep all the inventories in Hong Kong to facilitate timely deliveries. As
part of the agency agreement with BB Canada Ltd, Chatty HK Ltd does not have the authority to
negotiate prices and conclude contracts on behalf of BB Canada Ltd.

For the year ended 31 December 2019, BB Canada Ltd generated sales revenue of HK$50
million from the Hong Kong customers. Chatty HK Ltd is paid a 10% commission for sales made
by BB Canada Ltd to the Hong Kong customers. Most of the HK customers would remit the
payment electronically to BB Canada Ltd directly. However, some of the Hong Kong customers
are still making cash payments which Chatty HK Ltd has the responsibility to collect and remit
to BB Canada Ltd.

On 1 January 2020, Chatty HK Ltd entered into a distribution agreement with BB Canada Ltd
under which Chatty HK Ltd has the right to sell directly to its customers in the Asia region on a
principal to principal basis. Chatty HK Ltd will purchase the devices from BB Canada Ltd at 30%
bulk discount based on the prevailing market price of the devices. In return, Chatty HK Ltd will
pay a royalty of 7% of gross sales for using the BerryBest trademark name.

As part of Chatty HK Ltd’s ongoing marketing campaign, it engaged a popular Japanese

singer to perform a concert in HK and each concert ticket comes with a 20% discount coupon
that can be used when purchasing BerryBest from the various retail shops of Chatty HK Ltd.

Chatty HK Ltd paid HK$2 million to the Japanese singer for the above concert before she
flew back to Japan where she resides.

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 TAXATION

OVERVIEW

In the previous chapters, we have learned the various ways in which income of Hong Kong (HK)
incorporated and unincorporated businesses, including those carried on by individuals, who
carry on business in HK, are taxed under the HK territorial tax regime (also commonly known as
territorial source principle).

Under HK’s territorial source principle, it is the geographical source of the income rather
than an entity’s residency status that determines whether income is subject to HK profits tax
or not. As such, no distinction is made between residents and non-residents under the Inland
Revenue Ordinance (IRO).

The concept of a tax resident is only applicable to the extent of the relevant double tax
agreements (DTAs) that HK has entered into and are currently in force. Therefore, a HK
resident may derive profits from abroad without being charged tax in HK. On the other hand, a
non-resident may be chargeable to tax under the IRO on profits that are derived in HK.

The IRO contains no exemption from profits tax for offshore companies. Whether an
offshore company is liable to profits tax depends on the nature and extent of its activities in HK.

In Chapters 1 and 3, it has been stated that profits tax is levied under the IRO on the
assessable profits of legal persons, including individuals (i.e. sole proprietorships), corporations
(i.e. company), partnerships, trustees as well as bodies of persons carrying on any trade,
profession or business in HK.

Therefore, in this chapter, we cover the key issues relating to the profits tax implications on
cross-border transactions that are carried out by both resident and non-resident legal persons
in HK. In view that it creates an undue burden on the HK Inland Revenue Department (IRD) to
collect taxes owed by non-residents who are subject to tax in HK, students will learn the various
aspects of withholding tax such as its scope, calculation and obligations of the resident payer.

By the end of this chapter, students should have a good understanding of how taxes are
imposed on cross-border transactions and of the crucial role of the withholding agent in the
collection of profits tax on behalf of non-residents.

Significant Update

On 29 March 2018, the Inland Revenue (Amendment) (No. 3) Ordinance 2018 was enacted
and passed into law, thereby introducing a two-tiered profits tax rates regime. This two-tiered
profits tax rates regime was introduced with the objective of maintaining a competitive taxation
system to promote HK economic development while maintaining a simple and low tax regime.

The following is an extract of the two-tiered profits tax rates update that is relevant and
applicable to cross-border transactions relating to certain deemed receipts under ss.15(1) and 20B.

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 Profits Tax L iabilities for   C ross -border T ransactions

Two-Tiered Profits Tax Rates Regime

The two-tiered profits tax rates regime will be applicable to both corporations and
unincorporated businesses commencing from the year of assessment 2018/19 (i.e. on or after
1 April 2018).

• For corporations, the profits tax rate for the first HK$2 million of assessable profits
is reduced to 8.25% (i.e. 50% × 16.5%), while the remaining profits will continue to be
taxed at the standard profits tax rate of 16.5%.

• For unincorporated businesses such as partnerships and sole proprietorships, the profits
tax rate for the first HK$2 million of assessable profits is reduced to 7.5% (i.e. 50% × 15%)
while the remaining profits will continue to be taxed at the prevailing tax rate of 15%.

The applicable tax rates are summarised as in Exhibit 8.1.

Assessable profits Corporation tax rate Unincorporated business tax rate

First HK$2 million 8.25% 7.5%
Over HK$2 million 16.5% 15%

EXHIBIT 8.1 Tax rates on or after 1 April 2018

A more detailed discussion on the two-tiered profits tax rates regime is covered in
Chapter 3 Section 1.2.

8 . 1 TAX IMPLICATIONS OF RESIDENCE

AND NON-RESIDENCE

In general, for HK profits tax purposes, tax residency is not important in determining the
taxability of a person except for certain situations, such as the eligibility to elect for personal
assessment (see s.41(1) of the IRO), the taxation of businesses employing non-resident persons
and the exemptions available to non-resident persons.

The terms ‘resident’ and ‘non-resident’ are not defined for tax purposes under the IRO,
except in the case of aircraft owners (see ss.23C and 23D) and funds (see s.20AB(3)). However,
the Comprehensive Double Tax Agreement (CDTA) or OECD Model Tax Convention provide
some guidance on what types of activities carried on by a non-resident would constitute a
permanent establishment where such income would be subject to profits tax in HK.

The key factors to determine one’s chargeability to profits tax in HK are:

1. Whether the person is carrying on a trade, profession or business in HK; and

2. Whether the profits derived by the person from the trade, profession or business are
arising in or derived from HK.

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 TAXATION

In determining the tax residency of a legal entity such as corporation, companies

incorporated in HK that are centrally managed and controlled (subject to the provisions of the
relevant CDTA) in HK are generally considered to be HK tax resident.

However, for the purpose of ss.20A (Persons Chargeable on Behalf of a Non-resident)

and 20B (Persons Chargeable in Respect of Certain Profits of a Non-resident), the IRD views
that a non-resident is a person who has no permanent business presence in HK (DIPN No.17
(Revised): The Taxation of Persons Chargeable to Profits Tax on Behalf of Non-Residents).

8.1.1 Permanent Establishment

New PE Definition: Background

Generally, a permanent establishment (PE) refers to a fixed place of business where a person
would carry on a certain level of business activities to derive income from that particular
country. The term ‘fixed’ place would be associated to some degree of permanence or existence
of a particular work place or location. In addition to the concept of a fixed place of business,
the PE definition is also extended to include non-resident individuals who, on behalf of their
overseas company, carry on income-generating activities such as negotiating and concluding
trading contracts in a particular country.

On 29 December 2017, the HK Government gazetted Inland Revenue (Amendment) No. 6

Bill 2017 which was enacted on 13 July 2018 and known as The Inland Revenue (Amendment)
(No. 6) Ordinance 2018 (Amendment Ordinance).

The key proposals of the Amendment Ordinance in relation to PE for transfer pricing
purposes include the following:

• The domestic definition for PE generally follows the recommendations contained in

the final report on Action 7 of the OECD’s BEPS Project (i.e. Preventing the Artificial
Avoidance of Permanent Establishment Status).
• A fixed place of business could constitute a PE unless the overall activities carried
out through that place are preparatory or of an auxiliary character in relation to the
business of the non-resident entity as a whole.

• A dependent agent that habitually concludes contracts for a non-resident or plays the
principal role leading to the conclusion of contracts without material modification will
also constitute a PE.

• A PE is treated as a separate enterprise for transfer pricing purposes.

The Amendment Ordinance has introduced rules for determining whether a person has a
PE in Hong Kong (Schedule 17G of the IRO). The new PE definition has relevance for transfer
pricing (s.50AAK of the IRO) purposes in that it requires the attribution of income or loss to a
non-resident’s PE in Hong Kong as if the PE were a separate enterprise.

New PE definition under IRO

For HK tax purposes, the new definition of a PE is covered in Schedule 17G of the IRO (as
referred to by IRR Rule 5 and s.50AAC(5) of the IRO). According to Part 2 of Schedule 17G,
where a country has entered into a double taxation agreement with HK, the PE definition will
be governed under the PE article of the applicable agreement; According to s.4 in Part 3 of
Schedule 17G, an enterprise, which is a tax resident in a country that has not concluded a

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double taxation agreement with HK, is treated to have a PE in Hong Kong if it has a fixed place
of business in Hong Kong through which the business of the enterprise is wholly or partly
carried on.

A fixed place of business is defined to include, but is not limited to the following:

(a) A place of management;

(b) A branch;

(c) An office;

(d) A factory;

(e) A workshop; and

(f) A mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

Where a non-resident enterprise carries on activities in HK which involves a building site or

construction or installation project, such an enterprise is treated to have a PE in HK if any of the
following applies:

(a) It has carried on activities at the site or project for a period of more than 12 months or

(b) It meets all of the conditions below:

(i) The subject enterprise has carried on activities at the site or project for a
single period that exceeds 30 days, or 2 or more periods that in the aggregate
exceed 30 days.
(ii) Connected activities have been carried on at the site or project by one or more
closely related enterprises of the subject enterprise for one or more different
periods that each exceeds 30 days.

(iii) All the periods referred to in subparagraphs (i) and (ii) in the aggregate exceed
12 months.

The term ‘closely related enterprise’ is defined under Schedule 17G s.2. A person (person
A) is closely related to another person (person B) if, based on all the relevant facts and
circumstances:

(a) Person A has control of person B;

(b) Person B has control of person A; or

(c) Person A and person B are both under the control of the same other person or
enterprise.

Also, a person (person A) is taken to be closely related to another person (person B) if:

(a) Person A possesses directly or indirectly more than the specified interest in person B;

(b) Person B possesses directly or indirectly more than the specified interest in person A; or

(c) Another person possesses directly or indirectly more than the specified interest in each
of person A and person B,

where ‘specified interest’, in relation to a person, means:

(a) 50% of the beneficial interest in the person; or

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 TAXATION

(b) If the person is a company, 50% of the aggregate vote and value of the company’s
shares or of the beneficial equity interest in the company.

Schedule 17G s.4 provides that, in determining whether different activities are ‘connected’,
as mentioned above, regard is to be had to the facts and circumstances of the case, including in
particular:

(a) Whether the contracts covering the different activities were concluded with the same
person or closely related persons;

(b) Whether the conclusion of additional contracts with a person is a logical consequence
of a previous contract concluded with the person or closely related persons;

(c) Whether the activities would have been covered by a single contract absent tax
planning considerations;

(d) Whether the nature of the work involved under the different contracts is the same or
similar; and

(e) Whether the same employees are performing the activities under the different
contracts.

Certain activities performed by a non-resident enterprise in HK that are preparatory or

auxiliary in nature do not constitute a PE in HK. According to Schedule 17G s.5, if the first
or second set of conditions below is met in relation to an enterprise, the enterprise is not
regarded under Schedule 17G s.4 as having a PE in Hong Kong even if it has a fixed place of
business in Hong Kong through which the business of the enterprise is carried on.

The first set of conditions are:

(a) The activity carried on for the enterprise through the place consists solely of one of the
following:

(i) The use of facilities solely for the purpose of storage, display or delivery of goods or
merchandise belonging to the enterprise;

(ii) The maintenance of a stock of goods or merchandise belonging to the enterprise

solely for the purpose of storage, display or delivery;

(iii) The maintenance of a stock of goods or merchandise belonging to the enterprise

solely for the purpose of processing by another enterprise;

(iv) The maintenance of a fixed place of business solely for the purpose of purchasing
goods or merchandise, or collecting information, for the enterprise;

(v) The maintenance of a fixed place of business solely for the purpose of carrying on
any other activity for the enterprise; and

(b) In relation to the business of the enterprise as a whole, the activity is of a preparatory
or auxiliary character.

The second set of conditions are:

(a) The activities carried on for the enterprise through the place consist solely of any
combination of the activities mentioned in (a)(i), (ii), (iii), (iv) and (v) above; and

(b) The overall activity of the place resulting from the combination of the activities is of a
preparatory or auxiliary character.

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Schedule 17G s.6 provides that s.5 as stated above does not apply to an enterprise (subject
enterprise) with a fixed place of business (place A) in Hong Kong if:

(a) Either or both of the following apply:

(i) Business activities at place A are carried on by a closely related enterprise of the
subject enterprise;

(ii) Business activities are carried on at another place (place B) in Hong Kong by the
subject enterprise or its closely related enterprise;

(b) The business activities carried on at place A by the subject enterprise and those
referred to in (a) constitute complementary functions that are part of a cohesive
business operation; and

(c) Any one or more of the following apply:

(i) Place A would have constituted a PE for the subject enterprise but for s.5 of
Schedule 17G;

(ii) Place A constitutes a PE for the closely related enterprise;

(iii) Place B constitutes a PE for the subject enterprise or the closely related enterprise;

(iv) The overall activity resulting from the combination of the following is not of a
preparatory or auxiliary character:

(A) The business activities carried on at place A by the subject enterprise;

(B) Business activities referred to in (a).

On the other hand, a non-resident enterprise may be deemed to have a PE in HK by virtue

of the activities of its agent or authorised representative in HK. As outlined under Schedule
17G s.7, an enterprise that is a non-DTA territory resident person is taken to have a PE in Hong
Kong in respect of any activities that a person undertakes for the enterprise if the person is
acting in Hong Kong on behalf of the enterprise and, in doing so, habitually concludes contracts
or habitually plays the principal role leading to the conclusion of contracts that are routinely
concluded without material modification by the enterprise, where the contracts are in the
name of the enterprise, for the transfer of the ownership of, or for the granting of the right to
use, property owned by the enterprise or that the enterprise has the right to use, or for the
provision of services by the enterprise.

However, the above deeming provision does not apply if the activities of the person are
limited to activities that, if exercised through a fixed place of business, would not make the
fixed place of business a PE under s.4 of Schedule 17G, having regard to s.5 and s.6. Also, the
above deeming provision does not apply if the person carries on a business in Hong Kong as
an independent agent, and acts for the enterprise in the ordinary course of that business. A
person is not an independent agent if the person acts exclusively, or almost exclusively, on
behalf of one or more enterprises that are closely related to the person.

Tax implications for non-residents with or without PE in HK

Pursuant to s.50AAK(1), a non-resident person who has a PE in Hong Kong is regarded as

carrying on a trade, profession or business in Hong Kong for the purposes of charging profits
tax. The income or loss of the person that is attributable to the PE of the person are those that
the PE would have made in circumstances where it was a distinct and separate enterprise that

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engaged in the same or similar activities under the same or similar conditions, and dealt wholly
independently with the person. Such transfer pricing rules on attribution of profits to a PE in
Hong Kong (i.e. TP Rule 2) will apply to determine the amount of profits attributable to the PE in
Hong Kong with effect from the year of assessment 2019/20.

To allay concerns that the profits attributed to a PE in HK will be assessed to profits

tax automatically without applying the territorial source principle, the HK Government has
confirmed that there is no change in Hong Kong’s long-established territorial source principle
of taxation. In other words, income will first be attributed to the PE according to the separate
enterprise principle, then the source rules will be applied to determine whether such income
arises in or is derived from Hong Kong, and hence subject to profits tax or not. Income
attributable to the PE will be subject to Hong Kong profits tax only if such profits arise in or are
derived from Hong Kong. Detailed discussion on sources of profits can be found in section 3 of
Chapter 3 Profits Tax.

The IRD has stated in DIPN No. 60 (Attribution of Profits to Permanent Establishments
in Hong Kong) that while a non-resident person having a PE in HK is regarded as carrying on
a trade, profession or business in Hong Kong for the purposes of charging profits tax under
s.50AAK(1), as mentioned above, if a non-resident person does not have a PE in HK, it does
not necessarily follow that the non-resident person is not carrying on a trade, profession
or business in Hong Kong or does not have profits chargeable to profits tax. In such cases,
whether the non-resident person is carrying on a business would depend on the facts and
circumstances. Profits arising in or derived from Hong Kong in respect of a business carried
on in Hong Kong by a non-DTA territory resident person, without a PE in Hong Kong, remain
chargeable to profits tax under s.14. Chargeability to profits tax under s.14 does not depend
on having a PE in HK. Provisions under ss.16 and 17 will continue to be applicable to any
deduction claims.

On the other hand, even if a non-resident person does not carry on a business in Hong
Kong, having no PE or any physical presence in Hong Kong and hence not caught by s.14,
certain sums received by or accrued to such a non-resident person are deemed by s.15(1) to
arise in or be derived from Hong Kong from a trade, profession or business carried on in Hong
Kong. The following section will cover these deemed trading receipts.

Key Learning Point

The HK taxation system is based on a territorial source principle. Residents and non-
resident persons are subject to tax in HK if they carry on a business in HK or derive profits
from HK.
Notwithstanding that non-resident persons may not have a PE in HK, they may still be
subject to tax in HK under the deemed receipt provision in ss.15(1)(a), (b), (ba), (d) and 20B
of the IRO that are discussed in the next section in detail.

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8 . 2 PROVISIONS CONCERNING
NON-RESIDENT PERSONS

The IRO contains many special provisions relating to non-resident persons as listed in
Exhibit 8.2, especially for recovery of tax purposes. However, for the purpose of this chapter,
we focus our attention to the application of ss.15, 20A, 20B, 21, 21A and 79(3).

IRO provisions Contents

15(1)(a), (b), (ba), (bb) and (d) Deemed trading receipts
20A(3) Assessments on Hong Kong agents and non-resident persons
for goods on consignment
20AA Brokers and approved investment advisers not to be treated as
agents of non-resident persons
20AB, AC, ACA, ACB, AD, AE and AF Exemption for offshore funds and offshore private equity funds
20B Withholding obligations on resident persons paying or crediting
certain payments to non-resident persons
21 Assessable profits to be computed on a fair percentage
of turnover
21A Assessable profits from deemed trading receipts under ss.15(1)
(a), 15(1)(b) or 15(1)(ba)
70AB Revision of assessment due to exemption for offshore funds
79(3) Tax overpaid by non-resident persons to be refunded

EXHIBIT 8.2 IRO provisions concerning non-resident persons

IRO provision Methods of assessments

20A(1) Direct assessment on a non-resident person or in the name of a non-resident
person’s agent in Hong Kong
20A(3) Resident persons acting as agent are required to withhold consignment tax for the
sale of goods by non-resident persons
20B Assessment raised in the name of any person in Hong Kong who has directly or
indirectly paid or credited a non-resident person entitled to receive payment of
royalties or licence fees from Hong Kong, or who is an entertainer or sportsperson

EXHIBIT 8.3 IRO provisions on assessment of non-resident liability

8.2.1 Assessing Liability of a Non-resident Person with Permanent

Establishment in Hong Kong
The IRO provides three alternative methods of assessing a non-resident person’s liability to tax
in HK (Exhibit 8.3).

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Under Inland Revenue Rules (IRR) (Cap.112A) Rule 5, the Hong Kong profits of a person,
other than a financial institution, having a PE in Hong Kong, but whose head office is situated
elsewhere than in Hong Kong, are to be determined as follows:

1. Where accounts are kept, which disclose the true profits arising in or derived from HK,
those accounts will be adopted and adjusted in accordance with the provisions of the IRO.

2. Where accounts do not disclose the true profits arising in or derived from Hong Kong,
or accounts are not kept.

Hong Kong turnover

Assessable profits Adjusted worldwide profits
Worldwide turnover

3. Where the assessor is of the opinion that it would be impracticable or inequitable to

adopt methods (1) and (2), the assessor may compute the assessable profits on a fair
percentage of the Hong Kong turnover.

In a situation as described in (3), the IRD generally relies on s.21 of the IRO that provides
the legal basis to determine the true assessable profits of a non-resident person. As such, s.21
gives the assessor the power to compute the assessable profits based on a fair percentage of
the turnover of the trade or business in Hong Kong.

Similarly, under IRR Rule 3, the profits of the Hong Kong branch of a bank, whose head
office is situated elsewhere than in Hong Kong, are to be determined as follows:

1. Where accounts are kept which disclose the true profits arising in or derived from Hong
Kong, those accounts will be adopted and adjusted in accordance with the provisions
of the IRO.

2. Where accounts do not disclose the true profits arising in or derived from Hong Kong or
accounts are not kept.

Hong Kong assets

Assessable profits Adjusted worldwide profits
Worldwide assets

3. Where the assessor is of the opinion that it would be impracticable or inequitable to

adopt methods (1) and (2), the assessor may estimate the assessable profits of the
branch. If the person disagrees with the assessment raised by the assessor under IRR
Rules 3 or 5, an objection under s.64(1) can be lodged.

8.2.2 Non-resident Persons Selling Goods in Hong Kong

Notwithstanding that a non-resident person does not have a PE in HK, or may not be carrying
on a business or derive profits from HK, the non-resident person is liable to pay consignment
tax for goods sold in HK through a HK agent.

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Under s.20A(3) of the IRO, the HK agent is required to furnish quarterly returns
(Form BIR 52B) to the commissioner disclosing the gross proceeds from the sales of goods
in HK and is also required to pay consignment tax based on 1% of the sale proceeds to the
commissioner. A lower consignment tax rate of 0.5% may be applicable subject to approval by
the commissioner.

Generally, consignment tax is regarded as a final tax liability of non-resident persons. Final
tax means there is no tax credit mechanism available to non-residents that they can offset
against their home country’s tax liability. However, in the event that non-resident persons are
of the view that their actual tax liability is less than the consignment tax withheld, they may
request for the commissioner to assess their tax liability based on actual income and expenses
supported by financial statements and documents.

Where such consignment tax is applicable, the HK agent is required to retain an amount that
is sufficient to meet the tax liability of the non-resident person. Such an agent is indemnified
against any person in respect of the retention of the non-resident person’s assets (s.20A(2)).

Generally, where non-resident persons are willing to provide an undertaking to meet their
tax liability with the IRD, the commissioner has the discretion to exempt the HK agent from the
withholding obligation.

In the event that the HK agent’s activities in HK constitute a PE of the non-resident person,
s.20A(3) is no longer applicable. Instead, the non-resident person will be taxable in HK under
s.14 of the IRO and the corresponding assessable profit will be determined in accordance with
IRR Rule 5 as discussion in Section 8.2.1.

Apply and Analyse 1
With reference to the Opening Case, in particular, for the year ended 31 December
2019, there are a number of tax issues to consider. The following analysis is provided as
guidance to students when solving multi-issue situations such as those faced by BerryBest.

Analysis

There are a few issues to consider:

1. Did BB Canada Ltd carry on a business in HK or derive profits from HK based on its
activities? If so, would the sales revenue of HK$50 million be subject to tax in HK?

2. Did BB Canada Ltd have a PE in HK by the appointment of Chatty HK Ltd as its agent?

3. Was there any withholding tax applicable arising from the remittance of payment
by HK customers directly to BB Canada Ltd?

4. Was there any withholding tax applicable arising from the cash remittance by
Chatty HK Ltd to BB Canada Ltd?

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Apply and Analyse 1 (continued)

Referring to Article 5 of the Canada-HK DTA, BB Canada Ltd did not have a PE in HK due
to the following factors:

1. BB Canada Ltd did not have a fixed place of business in HK.

2. Chatty HK Ltd did not have an authority to negotiate and conclude contracts with
customers on behalf of BB Canada Ltd.

3. Chatty HK Ltd only maintained a place for storage of goods for the purpose of
delivery to customers.

Since BB Canada Ltd did not have a PE in HK, and the appointment of Chatty HK Ltd as
its marketing and distribution agent did not constitute carrying on a business in HK or the
deriving of profits from HK, the sale proceeds of HK$50 million should not be taxable in HK.

The sales commission of HK$5 million (10% × HK$50 million) received by Chatty HK Ltd
would be subject to tax in HK since the services were performed in HK. No withholding tax
obligation arose from the remittance of payment by HK customers directly to BB Canada
Ltd, and from the remittance by Chatty HK Ltd to BB Canada Ltd.

8.2.3 Deemed Trading Receipts of Non-resident Persons

A non-resident person who carries on a trade, profession or business in HK is exposed to profits
tax under s.14 of the IRO in respect of profits arising in or derived from Hong Kong from such
trade, profession or business. Thus, for example, a non-resident entertainer or sportsmen who
performs in Hong Kong is subject to profits tax in respect of the payment for a performance in HK.

However, a non-resident person who does not carry on business in HK and who may have
no physical presence in HK is still liable for profits tax if, for example, the person receives
sums in the form of royalties or licence fees for the use of, or right to use, certain industrial
or intellectual property in HK. Such receipts are deemed by s.15(1) of the IRO to arise in or be
derived from Hong Kong from a trade, profession or business carried on in Hong Kong.

Exhibit 8.4 summarises the amounts that are deemed as trading receipts for HK
tax purposes.

IRO provisions Amounts deemed as trading receipts

15(1)(a) Sums, not otherwise chargeable to profits tax, received by or accrued to a
person from the exhibition or use in HK of cinematograph or television film or
tape, sound recording, or any connected advertising material.
Example: Royalty payment to Disney Entertainment USA for the right to show
Disney movies in HK cinemas.
15(1)(b) Sums, not otherwise chargeable to profits tax, received by or accrued to a person
for the use of or right to use in HK any patent, design, trademark, copyright
material, layout-design (topography) of an integrated circuit, performer’s right,
plant variety right, secret process or formula or other similar property, or for
imparting knowledge connected with the use in HK of any such properties.
Example: Royalty payment to a Canadian beverage company for the use of a
secret formula in manufacturing a well-known baby milk powder.

EXHIBIT 8.4 Amounts deemed as trading receipts according to IRO provisions

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IRO provisions Amounts deemed as trading receipts

15(1)(ba) Sums, not otherwise chargeable to profits tax, received by or accrued to a
person for the use of or right to use outside HK any intellectual properties listed
in s.15(1)(b), or for imparting knowledge connected with the use outside HK of
any such properties, which are deductible in ascertaining the assessable profits
of a person under profits tax.
Example: Royalty payment to a Canadian company for the use of its brand name
outside HK and such royalty is treated as a deductible expense in the HK payor’s
tax return.
15(1)(bb) Sums, not otherwise chargeable to profits tax, received by or accrued to a
performer or an organiser for an assignment of, or an agreement to assign,
a performer’s right in relation to a performance given by the performer
in Hong Kong
15(1)(d) Sums received by or accrued to a person by way of hire, rental or similar charges
for the use of or right to use movable property in HK.

EXHIBIT 8.4 (Continued)

Where the transactions between a resident and non-residents of HK are not within
the scope of the basic charge as outlined under s.14 of the IRO, the deeming provisions of
ss.15(1)(a), 15(1)(b), 15(1)(ba) and 15(1)(bb) would apply. In other words, the provisions will
not apply to those transactions that have already been assessable under s.14. In general, they
apply to non-residents who do not carry on a business in Hong Kong. Assessable payments
include lump sum payments or periodical payments.

The deeming provisions of s.15(1)(c) and s.15(1)(d) do not stipulate an assessable profits
rate. In other words, the actual net amounts received or receivable will be taken into the
assessable profits. The deeming provision of s.15(1)(c) concerns only those persons carrying on
a trade or business in Hong Kong. However, the deeming provision of s.15(1)(d) targets those
persons who do not carry on a trade or business in Hong Kong.

Under s.21A, the assessable profits from deemed trading receipts under ss.15(1)(a), (b) or
(ba) are taken to be either 30% or 100% of the sum as follows:

• Where the transactions involve non-related parties, the assessable profits under
these provisions are deemed to be 30% of the payment made to the non-resident
taxpayer.

• However, if they are associates (e.g. they are holding and subsidiary companies),
then 100% of the payments are deemed to be assessable profits of the relevant
non-resident taxpayer unless the CIR is satisfied that no person carrying on a trade,
profession or business in Hong Kong has at any time wholly or partly owned the
property (e.g. cinematograph films, patents, trademarks, etc.) in respect of which the
sum is paid.

The provisions deeming 100% of the payment made by an associate as profits of the
non-resident person for the use of an intellectual property previously owned by a person
carrying on business in Hong Kong were enacted in 1993.

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Associates of a HK entity in the context of s.21A are defined as:

• If the Hong Kong entity is a natural person:

°° A relative of the person.

°° A partner of the person, or a relative of the partner.

°° A partnership in which the person is a partner.

°° A corporation controlled by the person.

°° A director or principal officer of a controlled corporation.

• If the Hong Kong entity is a corporation:

°° An associated corporation; that is,

–– a corporation over which the Hong Kong entity has control;

–– a corporation that has control over the Hong Kong entity; or

–– a corporation under the same control as the Hong Kong entity.

°° A person who controls the corporation, or a partner of the controller, or a relative

of the controller or partner.

°° A director or principal officer of the corporation (or any associated corporation), or

a relative of the director or officer.

°° A partner of the corporation, or a relative of the partner.

• If the Hong Kong entity is a partnership:

°° Any partner in the partnership.

°° A relative of any partner.

°° A corporation that is controlled by the partnership, or by a partner or any relative of

a partner.

°° A director or principal officer of a controlled corporation.

°° A corporation whose director or principal officer is a partner in the Hong Kong

partnership.

The purpose of the amendment is to prohibit persons within the same group from
obtaining a tax benefit by entering into a sale and lease back transaction of an intellectual
property. In addition, the applicable withholding tax rate may be reduced by the relevant tax
treaty that HK has signed with the counterparty and is currently in-force.

Key Learning Point

When non-resident persons are assessable under the deemed receipt provision such as
s.15(1)(a), (b), (ba) (bb) and 20B, the IRD has adopted various methods of determining the
assessable profits that are subject to tax in HK.

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Key Learning Point (continued)

Where the transactions involve non-related parties, the assessable profits under these
provisions are deemed to be 30% of the payment made to the non-resident taxpayer. For
related party transactions, the rate is increased to 100% unless no person carrying on a
trade, profession or business in Hong Kong has at any time wholly or partly owned the
property (e.g. cinematograph films, patents, trademarks, etc.) in respect of which the sum
is paid. In this case, the 30% rate on assessable profits may be used subject to approval by
the commissioner.

Apply and Analyse 2
ThermalCold Ltd (TC) is a company incorporated in HK. It developed and owned a
proprietary technology that can detect moisture behind the walls of a home. In 2019/20,
after a successful development of the technology, which cost TC HK$8 million, TC sold the
technology to a Canadian company, HomeStar Canada Limited (HSC), for HK$20 million.
HSC is a non-resident for HK tax purposes. TC subsequently leased back the technology
from HSC in the manufacture of the thermal devices for an annual royalty payment of
HK$2 million.

1. Calculate the gain on sale of ThermalCold’s technology.

2. Calculate the net tax benefit for ThermalCold and explain how it is affected if:

a. HSC was a related company.

b. HSC was not a related company.

Analysis

1. Gain on sale of technology = HK$20 million − HK$8 million = HK$12 million

If the gain of HK$12 million is treated as capital in nature, it is not taxable in TC’s
tax return. Similarly, should there be a loss on the sale of the technology, the
capital loss will not be tax deductible by TC.

2. a. If HSC is a related company of TC, the deemed profit rate is 100% of the royalty
payment made by TC to HSC since the technology was previously owned by TC.
If HSC and TC are subject to the same profits tax rate, no net tax benefit would
arise from the arrangement. This is illustrated in the following.

Tax deduction benefit by TC on annual royalty payment = HK$2 million × 8.25%

= HK$165,000

Tax payable by HSC on deemed assessable profit arising from the annual
royalty income = HK$2 million × 8.25% = HK$165,000

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Apply and Analyse 2 (continued)

b. If the transaction involves two unrelated parties, one of which is a non-resident
for HK tax purposes, such arrangement results in a net tax benefit calculated
as follows:

Tax deduction benefit by TC on annual royalty payment = HK$2 million × 8.25%

= HK$165,000

Tax payable by HSC on deemed assessable profit arising from the annual
royalty income = (HK$2 million × 30%) × 8.25% = HK$49,500

Net tax benefit of the sale and lease back arrangement = HK$115,500

Note: It is assumed that the commissioner has approved the use of lower rate of 30%
to compute the deemed assessable profits.

8.2.3.1 Precedent Court Cases on Deemed Trading Receipts Under s.15(1)(b)

Commissioner of Inland Revenue (CIR) v Emerson Radio Corporation (2000)

HKRC 90-102
Facts: Emerson Radio Corporation (the taxpayer) is an American corporation that
manufactures and sells electronic equipment. It is the registered owner of a trademark
‘Emerson’.

The taxpayer licenced to its HK subsidiary, Emerson Radio (Hong Kong) Ltd (Emerson
HK), the right to use the trademark ‘Emerson’ on products sold by Emerson HK to
customers in the USA. None of the goods were sold in HK.

The goods of Emerson HK were manufactured by unrelated contract manufacturers in

Hong Kong, mainland China, Japan, Korea, Malaysia, Thailand and Taiwan.

Emerson HK paid profits tax in HK in respect of its trading profits arising from its
ordinary course of business in Hong Kong.

Emerson HK entered into a royalty agreement with the taxpayer under which it was
allowed to use the trademark on goods sold to the US customers.

The royalties paid to the taxpayer were based on a percentage of the proceeds
received by Emerson HK from its customers in the USA.

Under s.15(1)(b) of the IRO, the commissioner contended that all of the royalties
received by Emerson US were assessable to profits tax on the basis that the royalties were
paid for the right to use the trademark in Hong Kong. The commissioner assessed the
royalty income as being derived from Hong Kong and subject to profits tax.

The taxpayer disagreed with the CIR’s position and was of the view that none of the
sums received as royalties should be subject to profits tax as the trademark was only ‘used’
in the place where the products were sold. The taxpayer appealed to the Board of Review,
which subsequently dismissed the taxpayer’s appeal and ruled that the royalty income was
an indivisible sum (i.e. it could not be apportioned between goods manufactured in and
outside of HK).

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Commissioner of Inland Revenue (CIR) v Emerson Radio Corporation (2000)

HKRC 90-102 (continued)
Issue: Whether royalty income from goods manufactured and sold outside of Hong
Kong, but which had the trademark affixed in Hong Kong, were assessable to profits
tax in HK.

Held: Although there were diverging views, the Court of Final Appeal (CFA) upheld the
decision of the Court of First Instance (CFI) that the trademark royalties paid by Emerson
HK to its US parent (i.e. the taxpayer) were only partly taxable in HK.

Some of the judges opined that there should be a fair and equitable method to
apportion the royalties relating to the use of the trademark in HK and those used outside
of HK relating to manufacturing or sales activities, as in the case of Emerson HK.

As a result of the CFA’s ruling, s.15(1)(ba) was enacted. With effect from 25 June 2004,
the IRD’s assessing practice with regards to the royalties received by a non-resident
company from a HK company was revised as follows:

1. Goods are manufactured and sold outside Hong Kong and the trademark is affixed
outside Hong Kong – the royalties are not assessable under s.15(1)(a) but subject to
s.15(1)(ba) which is to counteract the tax avoidance schemes following this case.

2. Goods are manufactured and sold outside HK and the trademark is affixed in
HK – the royalties are assessable to profits tax in HK. The affixing of the trademark
in HK is regarded as ‘use in HK’.

3. Goods are manufactured in HK and the trademarked goods are sold in HK – the
royalties are assessable in HK.

4. Goods are manufactured outside HK and the trademarked goods are sold in
HK – royalties are assessable in HK.

Lam Soon Trademark Limited v CIR (2005) HKRC 90-171

Facts: The taxpayer, Lam Soon Trademark Limited, is part of the Lam Soon Group of
Companies that is controlled by its ultimate holding company known as Lam Soon
Hong Kong Limited (LSHK). The taxpayer was incorporated in December 1997 in the
Cook Islands.

The directors of Lam Soon Trademark Limited are based in HK, Singapore and the
Cook Islands. After the board of directors of Lam Soon Trademark Limited met in HK, they
decided to transfer LSHK’s trademark to the taxpayer. The taxpayer subsequently licenced
the right to use the trademark to its associated companies.

Issue: What the relevant factors to consider are in deciding whether royalty earned from
licensing the right to use a trademark is sourced in Hong Kong.

Held: The Court of First Instance (CFI) upheld the Board of Review’s (BOR) decision that
the taxpayer was carrying on business in HK and the royalty earned by the taxpayer was
sourced from Hong Kong on the grounds that:

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Lam Soon Trademark Limited v CIR (2005) HKRC 90-171 (continued)

1. The effective decision to acquire the trademark and to grant licences were all made
in Hong Kong;

2. The negotiation for, and the agreements to grant, the licences were made in
Hong Kong;

3. The trademark was registered in Hong Kong; and

4. The steps taken to protect the trademark were all traceable to directions from
Hong Kong.

The CFI also held that s.60 was wide enough to apply to the case (i.e. additional
assessments to charge the taxpayer to tax under s.14 could be issued even though the
taxpayer has been assessed under s.15(1)(b) previously).

Both the Court of Appeal (COA) and the CFA upheld the CFI’s decision in this regard.

Exhibit 8.5 shows an overview of the tax liability of residents and non-residents.

Carrying on business in HK or derive HK territorial tax system NOT carrying on business in

profits from HK. Special provisions • Taxes are not imposed HK nor derive any profits from HK
for non-residents based on tax residency • HK company – not taxable.
a. Non-residents carrying on a • Non-resident company – not taxable.
business in HK – s.14.
b. Deemed trading receipts – s.15(1)
(a), (b), (ba), (bb) or (d).
c. Assessments on HK agents and Double tax agreement (DTA)
non-resident persons – s.20A. • PE definition.
d. Withholding obligations on • If non-residents have a PE in HK,
resident persons – s.20B. profits attributable to PE are
e. Assessable profits on % of subject to tax in HK.
turnover – s.21. • Double tax relief available under
f. Tax refund for tax overpaid by relevant DTA to ensure the same
non-resident persons – s.79(3). income is not subject to tax twice.
• Where no DTA, non-residents
may create a PE in HK by virtue
of Sch 17G of the IRO. In such
cases, they may be subject to HK
profits tax.

EXHIBIT 8.5 Tax liability of residents and non-residents of Hong Kong

Knowledge Check Questions

Question 1
Explain how to determine whether the below foreign companies constitute PE in HK.
A Central US Ltd, a company incorporated in the US, sets up a branch in HK to carry out
marketing activities for the home office.
B Trust Canada Inc, a company incorporated in Canada, sends employees to HK to conduct
customer service in Hong Kong every month.

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Knowledge Check Questions (continued)

Question 2
Identify which of the following is treated by the IRD as HK permanent establishments of a
non-DTA territory resident person.
A A place for storage, display or delivery of goods only
B A place for maintenance of goods to be processed by another enterprise
C An agent who habitually negotiates and concludes contracts for a non-resident
D A fixed place of business that carries out auxiliary activities on behalf of the non-resident

Question 3
As stated in the Opening Case, Chatty HK Ltd has to pay a royalty of 7% on gross sales
for using the BerryBest trademark in HK. Assume that in 2020, Chatty HK Ltd generated
HK$100 million in sales to HK customers. How much is the withholding tax which Chatty
HK Ltd must deduct from the payment to BB Canada Ltd and remit to the IRD? (Assume
a royalty withholding tax rate of 10% under Canada – HK DTA.) Since BB Canada Ltd and
Chatty HK Ltd are not related parties, the withholding tax is calculated based on deemed
assessable profit of:
A (30% × HK$100 million) × 16.5%  = HK$4.95 million
B (7% × HK$100 million) × 10%  = HK$700,000
C HK$4.95 million − HK$700,000 = HK$4.25 million
D HK$4.95 million + HK$700,000 = HK$5.65 million

Question 4
Further to Question 3, Chatty HK Ltd also generated sales of HK$200 million from its
customers outside HK. Royalty payments of 7% were applicable to these sales proceeds as
well. Chatty HK Ltd recorded the royalty payment as an expense in its profit tax return for
year of assessment 2018/19 for both HK and regional customers. What is the withholding
tax amount payable to the IRD? (Assume a royalty withholding tax rate of 10% under
Canada–HK DTA.)
A (7% × HK$100 million) × 10% = HK$700,000
B (7% × HK$200 million) × 10% = HK$1.4 million
C (7% × HK$300 million) × 10% = HK$2.1 million
D (30% × HK$300 million) × 10% = HK$9 million

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 TAXATION

8 . 3 WITHHOLDING TAX

As mentioned in the beginning of this chapter, HK adopted a tax system called the ‘territorial
source principle’. Under such a system, it is the geographical ‘source of the income’ rather than
an entity’s residency status that determines whether income is subject to HK profits tax or not.
As such, no distinction is made between residents and non-residents under the IRO. When
a HK resident person makes certain types of payment to a non-resident person for services
performed by the latter in HK, the HK resident person has the legal obligation to withhold the
appropriate amount of tax and remit such amount to the IRD on a timely basis. The amount of
tax deducted against payment made to a non-resident person is known as withholding tax.

In other words, withholding tax is the tax charged to a non-resident entity that derives
income from a Hong Kong source for services provided or work done in Hong Kong. Generally,
where a non-resident person incurs withholding tax in HK, it may be entitled to a foreign tax
credit against its home country’s tax liability subject to any tax treaty benefit limitation under
the relevant article of the treaty into which HK has entered with its home country.

In addition to understanding the scope and calculation of withholding tax in HK, we also
need to appreciate the role of a withholding agent who has the responsibility to deduct,
withhold and remit the correct amount of tax to the IRD on a timely basis.

8.3.1 Withholding Obligations on Hong Kong Agents

Under s.20A (Persons Chargeable on Behalf of a Non-resident), a non-resident person may be
assessed directly, or in the name of their agent jointly or severally.

An assessment can be raised on an agent irrespective of whether or not they have receipt
of the profits, and the tax shall be recoverable by all means provided in the IRO out of the
assets of the non-resident person or from the agent.

The agent is required to deduct, at the time that they pay or credit the non-resident person,
a sum sufficient to meet the non-resident person’s tax liability in Hong Kong. The agent is
statutorily indemnified against any person in respect of such withholding. In other words, the
agent is protected under the IRO from the potential legal liability against the non-resident
person if such person does not agree that withholding tax should apply or disputes the amount
of tax withheld by the agent.

The term ‘agent’ in relation to a non-resident person is defined in s.2 to include:

1. The agent, attorney, factor, receiver or manager in Hong Kong of such a person, and

2. Any person in Hong Kong through whom such a person is in receipt of any profits or
income arising in or derived from Hong Kong.

For many years, the IRD has relied on s.20A to enable the tax due by a non-resident to
be assessed and collected by making the agent liable for such withholding even where the
non-resident has no physical presence in Hong Kong. However, where the transactions involve
two parties who act on a principal to principal basis, s.20A does not have the legal authority to
enforce such withholding responsibility in the absence of an agent. This deficiency is shown in
the ATV case described next.

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 Profits Tax L iabilities for   C ross -border T ransactions

CIR v Asia Television Limited (1987) 2 HKTC 198 (ATV case)

Facts: A non-resident film distribution company was paid a licence fee by Asia Television
Limited (ATV), a HK incorporated company for the broadcasting of films in HK.

The fees were paid by ATV directly to the non-resident outside HK.

The IRD assessed the non-resident under s.15(1)(a) and considered ATV as the ‘agent’
of the non-resident.

Issue: What constitutes an agent on behalf of a non-resident and its liability to profits
tax in HK.

Held: ATV appealed against the assessment raised by the IRD and contended that it was
not acting as an agent on behalf of the non-resident.

ATV asserted that it was dealing with the non-resident on a principal to principal basis.

The High Court determined in this particular case, the non-resident received the
payment directly from, not through, ATV.

As a result, it was decided that ATV was not acting in the capacity of an ‘agent’ and
the assessment raised under s.20A is not applicable in this case. It also followed that the
non-resident could only be charged by direct assessment.

Due to the ATV case, s.20B was introduced to restore the original intent of the law
under s.20A as it is common for non-residents in receipt of royalties and licence fees
from Hong Kong to have entered into an arrangement with a HK lessee on a principal to
principal basis. Similarly, it is also common for non-resident entertainers and sportsmen
who perform in Hong Kong to derive income not through a Hong Kong agent but from a
Hong Kong principal. To overcome the limitations imposed by the interpretation of ‘agent’
in the ATV case, s.20B was introduced to provide for the taxation of a non-resident person
in the name of any person who pays or credits certain payments to the non-resident
person. DIPN No. 17 (Revised) provides guidance on the taxation of persons chargeable to
profits tax on behalf of non-residents. This is discussed in the next section.

Concerning the definition of ‘agent’, an issue arises for a broker or an investment adviser
carrying out transactions, as an agent, for a non-resident client. The IRD has expressed its
view in DIPN No. 30 (Revised) that it would be unusual for the transactions of a non-resident
through a broker or an investment adviser to amount, in themselves, to carrying on a trade,
profession or business. Consequently, the IRD would not generally seek to charge non-residents
to profits tax in the name of such a broker or an investment adviser. S.20AA was therefore
enacted to specify the circumstances under which a broker or an investment adviser acting for a
non-resident person is deemed not to be an agent of the non-resident for the purposes of s.20A.
A detailed discussion on each subsection of s.20AA has been contained in DIPN No. 30 (Revised).

8.3.2 Withholding Obligations on Resident Persons Paying or Crediting

Certain Payments to Non-resident Persons
Against this background the Inland Revenue (Amendment) Ordinance 1989 introduced a new
s.20B that became effective from 1 April 1989.

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 TAXATION

Students should note that s.20A has remained unchanged and continues to apply in
situations where the Hong Kong payer is truly an agent of the non-resident. S.20B only applies
to situations where persons in Hong Kong who are not agents deal with a specified class
of non-residents. In essence, this class comprises non-residents in receipt of royalties and
licence fees from Hong Kong and non-resident entertainers and sportsmen who perform in
Hong Kong.

Following the enactment of the Inland Revenue (Amendment) Ordinance 2004, the
coverage of s.20B is expanded. The section now applies in respect of a non-resident who is
chargeable to profits tax in respect of:

1. Sums deemed under s.15(1)(a), (b), (ba) and (bb) to be receipts arising in or derived
from Hong Kong from a trade, profession or business carried on in Hong Kong, in other
words, royalties and licence fees; or

2. Sums received in respect of the performance in Hong Kong by a non-resident

entertainer or sportsman of an activity as an entertainer or sportsman on or in
connection with a commercial occasion or event, including appearance in any
promotional activity or participation in any sound recording, films, videos, radio,
television, and so on.

For clarity, below are the definitions of the terms used in the Inland Revenue (Amendment)
Ordinance 2004:

• ‘Entertainer or sportsman’ means a person, other than a corporation, who gives

performances in any kind of entertainment or sport, including any physical activity
which the public is permitted to see or hear. In terms of the definition it matters not
whether the activity is in a live or recorded form or whether the public is required to
make payment to see or hear.

• ‘Commercial occasion or event’ includes any occasion or event for which an entertainer
or sportsman might receive cash or other form of property for their performance, or
any occasion or event designed to promote commercial sales or activity. As presently
defined, it is considered that the phrase will cover all those occasions or events,
whether commercial or charitable, in respect of which an entertainer or sportsman
might receive profits assessable to tax.

The IRO contains no definition of ‘non-resident person’ but the IRD, as a matter of
administrative practice, has long accepted in relation to s.20A that the term refers to a person
who has no permanent business presence in Hong Kong. If there are disputes, the term will be
interpreted in accordance with the principles established by the courts.

8.3.3 Amount of Tax to Be Withheld

Historically, s.20A gives the legal basis for a HK payor to withhold tax when making payment to
non-resident persons who derive profits from HK from a trade or business carried on in HK. It
has remained unchanged and continues to apply in situations where the Hong Kong payor is
truly an agent of the non-resident. However, where the two parties (resident and non-resident
persons) act on a principal to principal basis, s.20A does not have the legal authority to enforce
such withholding responsibility in the absence of an agent. Therefore, s.20B is introduced to
overcome this deficiency.

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 Profits Tax L iabilities for   C ross -border T ransactions

For the purpose of s.20B, where sums are payable for the performance of a non-resident
sportsman or entertainer in connection with a commercial occasion or event, the IRD has
introduced a practical approach of deeming one-third of such sums to be allowable expenses
and the balance of two-thirds as assessable profits subject to wNo. ithholding tax. With regards
to the remittance of the appropriate withholding tax amount to the IRD, the resident person is
required to deduct such amount when actual payment is made or credited for the benefit of
the non-resident person. The amount withheld must be sufficient to pay the withholding tax
due, otherwise the resident person will be held accountable by the IRD.

The amounts to be withheld are as in Exhibit 8.6.

Types of payment (i.e. income to Withholding tax on behalf of non-resident

non-residents) persons
Sums taxable under ss.15(1)(a), (b) or (ba) Standard rate or corporate profits tax rate on 30%
or 100% of the sums (s.21A)
Sums payable for the performance of a Standard rate or corporate profits tax rate on
non-resident sportsman or entertainer in two-thirds of the sums (s.21)a
connection with a commercial occasion or event
a
 ith regards to non-resident entertainers and sportsmen, the IRD, as a matter of general practice, has allowed
W
HK promoters who represent the non-resident entertainers and sportsmen to withhold tax on the basis that the
assessable profits represent two-thirds of the gross receipts payable to them and the balance of one-third is treated
as allowable expenses. This practice is supported by DIPN No. 17 (Revised), para. 14.
EXHIBIT 8.6 Amounts to be withheld for types of payment

The IRD is authorised under s.21 of the IRO to compute the assessable profits of a
non-resident based on a percentage of turnover as previously outlined. Non-resident persons
may claim a larger deduction but they must be able to prove that any additional expenses are
properly deductible and supportable by valid documentation. Non-resident personss or their
authorised representatives would need to consider the benefits and costs of adopting the IRD’s
method of computation based on a percentage of turnover against actual expense claims since
the latter may require time and effort to ensure proper supporting documents are available on
request by the IRD.

DIPN No. 17 (Revised) states that pursuant to s.20B(2), where the non-resident person is
chargeable to tax in HK in respect of the sums as described in s.20B(1), the resident person
would remain chargeable to tax on behalf of such a non-resident person even if the payment
or credit was made to a non-resident other than the non-resident who is chargeable by virtue
of section 20B(1) (e.g. where the payment is made to a non-resident manager of a non-resident
entertainer or sportsman). The IRD reserves the right to use all legal means to recover such tax
from the resident person who has the responsibility to deduct and remit the correct amount of
tax in its capacity as the withholding agent on behalf of such a non-resident person. Exhibit 8.7
better illustrates this withholding tax obligation.

Non-resident chargeable
Resident payor* Non-resident manager
to HK tax under s.20B(1)

* Resident payor has the obligation to deduct and withhold tax (s.20B(2)).

EXHIBIT 8.7 Withholding tax obligations of resident payor and

non-resident manager

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 TAXATION

S.20B would also be applicable where sums falling within s.20B(1) were paid by a resident
person to another resident person for the account of a non-resident person. In this situation,
the other resident person would be chargeable on behalf of the non-resident person
(Exhibit 8.8).

Non-resident chargeable
Resident payor Resident manager**
to HK tax under s.20B(1)

** Resident Manager has the obligation to deduct and withhold tax (s.20B(2)).

EXHIBIT 8.8 Withholding tax obligations of resident payor and

resident manager

Please note that the resident person (payor) must retain the tax withheld until a demand
note calling for payment is received from the IRD. They are indemnified, by virtue of s.20B(3),
against any person in respect of the deduction of withholding tax that is set off against the
amount payable to the non-resident.

Key Learning Point

Under s.20B of the IRO, a resident person who makes certain royalty, license fee or service
fee payments to a non-resident person has the responsibility to deduct and remit the
appropriate amount of tax to the IRD on a timely basis. The amount withheld must be
sufficient to meet the tax liability owed by the non-resident person.

Apply and Analyse 3
Premier (HK) Tennis Champions Ltd (PTC) is a HK incorporated company that specialises in
organising top-level tennis exhibition matches worldwide. Due to its global commitment in
staging such events, PTC works together with other reputable companies in putting such
events together. In June 2018, PTC was asked to organise an exhibition match between a
HK top tennis player and a famous international tennis superstar, MC, who is based in the
United States. MC has set up MC USA Inc for such types of engagement.

PTC appointed TennisAccess Ltd (TA), a company incorporated in HK, to coordinate the
event. PTC entered into a contract with MC USA Inc for the latter to procure the services of
MC to take part in the above event in HK.

Under the above arrangement, PTC would pay TA a service fee of HK$2 million and, in
turn, TA would pay MC USA Inc an agreed performance fee of HK$1.5 million. MC receives
the entire amount of HK$1.5 million from MC USA Inc.

Identify the withholding tax obligations of the three parties.

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 Profits Tax L iabilities for   C ross -border T ransactions

Apply and Analyse 3 (continued)

Analysis

In order to apply the correct withholding tax treatment, students are advised to determine
the various payment flows:

1. Payment of HK$2 million from PTC to TA

Since this payment involves two HK incorporated companies, PTC is not required to
deduct and withhold tax when making such payment to TA.

2. Payment of HK$1.5 million from TA to MC USA Inc

For the purposes of s.20B(1)(b)(i) of the IRO, the sum of HK$1.5 million is treated
to be sum payable in respect of the performance in Hong Kong by a non-resident
sportsman in connection with a commercial occasion or event.

MC, who resides in the US, is a non-resident for HK tax purposes. He is

chargeable to tax in respect of the above amount in the name of TA, which is a
resident person.

Under s.20B(2), TA is required to deduct from the payment, at the time it

pays or credits the said payment to MC USA Inc, a sum sufficient to pay the tax. In
addition, TA is indemnified against any person in respect of its deduction of such a
sum as provided under s.20B(3) of the IRO.

3. HK withholding tax calculation

Under DIPN No. 17 (Revised), para. 14, there are two methods in computing the HK
withholding tax calculation in this case:

a. Deemed profit method

 nder s.21 of the IRO, the IRD would accept that the assessable profit of the
U
non-resident is computed based on a percentage of turnover or gross receipts.
Where this option is selected, one-third of the fee payable to MC USA Inc will be
allowed as a deduction for expenses and the other two-thirds of the fee would
be treated as assessable profits of MC USA Inc and subject to tax in HK.

 herefore, TA is required to deduct tax against the fee payable to MC USA Inc
T
as follows:

2
HK$1.5 million 8.25% HK$82, 500
3

 ote: Under the two-tier profits tax rates regime which is effective from the
N
year of assessment 2018/19, the standard tax rate of 16.5% is reduced by 50%
for the first HK$2 million of assessable profits.

b. Actual profit method

 lternatively, if TA is of the view that actual expenses incurred is greater than

A
the deemed allowable deduction of one-third of the gross receipts, TA has
the option to deduct and withhold tax based on the actual assessable profit
generated. If this option is selected, TA will be required to provide supporting
documents to substantiate the claims for deduction to the IRD.

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 TAXATION

8.3.4 Refund of Tax Overpaid

The repayment or refund of tax overpaid is generally governed under s.79 of the IRO. In cases
where a non-resident has been properly assessed to tax but the amount of tax withheld under
s.20A or s.20B is excessive, s.79(3) provides the legal right for the non-resident person or the
resident person who acts as withholding agent for the non-resident person, to claim repayment
of any tax overpaid.

For the purposes of s.79(3), the IRD has taken the position as in DIPN No. 17 (Revised)
para. 15 that the term ‘another person’ would include both an ‘agent’ as referred to in s.20A
and ‘any other person in HK’ as described in s.20B.

Knowledge Check Question

Question 5
Further to the preceding scenario, MC USA Inc believes that the tax liability calculated
under the deemed profit method is higher than the actual profit method. The following
expenses were incurred by MC USA Inc in connection with the tennis exhibition
match in HK.

Return first class airfare for MC HK$100, 000

Return first class airfare for MC s close friends HK$400, 000

Direct expenses related to MC:

Hotel accommodation HK$10, 000

Local transportation HK$5, 000
Food and beverages HK$6, 000

Calculate the amount of HK tax payable by MC USA Inc under the actual profit method.
A HK$113,768
B HK$227,535
C HK$80,768
D HK$161,535

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SUMMARY

• HK tax system is based on a territorial source principle. Therefore, it is the location of the
‘source of the income’ rather than entities’ residency status that determines whether income
is subject to HK profits tax or not. As such, no distinction is made between residents and
non-residents under the IRO.

• For HK profits tax purposes, the source of income is closely related to the place where a
person carries on a business or from where they derive profits. A non-resident person, who
carries on a business in or derives profits from HK, would be taxable in HK. However, to the
extent that a HK company carries on business activities or derives profits from outside of HK,
it would not be subject to tax in HK.

• There are special provisions in the IRO that deem certain receipts or sums derived by
non-resident to be profits assessable to tax in HK. These are:

°° Deemed trading receipts – s.15(1)(a), (b), (ba), (bb), (bc) and (d).

°° Non-resident entertainer or sportsman – s.20B.

• Under s.20A(2) and s.20B(2), the HK resident payor has the obligation to withhold tax when
making or crediting sums payable to non-resident persons who are taxable in HK. In addition,
under s.20A(2) and s.20B(3), the HK resident payor is also indemnified against any person in
respect of the deduction of such sum.

• As a general practice by the IRD and in accordance with DIPN No. 17 (Revised), para. 14, the
assessable profits of a non-resident entertainer or sportsman can be calculated using the
formula as follows:

°° Allowable deduction = one-third of the sum payable for the performance of a non-resident
sportsman or entertainer in connection with a commercial occasion or event (the sum).

°° Assessable profit = two-thirds of the previous sum.

The above non-resident persons who are chargeable to tax in HK, have the option to
calculate their net assessable profits based on the actual expenses incurred. A tax return
and supporting documents to substantiate the deduction claims must be made available on
request by the IRD.

• Under s.21A(1), withholding tax on sums taxable under ss.15(1)(a), (b) or (ba) is calculated
as follows:

°° Payment to a non-resident ‘associate’: Deemed assessable profit = 100% of the sums

*

payable/creditable.

*Note: The rate of 100% shall not apply in the case where the commissioner is satisfied
that no person carrying on a trade, profession or business in Hong Kong has at any time
wholly or partly owned the property in respect of which the sum is paid. In this case, the
30% rate for payment to a non-resident ‘non-associate’ will apply.

°° Payment to a non-resident who is not an ‘associate’: Deemed assessable profit = 30% of

the sums payable/creditable.

• Non-resident persons who have been assessed under s.20A or 20B have the right to request
for tax refund for tax overpaid in accordance with s.79(3).

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 TAXATION

MIND MAP

TAX IMPLICATIONS OF RESIDENT AND WITHHOLDING TAX

NON-RESIDENT
s.20A(1) – direct assessment in the name of the
Resident: Taxability governed by s.14 HK agent or non-resident person.
Non-resident: s.20A(3) – consignment tax withheld by HK payor
• Has PE in HK: Regarded as carrying on business relating to sale of goods in HK by non-resident.
in HK; Taxability of receipts is governed by s.14. s.20B – withholding tax applicable to licence
• Has no PE in HK but deemed to derive income fees, royalties derived from HK by non-residents
from HK: Deemed trading receipts under and sums derived by non-resident entertainer
s.15(1)(a), (b), (ba), (bb) or (d). or sportsman performing in HK.
• Payment to non-related party: 30% is deemed
as assessable profit. PROFITS TAX
• Payment to related party: 100% is deemed as LIABILITIES FOR
assessable profit; 30% if such rights were not CROSS-BORDER
owned previously by a person carrying on TRANSACTIONS
trade or business in HK.
PROVISIONS CONCERNING NON-RESIDENT
PERSONS
Relevant charging sections for deemed trading
receipts in HK: S15(1)(a), (b), (ba), (bb) or (d).
Relevant withholding tax sections: S.20A(1), (3)
and s.20B.
Under s.21, IRD can compute assessable profits
of non-resident based on percentage of turnover.
Under s.79(3), non-resident can request for tax
refund for over-payment of tax.

LIST OF FORMULAS

Withholding tax calculation

Types of payment (i.e. income to Withholding tax on behalf of non-resident

non-residents) persons
Sums taxable under ss.15(1)(a), (b) or (ba) Standard rate or corporate profits tax rate on 30%
or 100% of the sums (s.21A)
Sums payable for the performance of a Standard rate or corporate profits tax rate on
non-resident sportsman or entertainer in two-thirds of the sums (s.21)a
connection with a commercial occasion or event
a
 ith regards to non-resident entertainers and sportsmen, the IRD, as a matter of general practice, has allowed
W
HK promoters who represent the non-resident entertainers and sportsmen to withhold tax on the basis that the
assessable profits represent two-thirds of the gross receipts payable to them and the balance of one-third is treated
as allowable expenses. This practice is supported by DIPN No. 17 (Revised), para. 14.

Where the Hong Kong profits of a person, other than a financial institution, having a PE in
Hong Kong, but whose head office is situated elsewhere other than in Hong Kong and do not
disclose the true profits arising in or derived from Hong Kong or accounts are not kept;

Hong Kong turrnover

Assessable profits Adjusted worldwide profits
Worldwide turnover

Assessable profits of a Hong Kong branch of an overseas bank

Hong Kong assets

Assessable profits Adjusted worldwide profits
Worldwide assets

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Answers to Knowledge Check Questions

Question 1
A: There is no DTA between HK and the US. In determining whether the HK branch of
Central US Ltd constitutes a PE in HK, Sch. 17G Part 3 of the IRO should be referred to.
The nature of the marketing activities must be carefully examined.
B: There is a DTA between HK and Canada. In determining whether Trust Canada Inc
constitutes a PE in HK by providing customer services in HK through its employees,
Article 5 of the DTA should be referred to. The nature of the customer services and the
pattern in which they are offered must be carefully examined.

Question 2
Answer A is incorrect. Places for storage, display and delivery of goods do not constitute a
PE under Sch 17G Part 3 of the IRO.
Answer B is incorrect. A place for maintenance of goods to be processed by another
enterprise does not constitute a PE under Sch 17G Part 3 of the IRO.
Answer C is correct. The key word is ‘habitually’ negotiates and concludes contracts on
behalf of the non-resident principal. When an agent frequently undertakes such activities
on behalf of the non-resident persons, this will trigger a PE in the country where such
activities take place.
Answer D is incorrect. A fixed place of business which carries out auxiliary activities on
behalf of the non-resident does not constitute a PE under Sch 17G Part 3 of the IRO.

Question 3
Answer A is incorrect. The notional percentage method under s.21A of the IRO is applicable
where non-resident persons are deemed to derive profits from HK from a trade or
business carried on in HK under s.15(1)(a), (b) or (ba). Since the Canada-HK DTA is currently
in force, the applicable withholding tax rate on royalty payment at 10% will prevail over the
deemed notional percentage method as provided under s.21A.
Answer B is correct. The withholding tax on the royalty payment payable by Chatty HK Ltd
to BB Canada Ltd is calculated according to Article 12 of the Canada – HK DTA instead of
s.21A of the IRO. On the other hand, the trading profits generated by Chatty HK Ltd in 2020
will be assessed directly in its own name.
Answer C is incorrect. See answers A and B for reasons.
Answer D is incorrect. See answers A and B for reasons.

Question 4
Answer A is incorrect. The royalty payment of HK$200 million needs to be included as sums
derived from HK under s.15(1)(ba).
Answer B is incorrect. The royalty payment of HK$100 million needs to be included as sums
derived from HK under s.15(1)(b).
Answer C is correct. Under s.15(1)(b) and (ba), BB Canada Ltd is deemed to derive royalty
income in HK since Chatty HK Ltd claimed a deduction against its assessable trading
profits. Since the Canada–HK DTA is currently in force, the applicable withholding tax rate
on royalty payment at 10% would prevail over the deemed notional percentage method as
provided under s.21A.

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 TAXATION

Answer D is incorrect. The notional percentage method under s.21A is prevailed over by
Article 12 of the Canada–HK DTA.

Question 5
Answer A is correct. The airfare costs for MC’s friends are likely not deductible against the
gross receipt of HK$1.5 million since they are not directly related to MC’s exhibition match
in HK. Therefore, the net assessable profit and tax liability is computed as follows:
Gross receipt = HK$1.5 million
Less: deductible expenses = (HK$121,000)
Net Assessable profits = HK$1,379,000
Tax rate @ 8.25% = HK$113,768

Answer B is incorrect. A standard profits tax rate of 16.5% has been used to arrive at the
tax liability of HK$227,535. Under the two-tier profits tax rates regime, the standard tax
rate for corporations has been lowered to 8.25% with effect from 2018/19.
Answer C is incorrect. The tax liability has been arrived by deducting the airfare costs
for MC’s friends (in addition to the allowable deductions) against the gross receipt of
HK$1.5 million.
Answer D is incorrect. The tax liability has been arrived by using the standard rate of 16.5%
and deducting the airfare costs for MC’s friends (in addition to the allowable deductions)
against the gross receipt of HK$1.5 million.

EXAM PRACTICE

QUESTION 1
Hiphop Ltd, a Hong Kong incorporated company, is in the business of staging international
entertainment events in HK. In June 2018, Hiphop Ltd decided to bring in a Canadian
resident artist, JB, to perform a Christmas concert in HK for three days from 23 to 25
December 2018.

Hiphop Ltd contracted the services of a local Hong Kong company, Studio X Ltd, to
procure the services of JB to perform for the above event. Hiphop Ltd has agreed to pay
Studio X Ltd a flat fee of HK$2 million plus 20% of the gross ticket sales for the three-day
event. The Christmas concert generated gross sales of HK$20 million.

Separately, Studio X Ltd entered into a contractual agreement with JB to perform at

the Christmas concert above for an agreed fee of HK$5 million. In its contract with JB,
Studio X Ltd reserved the right to deduct and withhold tax @10% where applicable, or any
other amount which must be sufficient to cover the applicable HK tax liability arising from
the previously mentioned concert. Studio X Ltd explained that it was obligated to withhold
such tax in accordance with the IRO.

Mr. Bean Counter, who is the personal accountant of JB, did not agree that there should
be any withholding tax applicable in this arrangement since the three-day concert by JB did
not create a PE in HK.

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Consequently, Mr. Bean Counter raised the following issues:

1. JB did not have a PE in HK relating to her concert performance for the previously
mentioned period. As such, no withholding tax should be deducted against the
payment of HK$5 million.

2. Should there be any tax liability arising, an assessment should be made by the IRD
and issued to JB directly, who was the actual performer, as a demand for tax.

3. Hong Kong profits tax liability should be based on the net assessable profits
calculated with reference to the gross income and actual deductible expenses. The
10% or any other deemed notional percentage had no legal basis.

4. Studio X Ltd was not an agent of JB since each party acted in its capacity as
a principal. Therefore, Studio X Ltd had no authority to deduct any tax from
the payment.

Required:

(a) Advise whether JB had a PE in HK.

(b) Explain whether JB should be chargeable to Hong Kong tax.

(c) Explain how JB’s HK tax liability is calculated and collected.

(d) Explain whether there will be any difference in the tax position if JB incorporated a
company in Hong Kong to receive the payment on her behalf.

(e) Advise JB what can be done if tax is overpaid on her behalf by Studio X Ltd.

QUESTION 2
Yummy HK Ltd carries on business in Hong Kong as a manufacturer of instant noodles that
it sells to customers in HK. Under the trademark licencing agreement with ChowMe Japan
KK, a Japan incorporated company, Yummy HK Ltd agreed to pay a royalty of 3% of the gross
sales for the use of the ‘ChowMe’ trademark. Yummy HK Ltd recorded all its sales in its HK
tax return and claimed the royalty payment as deductible expenses.

During the year ended 30 June 2018, Yummy HK Ltd generated gross sales of
HK$20 million from the sales of its products in HK.

ChowMe Japan KK has developed the first cup noodle where customers can cook and eat
on the go. Under the trademark licencing agreement, Yummy HK Ltd is granted the right to
use ‘ChowMe’ in its manufacturing process in mainland China.

ChowMe Japan KK does not carry on a business in Hong Kong and has no relationship to
Yummy HK Ltd, except for the contractual relationship relating to the ‘ChowMe’ trademark
licencing agreement.

Required:

(a) Based on the preceding information, identify whether ChowMe Japan KK derives profits
from HK under s.14(1) of the IRO. If not, explain whether there is any specific provision
in the IRO which may deem the royalty income from Yummy HK Ltd to be assessable
to HK tax.

(b) Assuming that ChowMe Japan KK is subject to tax in Hong Kong, calculate its profits
tax liability for the year of assessment 2018/19, and advise Yummy HK Ltd of its tax
reporting obligation in respect of the royalty payment.

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 TAXATION

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Since there is a tax treaty between Canada and HK, we need to look at the definition of
a PE under Article 5 of the DTA which states that a PE includes specifically:

(i) A place of management;

(ii) A branch;

(iii) An office;

(iv) A factory;

(v) A workshop; and

(vi) A mine, an oil or gas well, a quarry or any other place relating to the exploration
for or the extraction of natural resources.

The term ‘permanent establishment’ also includes a building site, a construction,

assembly or installation project, or supervisory activities in connection with a building
site, or with such a project, but only if that site, project or activities last more than
six months.

From a HK domestic tax perspective, the IRD generally does not view the following
activities as establishing a PE in HK:

(i) A physical location or site for storage, display or delivery of goods only.
(ii) A physical location or site for maintenance of goods only.

(iii) A physical location or site for maintenance of goods to be processed by another

enterprise.

(iv) A physical location or site for purchasing goods or for collecting information for
the enterprise.
(v) A physical location or site for carrying on activity of a preparatory or auxiliary
nature for the enterprise.

(vi) A physical location or site for any combination of the preceding activities that is
of a preparatory or auxiliary nature for the enterprise.

In addition, the PE definition in Schedule 17G of the IRO is applicable to a non-DTA

territory resident person.

Based on the preceding information, JB did not have a PE in HK under both DTA and
the IRD’s definition of a PE.

(b) Due to HK’s territorial tax system, a person, whether a resident or non-resident of HK, is
chargeable to profits tax in HK if the person’s profits are derived from HK from carrying
on a trade, profession or business in Hong Kong as provided under s.14 of the IRO.

In the case of JB, she is regarded as deriving profits from HK by virtue of her
performance in HK. The relevant charging provision under the IRO for such an
entertainer is provided under s.20B. For this purpose, ‘entertainer’ means a person,
other than a corporation, who gives a performance in the character of an entertainer in
any kind of entertainment, including any activity of a physical kind that the public may
be permitted to see or hear (s.20B(4)).

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Under s.20B(1)(b), the sum that is assessable to tax includes amount paid for any
appearance made in connection with the promotion of a commercial occasion or
event; and any participation by the entertainer in sound recording, films, videos, radio,
television or similar transmissions, whether live or recorded.

Based on the preceding information, JB should be chargeable to profits tax in HK.

(c) The performance fee received by JB is treated as income earned by a non-resident

entertainer which was derived from HK under s.20B(1)(b) of the IRO. Therefore, JB, as a
non-resident, is chargeable to tax in respect of the payment in the name of the person
in Hong Kong, that is, Studio X Ltd, who paid or credited the payment to JB (s.20B(2)).

Although Studio X Ltd was not an agent representing JB as a performer, from the
IRD’s point of view, Studio X Ltd acted as a withholding agent on behalf of JB for HK tax
purposes. Such withholding obligation is governed under s.20B(3).

Since HK tax administration is not based on a self-assessment system, Studio X

Ltd is required to remit the amount of tax withheld to the IRD on receipt of demand
note or notice of assessment issued by the IRD. Studio X Ltd would also be required
to complete and submit Form IR623 to the IRD which serves as a notification about
the contractual arrangement between the HK payor (i.e. Studio X Ltd) and JB. A copy of
Form IR623 can be found online: https://www.ird.gov.hk/eng/pdf/ir623.pdf.

The withholding tax calculation is set out as follows:

i) Payment from Hiphop Ltd to Studio X Ltd

Amount payable HK$2 million (20% HK$20 million) HK$6 million

Since this is a payment between two HK entities, Hiphop Ltd does not have the
obligation to withhold tax when making payment to Studio X Ltd.

ii) Payment from Studio X Ltd to JB

 ince JB is an individual (i.e. unincorporated person), she is chargeable to profits

S
tax in HK at the rate of 15%. However, under s.21 of the IRO and DIPN No. 17
(Revised), para. 14, the IRD accepts that one-third of the fee payable can be
allowed as deductions for expenses while the balance of two-thirds of the fee is
deemed to be assessable profits subject to tax in HK. Therefore, the withholding
tax is calculated as follows:

Net assessable profits 2

3 HK$5 million HK$3, 333, 333
HK tax to be withheld for the first HK$2 million of assessable profits

(HK$2 million 15%) 50% HK$150, 000

HK tax to be withheld for the balance of HK$1, 333, 333 of assessable profits

HK$1, 333, 333 15% HK$200,000

Amount of tax to be withheld by Studio X Ltd

HK$150, 000 HK$200,000 HK$350,000

Net amount received by JB HK$4 , 650, 000

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 TAXATION

Under s.20B(3) of the IRO, Studio X Ltd should fulfill its withholding obligation and
is indemnified against any person in respect of the sum deducted to meet JB’s tax
liability in HK.

Under Para 14 of DIPN No. 17 (Revised), JB has the right to have her earnings to be
taxed based on the actual expenses incurred instead of the automatic deduction as
allowed by the IRD. This option would only be beneficial if the actual expenses incurred
are significantly higher than the one-third automatic deduction. In addition, JB would
be required to file a tax return with all the supporting documents to substantiate the
actual deduction claimed.

(d) Incorporation of a Hong Kong company: assume that JB incorporates a new HK

company called Freelance Ltd to receive such payment. There is no tax differential
whether JB incorporates a company in HK for the sole purpose of receiving the payment
of HK$5 million from Studio X Ltd provided the same amount of fee will be paid by
Freelance Ltd to JB. Studio X Ltd is no longer required to act as the withholding agent
on behalf of JB for HK tax purposes. Under s.20B(3), the withholding tax obligation now
lies with Freelance Ltd since it is responsible for making that payment to JB, who is
the non-resident entertainer in this case. In other words, Freelance Ltd takes over the
withholding tax obligation from Studio X Ltd.

The overall tax position of JB remains the same as the calculation of HK tax required
to be withheld by Freelance Ltd would be the same – as described in the calculation
outlined in c(ii) above.

(e) Where JB has been assessed in the name of Studio X Ltd and the tax so assessed has
been paid by Studio X Ltd, either Studio X Ltd or JB, but not both, may claim repayment
of any tax overpaid to the IRD as provided under s.79(3) of the IRO. The term ‘another
person’ in s.79(3) covers both an ‘agent’ (as referred to in s.20A) and ‘any person in
Hong Kong’ (as referred to in s.20B) (DIPN No. 17 (Revised), para. 15).

QUESTION 2
(a) The general charging provision for profits tax is governed under s.14(1), which states
that profits tax shall be charged for each year of assessment on every person carrying
on a trade, profession or business in Hong Kong in respect of the person’s assessable
profits arising in or derived from Hong Kong for that year from such trade, profession
or business.

Based on the information available, ChowMe Japan KK does not carry on a business
in Hong Kong, therefore the general charging section s.14(1) is not applicable in this
case. However, since ChowMe Japan KK derives royalty income from HK where the
trademark is used outside HK (i.e. in mainland China in this case) and the royalty
payment is treated as deductible expense in Yummy HK Ltd’s tax return, such an
amount is caught under the deemed trading receipt provision of s.15(1)(ba).

Notwithstanding that the trademark is used outside HK, to the extent that Yummy
HK Ltd claims a deduction for the royalty expense against its assessable profit, such
royalty payment is deemed to be sums derived from HK and is subject to tax in HK by
way of withholding.

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(b) The deemed assessable profits from the chargeable royalty income are 30% of the
gross royalty payment received by ChowMe Japan KK since both companies are not
related parties (s.21A). As the recipient is a corporation, the applicable tax rate is
8.25% (for the first HK$2 million of assessable profit) under the recently introduced
two-tiered profits tax rates regime which is applicable from the year of assessment
2018/19 onwards.

Therefore, the estimated profits tax payable by ChowMe Japan KK for the year of
assessment 2018/19 is calculated as follows:

Gross sales × Royalty rate × Deemed profit rate × Applicable profits tax rate

HK$20 million 3% 30% 8.25%

HK$14 , 850

Yummy HK Ltd is required to withhold this tax amount from the gross royalty
payment, and only remit the net amount of HK$585,150 to ChowMe Japan KK.

Yummy HK Ltd is required to inform the IRD of ChowMe Japan KK’s chargeability
to profits tax within four months after the accounting year-end date of the year in
which the royalty payment is paid (i.e. on or before 31 October 2018). Yummy HK Ltd
is also required to file a Hong Kong profits tax return on behalf of ChowMe Japan KK,
disclosing the total royalty income chargeable to tax in HK and the corresponding tax
amount withheld.

Yummy HK Ltd will be required to settle the above tax liability of HK$14,850 on
behalf of ChowMe Japan KK when it receives an assessment issued by the IRD.

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 Part D

Tax System and Administration
in Mainland China

Chapter 9 Tax System and Administration in Mainland China

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 9
Tax System and
Administration in
Mainland China

CHAPTER TOPIC LIST

9.1 Overview of the Tax System in 9.3.5 Corporate Income Tax

Mainland China Calculation
9.1.1 Tax Administration and 9.3.6 Tax Incentives
Collection 9.3.7 Annual Tax Returns and Final
9.1.2 Tax Penalties and Surcharges Settlement
9.1.3 Tax Disputes and Appeals 9.3.8 Common Issues Relating to
9.1.4 Restriction on Foreign Investors Cash Repatriation Out of China
9.1.5 Designated Zones to Attract by Foreign-invested Enterprises
Investments 9.4 Individual Income Tax
9.2 Turnover Tax 9.4.1 Tax Residence
9.2.1 Value Added Tax 9.4.2 Non-tax Resident
9.2.2 Consumption Tax 9.4.3 Types of Taxable Income
9.3 Corporate Income Tax 9.4.4 Tax Rates and Computation
9.3.1 Tax Resident Enterprise 9.4.5 Tax Incentives
9.3.2 Non-tax Resident Enterprise 9.4.6 Tax Filing and Payment
9.3.3 Scope of Tax Liability
9.3.4 Withholding Tax on Non-tax
Resident Enterprise

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 TAXATION

LEARNING OUTCOMES

PRINCIPAL LO4: DEMONSTRATE AN UNDERSTANDING OF THE TAX SYSTEM AND ADMINISTRATION

IN MAINLAND CHINA
LO4.01: Describe and apply the key aspects of the tax system in mainland China
4.01.01 Describe and apply the key aspects of China tax system
4.01.02 Illustrate the turnover tax regimes including value added tax and consumption tax,
and analyse the related tax implications for transactions in mainland China
4.01.03 Illustrate the regime of individual income tax and analyse the related tax implications
for individuals
4.01.04 Illustrate the regime of corporate income tax and analyse the related tax implications
for entities

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OPENING CASE

CLA (HK) LTD

C heung Luck An (HK) Ltd (CLA) was incorporated in Hong Kong (HK) in 2000 and has a year
end of 31 December. CLA has been in the business of manufacturing medical equipment
since its incorporation. For the purpose of double taxation arrangement/agreement with HK,
CLA is regarded as a tax resident in HK.

CLA employs about 100 employees in HK, including its chief medical innovator,
Mr. Wong. CLA’s business has done well in HK and its annual sales revenue for the year ended
31 December 2017 exceeded its target of HK$100 million. As part of Mr. Wong’s responsibilities,
he has been tasked to expand CLA’s operation into China.

From January to July 2018, Mr. Wong made several trips to China to look for a suitable site
to expand the manufacturing operation, and to determine how many employees he would
need to hire. He spent 85 days in China in total during those trips.

After presenting his findings to the board of CLA in October 2018, Mr. Wong was asked
to lead the China operation and execute the management strategy of obtaining a high-tech
status and a sales target of RMB20 million in its first year of operation. Mr. Wong is entitled to
a variable bonus of 2% in excess of the sales target revenue. Mr. Wong will be seconded to CLA
China Limited, a wholly-owned subsidiary of CLA, starting from 1 January 2019, for two years.

Mr. and Mrs. Wong, together with their 12-year-old daughter, relocated to Shanghai on
1 January 2019, and he commenced employment there. Mr. Wong is also paid HK$20,000 per
year for his management oversight for CLA’s operation in HK.

Within the first year of operation, CLA China Limited generated a sales revenue of RMB25
million, serving both domestic and international customers.

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 TAXATION

OVERVIEW

In Chapter 8, we learned about the tax impact of a cross-border transaction from a Hong Kong
tax perspective. Given that Hong Kong and mainland China (mainland China is abbreviated
to China for the rest of this chapter while taxes in mainland China are similarly referred to as
China tax) are described as ‘one country two systems’, and since they have close economic
relationships, it is important for us to appreciate and understand the tax system in China. This
applies both to the corporate and individual level, including the implication of indirect tax such
as value added tax (VAT), which is absent from the HK tax system.

This chapter provides a general overview of the tax administration in China, particularly the
powers and authority of the relevant tax bureaus, tax collection and administration, tax filing
and payment due dates, tax disputes and appeals.

We also explore how individuals and companies are subject to China tax on their
domestic and foreign-sourced income based on their residency in China. In addition, there
are some Illustrative Examples provided as the chapter progresses to help you gain a better
understanding of the China tax system.

A key component of the Chinese tax system is the imposition of indirect taxes in addition to
direct taxes such as corporate income tax (CIT) and individual income tax (IIT). Although there
are many types of indirect taxes, this chapter focuses on the more common type of indirect
taxes such as VAT and consumption tax (CT).

Given the increasing trend of globalisation, this chapter also touches on the restriction on
foreign investments, and the complexity of China foreign exchange administration that is being
managed by the State Administration of Foreign Exchange (SAFE).

By the end of this chapter, you will have an appreciation of the key aspects of the China tax
system and the relevant tax implications of doing business in China.

9 . 1 OVERVIEW OF THE TAX SYSTEM IN

MAINLAND CHINA

As illustrated in Exhibit 9.1, mainland China imposes a wide range of taxes, including but not
limited, to:

• Income tax (corporate and individual income tax);

• Turnover tax (value added tax and consumption tax);

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 T ax S ystem and A dministration in M ainland C hina

Corporate income tax (CIT) Real estate taxes

Individual income tax (IIT) Tax Revenue–China Custom duties

Turnover taxes Others

EXHIBIT 9.1 Taxes in China

• Taxes on real estate (land appreciation tax, real estate tax, land occupation tax, urban
and township land use tax); and

• Other taxes (e.g. stamp duty, custom duty).

Capital gains and losses of companies are included with other operating income and are
subject to the normal prevailing corporate tax rate of 25%. They are not treated separately.
Gains on real property, net of development costs, are treated separately and are subject to land
appreciation tax.

The 2008 Corporate Income Tax Law applies to both domestic and foreign-invested
enterprise generally at the same prevailing tax rate of 25%, with special rates applying in certain
cases, such as companies with high-tech status or tax incentives provided for companies
operating within the designated free trade zones (FTZs).

China has transfer pricing, thin capitalisation and controlled foreign corporation rules as
well as general anti-avoidance rules (GAAR).

Although China is currently not a member of the Organisation for Economic Co-operation
and Development (OECD), it has a broad treaty network based on the OECD model treaty, which
provides relief from double taxation and reduced withholding tax rates on various types of
income. China’s treaties generally contain OECD-compliant exchange of information provisions.

9.1.1 Tax Administration and Collection

China’s major tax laws are passed by the National People’s Congress (NPC), which is the highest
legislative body in China while the State Council is the highest body of state administration.

Tax law and policy are developed jointly by the State Taxation Administration (STA) and
the Ministry of Finance under the State Council. The STA is responsible for collecting tax and
enforcing compliance. The STA is assisted by state and local tax bureaus at the provincial level
and below.

In March 2018, China started a reform to merge the STA sub-bureaus with the local tax
bureaus (LTBs) at the corresponding level into a consolidated local tax authority. Upon the
completion of the merger, the local tax authority will follow the direction of both the STA
and the local government, with the STA playing the major leading role. The reform has been
conducted in downward stream, with the provincial-level and municipal-level mergers formally
announced on 15 June 2018 and 5 July 2018, respectively.

Currently, the tax revenue split between the central and local governments for some of the
principal taxes affecting foreign investment is as shown in Exhibit 9.2.

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 TAXATION

Type of tax Central government Local government

Value added tax 50% 50%
Consumption tax 100% –
Corporate income tax (Caiyu (2008) No. 10) 60% 40%
Stamp tax on share trading 97% 3%
Resource tax (offshore) 100% –
Land appreciation tax – 100%

EXHIBIT 9.2 Types and splits of tax revenue between central and local governments in China

Exhibit 9.3 summarises some of the common type of taxes that are collected by the state
and local tax bureaus respectively.

State tax bureaus and offices Local tax bureaus and offices
VAT BT (prior to VAT reform)
Consumption tax Individual income tax
Income tax for FIEs Income tax for domestic companies
Vehicle purchase tax Stamp duties
Custom duty Land appreciation tax

EXHIBIT 9.3 Common taxes collected by the state and local tax bureaus
respectively

Generally, the administration and collection of tax revenues that are shared between the
central and local governments are handled by the state tax bureaus. Such tax revenues are
generated from, including but not limited to, corporate income tax, value added tax and vehicle
purchase tax.

However, the administration and collection of tax revenues that are for the sole benefit of
the local governments and not shared between the central and local governments are handled
by the local tax bureaus. Such tax revenues are generated from, including but not limited to,
individual income tax, land appreciation tax, real estate tax and stamp duties.

With regard to the tax collection from non-resident enterprises, the China tax authority
implements a withholding tax system whereby the domestic payers or the authorised
representatives of the non-resident enterprises are required to be the withholding agent
and remits the appropriate tax amount to the relevant tax authority within a prescribed
time period. The China tax authority frequently uses readily public information to detect any
potential tax withholding, particularly in the areas of direct or indirect equity transfers. Any
non-compliance with the prevailing tax law will result in significant penalty.

9.1.2 Tax Penalties and Surcharges

Under the Administrative Law on Levying and Collection of Taxes (ALLCT), Article 32, a daily
surcharge of 0.05% of the tax owing will be imposed if the taxpayer or its withholding agent
fails to remit the tax due within the prescribed time period. Such daily surcharge is computed
from the first day after such prescribed time period lapses.

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However, where such non-compliance is due to a mistake by the tax authorities, the
taxpayer may be required to remit the correct amount of tax within three years from the date
of such notice. No penalties or surcharges will be applied (ALLCT, Art. 52).

In the case where such non-compliance is due to the mistake by the taxpayers, the tax
authorities may require such taxes owing to be remitted within three to five years, depending
on the relevant circumstances and reasons for such an error. In addition to the daily surcharge
of 0.05%, this may also attract a penalty that ranges from 50% to 500% of the tax owing.

Where there is a deliberate omission involving tax evasion or fraud, there is no statute of
limitations that applies on the payment of taxes owing. The tax authorities reserve the right to
demand full payment, including surcharges and penalties, at any time. Criminal prosecution
may be considered as well.

Alternatively, where a taxpayer is in a tax refund situation, the taxpayer may apply to the
relevant tax authority for the tax refund plus interest at the prevailing bank deposit rate with
similar terms within three years from the date of tax payment (ALLCT, Art. 51).

9.1.3 Tax Disputes and Appeals

There are two ways in which to deal with a tax dispute in China, namely:

1. Tax administrative review (TAR)

2. Tax administrative litigation

9.1.3.1 Tax Administrative Review

When a taxpayer disagrees with the assessment made by the relevant tax authority, the
taxpayer has the right to file an objection in writing to a higher-level tax authority for
reconsideration in the correct application of the relevant tax laws and regulations under the
specific circumstances involving the taxpayer.

9.1.3.2 Tax Administrative Litigation

Where a taxpayer disagrees with and intends to object to the assessment made by the tax
authority, the taxpayer is still required to pay the amount of tax assessed, including any
penalties and surcharges, prior to filing a written objection to the higher-level tax authority.

Such objection must be filed within 60 days from the date of the notice issued by the tax
authority or the date such tax owing is fully paid up or guaranteed, whichever is the earlier.

The higher-level tax authority has 60 days from the date that such an objection or tax
administrative review application is received to make a decision.

In the event that the taxpayer is not satisfied with the decision made by the higher-level tax
authority, the taxpayer may commence legal proceedings with the People’s Court. The judge
would then determine the merits of the case and the findings by the relevant tax authority.

Where taxpayers or other affected parties believe that certain tax administrative acts
of the China tax authorities have infringed upon their legal rights or interests, they may
apply in accordance with the law for a tax administrative review to examine the legality and
appropriateness of the acts.

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 TAXATION

On 10 February 2010, the STA took steps to reconsider the 2004 Tax Administrative Review
Regulations (TARR) and formulate comprehensive review procedures for the following reasons:

• To prevent and rectify tax administrative acts that are inappropriate or that
violate the law.

• To safeguard the lawful rights and interests of taxpayers and other concerned parties.

• To supervise the tax administrative practices of the tax department, and to ensure that
these practices are carried out in accordance with the prevailing rules.

On 1 April 2010, the revised TARR were enacted in accordance with the Law of the People’s
Republic of China on Administrative Review, the Law of the People’s Republic of China on Tax
Administration and Collection and other relevant rules.

This process can be summarised as in Exhibit 9.4.

Disputes over items related to Disputes over ‘administrative tax measures’

‘imposition of taxes’ (TARR, Art (TARR, Art 14(2)–(12)). Examples:
14(1)). Examples: • Business licencing and approval
• Taxable items and deduction • Issuance and revocation of tax invoice
• Tax exemption, rebate and credit • Enforcement measures for tax collection
• Applicable tax rate • Failure to issue tax registration and payment
• Tax collection and late payment certificate
surcharges • Detention notice by the relevant authorities
• Withholding tax collection relating to the prevention of an individual
from leaving the country

Either/or

60 days* 60 days*

Tax Administrative Review

(TAR) by Higher-level Tax
Authorities

Disagrees Rejected
(15 days)** (15 days)**

Tax Administrative Litigation (TAL) to

the People’s Court (6 months)***

Key timeline:
* Taxpayer can apply for TAR within 60 days from date of settlement of taxes or date when
tax security is received by tax authority.
** Taxpayer can apply for TAL within 15 days from the date of receipt of the decision.
*** Taxpayer can apply for TAL within six months from the date of notice that states certain
administrative tax matters are under dispute.

EXHIBIT 9.4 Process for tax disputes and appeals

In recent years, the Chinese tax authorities have made great efforts to improve the tax
services and provide greater transparency to the taxpayers. Nevertheless, the tax environment
in China remains one of the most challenging around the globe. Some of the possible
contributing factors include those from the many regulatory changes as China strives to be
consistent with other developed countries, particularly relating to the interpretation and
application of its tax laws and regulations.

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Although such improvements are welcomed by the business community, these may have
also led to a certain degree of uncertainties and challenges for taxpayers such as:

• Multiple audits conducted by different levels of tax bureaus relating to different types
of taxes (including transfer pricing investigation, base erosion and profit-shifting (BEPS)
driven investigation and other anti-tax avoidance investigations).

• Disallowance on cost/expense deductions and other filing positions due to ambiguous

tax rules and inconsistent interpretation of the tax laws and regulations.

• Inability to assess risks where dealing with complex transactions requiring in-depth
technical interpretation of the tax laws and regulations (including direct and offshore
indirect equity transfers, corporate restructuring, outbound payments and secondment
issues of international employees).

The above factors are likely to expose taxpayers to potential compliance risks, heavy
penalties and surcharges, loss of tax benefits, double or multiple taxation and reputational risks.

9.1.4 Restriction on Foreign Investors

Foreign investments are welcome in China. Since becoming a member of World Trade
Organization (WTO) on 11 December 2001, China is bound by WTO rules to open its industries
to foreign investors. In China, the Ministry of Commerce (MOFCOM) is the major regulator of
foreign investments. Subject to the approval from the MOFCOM and other relevant ministries,
foreign companies or individuals may establish equity joint ventures, contractual joint ventures
or wholly-owned foreign enterprises (WOFE) in China. With effect from 1 March 2010, foreign
investors are allowed to establish partnerships in China.

On June 17 2014, MOFCOM issued the ‘Notice on Improving Foreign Investment

Review Administration’ (the MOFCOM Notice) to clarify that registered capital contribution
requirements for foreign-invested enterprises (FIEs) have been relaxed and the minimum
registered capital requirement has been removed.

However, notwithstanding the above relaxation of registered capital requirements, the

proportion of registered capital to total amount of investment shall continue to follow the
‘Provisional Regulations for the Proportion of Registered Capital to Total Amount of Investment
of Joint Ventures Using Chinese and Foreign Investment’ (the Provisional Regulations). For
instance, according to this Provisional Regulations, for an FIE with a total investment amount
below US$3 million, its registered capital shall be at least 70% of its total investment amount.

Exhibit 9.5 illustrates the proportion of the registered capital of a FIE to its total investment.

Amount of total investment Registered capital

US$3 million or less 70% of total investment (TI)
US$3 million–US$10 million Higher of US$2.1 million or 50% of TI
US$10 million–US$30 million Higher of US$5 million or 40% of TI
> US$30 million Higher of US$12 million or 33.3% of TI

EXHIBIT 9.5 Registered capital needed for different levels of

total investment

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9.1.5 Designated Zones to Attract Investments

In order to attract foreign and domestic investments, including export activities, China has
established a number of designated areas with preferential tax rates and policies such as:

• Special Economic Zones (SEZ)

• Technological Development Zones (TDZ)

• Export Processing Zones (EPZ)

• Bonded Warehouse Zones

The China (Shanghai) Pilot Free Trade Zones (Pilot FTZ) was launched in September 2013.
The main purpose is to introduce policy innovations to establish advance rules on trade and
investments.

In April 2015, three additional Pilot FTZs were introduced in Fujian, Guangdong and Tianjin.
As of April 2017, Pilot FTZs started its operation in the provinces of Henan, Hubei, Liaoning,
Shaanxi, Sichuan, Zhejiang and Chongqing Municipality.

Key Learning Point

In addition to understanding the various restrictions on foreign investments in China
and the expansion of its free trade zones, it is important for taxpayers to understand the
different levels of authority within the China tax system as well as available avenues when
there is a dispute between taxpayers and tax authorities.

Knowledge Check Questions

Question 1
CLA China Limited is a foreign-invested enterprise that is a tax resident enterprise in
Shanghai, China, and pays corporate income tax (CIT) in China. Identify which tax office is
responsible for collecting its CIT.
A State tax bureau located in Shanghai
B State tax bureau located in Beijing
C Local tax bureau located in Shanghai
D Any of the above as long as there is available tax officer to collect the CIT payable

Question 2
CLA China Limited is a VAT general taxpayer. For the month of June 2018, it has a net VAT
payable of RMB100,000. Calculate how much of the VAT payable is collected by the local
government where CLA China Limited is located.
A RMB30,000
B RMB50,000
C RMB75,000
D A reasonable amount as determined by the local tax authority

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Knowledge Check Questions (continued)

Question 3
CLA China Limited disagrees with the tax assessment issued by the tax authority relating
to certain tax deductions. CLA China Limited refuses to settle the tax owing and filed
an objection in writing to TAR within 60 days from the date of the assessment notice.
Assuming that CLA China Limited disagrees with TAR’s findings, identify how long CLA has
to file an appeal to the People’s Court.
A 15 days
B 45 days
C 60 days
D None of the above

9 . 2 TURNOVER TAXES

Historically, China imposed BT on provision of services and VAT on sale of goods. However, with
effect from 1 May 2016, the BT regime has been abolished and is consolidated into the VAT
regime. Currently, there are two main types of indirect taxes applicable in China, i.e. VAT and CT.

Similar to the VAT regime in other countries, the China VAT system (with some exceptions)
is intended to tax the final personal consumption expenditures by generally making the VAT as
a pass-through cost for VAT registered businesses through an input VAT credit mechanism.

CT, on the other hand, applies to manufacturing, processing, importation and selling of 15
different kinds of goods in China, mainly relating to luxury goods and environmental unfriendly
goods, including cigarettes, alcoholic beverages, high-end cosmetics, jewellery, gasoline,
automobiles, battery and coating, etc. Unlike input VAT for the general taxpayer, CT is not
recoverable but is deductible as an expense for CIT purposes.

This section will focus more on understanding the mechanics of both VAT and CT systems
and their impacts on taxpayers.

9.2.1 Value Added Tax (VAT)

VAT in China is governed by the Provisional Regulations on VAT of the PRC, which were
originally promulgated by the State Council in 1993 and effective from 1 January 1994 (State
Council Order No. 134). The current VAT system is the product of China’s most significant
tax reform in more than two decades, which was completed and fully implemented in
2016. It effectively consolidated the BT regime into the Revised Provisional Regulations on
VAT of the PRC (RPRVAT) by means of the promulgation of the State Council Order No. 691
on 19 November 2017. This reform was part of Beijing’s efforts to restructure the Chinese
economy from one driven by labour-intensive manufacturing to one that is service-oriented, by
easing the tax burden on service industries.

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On 24 March 2016, the MOF and the STA jointly issued Caishui [2016] No. 36 (the
Circular 36), which marks the overall replacement of BT with VAT as part of the indirect tax
system in China with effect from 1 May 2016.

The previous VAT regime in China was established in 1994 and applied to the sale of goods,
processing and repair services, whereas co-existing BT was applied to provision of other
services, transfer of intangible assets and sale of real estate.

With effect from 1 May 2016, the scope of Circular 36 is also extended to new industries,
including construction, real estate, financial services and consumer services.

Further to the Report to the NPC on the Works of the Central People’s Government
addressed by Premier Li Keqiang on 5 March 2019, the MOF, the STA and the General
Administration of Customs jointly issued Joint Announcement [2019] No. 39 (the Circular 39),
on 20 March 2019, to set forth the details of a bundle of VAT policy changes to be effective from
1 April 2019. Circular 39 covers the following key features:

• Reducing the VAT rates

• Amending the input VAT recovery rates on purchasing of agricultural products,

acquiring of immovable properties and passenger transportation services

• Increasing the export VAT refund rates for regular export and goods purchased by
foreign tourists

• Introducing an additional 10% of ‘Super Input VAT Credit’ regime to taxpayers engaging
in the provision of postal, telecommunications, modern and lifestyle services

• Introducing a Pilot Scheme to enable the qualifying General VAT Payers to claim partial
refund of excessive input VAT credit

The main emphasis of RPRVAT, together with both Circular 36 and Circular 39, are
summarised in the following section.

9.2.1.1 Key Issues of the VAT Reform

The primary objective of the VAT reform is to create a general tax system that is fair and
equitable to both manufacturing and services industries, as well as avoiding double taxation on
the same transactions by implementing the VAT credit mechanism.

Historically, the turnover of manufacturing and other industrial firms was subject to VAT
while service industries were subject to BT. Given the BT rates and the taxing mechanism,
this meant service industries faced higher taxes in the form of revenue-based taxes across
the entire supply chains, while not being able to claim Input VAT as permitted under the VAT
system. With this latest reform, service industries enjoy a reduced tax burden since they are
only taxed on the value added at each transaction.

This is consistent with the general principle of indirect tax system in developed countries
where indirect tax should be seen a pass-through cost for a General VAT Payer and borne by
the final consumer.

It is worth noting that the MOF and the STA jointly released a Public Consultation Document
for Draft Law of the PRC on VAT on 27 November 2019. This set of the draft VAT law was
presented according to the following sections:

1. Preamble

2. Taxpayer and Withholding Agent

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3. Scope of Charge

4. Tax Rates

5. Taxable Amounts

6. Tax Incentives

7. Time of Supply and Place of Tax Payment

8. Tax Collection and Administration

9. Supplementary Notes

The public consultation was closed on 26 December 2019, after which the draft VAT law is
to be reviewed overall, taking into account feedback received. The finalised version of the draft
VAT law will be enacted officially by the NPC in due course. The effective date of the new VAT
Law has not yet been announced.

9.2.1.2 Scope of Charge
VAT is a form of indirect tax that is imposed on the sale of goods and services within China,
including the importation of goods into China. Currently, the standard VAT rate is 13%.

Generally, foreign entities are not eligible to register as a General VAT Payer in China. If they
would like to carry on a business in China and obtain the General VAT Payer status, they have
the options to establish the following entities:

• FICE (Foreign Invested Commercial Enterprise)

• WOFE (Wholly Owned Foreign Enterprise)

• JV (Joint Ventures)

Alternatively, they may operate within the Free Trade Zone area as mentioned in
Section 9.1.5 above.

It is important to note that China VAT is governed by the following legislations (individually
or collectively known as ‘China VAT regulations’ for the purpose of this chapter):

• The RPRVAT (the State Council Order No. 691) and

• The Revised Implementing Rules for the VAT (MOF and STA Joint Order No. 50).

Pursuant to the prevailing China VAT regulations, businesses (also known as ‘units’) and
individuals who are engaged in the sale of goods, provision of services, transfer of intangible
or immovable property, or the importation of goods within the territory of the PRC, are subject
to VAT. Below are some key terms that would help students have a better understanding of the
VAT scope in China.

9.2.1.3 Types of VAT Payer

There are two types of VAT payers:

(a) General VAT Payers

(b) Small-Scale VAT Payers

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Small-scale VAT Payers are those without sound accounting and auditing systems and
whose taxable sales value does not exceed the prescribed threshold as outlined below: -

(i) Sales not exceeding RMB 0.5 million per year for those entities that are involved in the
manufacturing or provision of services or

(ii) Sales not exceeding RMB 0.8 million per year for those entities that are involved in the
wholesale or retail trade or

(iii) Sales not exceeding RMB 5 million if providing all other VAT applicable services
including the transfer of immovable or intangible property.

With effect from 1 May 2018, the Small-Scale VAT Payer sales revenue threshold has been
unified to RMB 5 million for all taxpayers. It is possible for taxpayers that would otherwise be
‘Small-Scale VAT Payers’ to register as ‘General VAT Payers’. They need to demonstrate a sound
accounting system and provide accurate tax information as well as having a fixed place of
business in China and be approved by the tax authority.

All other taxpayers whose annual taxable sales value exceeds the prescribed threshold
of Small-Scale VAT Payers and have sound accounting and auditing systems are regarded as
General VAT Payers.

For General VAT Payers, there is a compulsory VAT registration for taxpayers who are
engaged in VAT taxable activities and the annual gross revenue exceeds RMB 5 million per year.

The above is summarised in Exhibit 9.6.

Wholesale, retail trade

Yes Annual sales < RMB 800,000
No

Processing, repair and replacement

Annual sales < RMB 500,000
No

Yes Small-Scale VAT Payer

(Input VAT not creditable)

General VAT Payer

(Input VAT creditable)

Annual sales Annual sales

> RMB 5 million < RMB 5 million
(Compulsory VAT (Voluntary VAT registration
registration) but must have sound
financial system)

EXHIBIT 9.6 Overview of VAT Payers

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Exhibit 9.7 is a summary of the VAT implications between a General VAT Payer and a
Small-Scale VAT Payer.

General VAT Payer Small-Scale VAT Payer

Output VAT Yes, at different VAT rates depending on the 3%
types of goods or services being supplied
(see next section for various VAT rates)
Input VAT Yes, generally can claim as Input VAT credit No, Input VAT credit
mechanism is not available
Issue special VAT Yes No, except for those in pilot
invoices industries
Receive special VAT Yes No
invoices from supplier

EXHIBIT 9.7 VAT implications for General and Small-Scale VAT Payers

9.2.1.4 VAT Rates and Computations

Pursuant to Circular 39 and with effect from 1 April 2019, the VAT rates for General VAT Payers
are as in Exhibit 9.8.

No. Taxable activities VAT rate

1 Sales or importation of goods; provision of repairs, replacement and processing 13%
services; provision of leasing services of tangible movable assets; and taxable
activities other than those stipulated in Rows 2 and 5.
2 Sales or importation of specified goods (e.g. agricultural products, water, 9%
gas, etc.); provision of transportation, postal, basic telecommunication and
construction services; supply of immovable property leasing services; sales of
immovable properties; and transfer of land use rights, etc.
3 Provision of services and intangible assets, other than those detailed in Rows 6%
1, 2 and 5, such as financial and insurance services; value-added telecom and
internet data services, modern services and lifestyle services; and transfer of
intangible assets other than land use rights.
4 Reduced rate applicable to taxpayers other than General VAT Payers (e.g. 3%
Small-Scale VAT Payers); and specific supplies (e.g. provision of certain public
transportation services).
5 Export of goods, international cross-border supply of service and intangible 0%
assets as prescribed by the State Council.

EXHIBIT 9.8 VAT rates for General VAT Payers

Basic VAT Computation

As the name suggests, VAT is a tax on the value-added component in a supply chain process.
For a General VAT Payer, the VAT that it pays on its purchases of taxable goods is known
as Input VAT. After undergoing some form of processing, the goods may then be sold to
a consumer. The VAT charged by the General VAT Payer on the sale of goods is known as
Output VAT.

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There are two methods in calculating VAT payable:

(a) The general calculation method for ‘General VAT Payer’ and

(b) The simplified calculation method, which applies to ‘Small-Scale VAT Payer’.

General Calculation Method

VAT payable under the general calculation method is the current period Output VAT deducted
by the current period Input VAT:

VAT payable = Current Output VAT – Current Input VAT

Output VAT refers to the VAT amount calculated according to the sales turnover of the
taxable goods or services provided and the applicable VAT rate:

Output VAT = Sales Turnover × VAT rate

Sales turnover refers to the entire price and other charges obtained by the taxpayer
from sales made or provision of taxable services to customers. Where the taxpayer’s pricing
combines sales turnover with Output VAT, the taxpayer should use the formula below to
calculate the sales turnover:

Sales Turnover = Tax-inclusive sales turnover/(1 + VAT rate)

Input VAT refers to the VAT paid by the taxpayer when purchasing goods, receiving
processing, repair and replacement services as well as other taxable services, or purchasing
intangible or immovable properties. Input VAT that taxpayers can deduct from Output VAT
includes the VAT amount specified on:

• A special VAT invoice (including goods transportation industry VAT special invoices)
obtained from the seller;

• A Customs Import VAT Special Payment Document obtained from Customs in respect of
goods imported from abroad; or

• A tax payment certificate obtained from the tax authority or a Chinese agent for taxable
goods, services or properties provided by foreign entities or individuals (in this case, the
written contract, proof of payment and bill or invoice issued by the foreign entity are
also required).

As a General VAT Payer, VAT is treated as a pass-through business cost since the VAT is
borne by the final consumer (Exhibit 9.9).

With effect from 1 January 2009, Input VAT incurred on the purchase of fixed assets is
creditable and can be offset against the Output VAT of the taxpayer.

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Input VAT Output VAT

Raw materials supplier Manufacturer Final consumer

Note: Assume that the supplier and manufacturer are both registered General VAT Payers.

EXHIBIT 9.9: Impact of VAT on final consumers

Illustrative Example 1
A footwear manufacturer in China produces and sells sport shoes to customers in China.

Cost of materials purchased from domestic supplier in China is RMB 100.

Cost of other materials imported from overseas is RMB 50 (assuming the materials are
not subject to CT and import duty upon importation into China).

The footwear manufacturer sells the finished product in China for RMB 250.

All prices are exclusive of VAT at 13%.

Input VAT = 13% × (RMB 100 + RMB 50) = RMB 19.5

Output VAT = 13% × RMB 250 = RMB 32.5

VAT payable = RMB (32.5 – 19.5) = RMB 13

The footwear manufacturer is required to pay RMB 13 to the relevant tax authority in China
when filing its VAT returns. To the manufacturer, the VAT payable to the tax authority is a pass-
through cost, which is in effect borne by the final consumer.

If the current Output VAT amount is less than the current Input VAT amount, taxpayers can
carry forward the excess amount to the next filing period.

Where an overseas entity or individual provides taxable services in China and does not have
an operating establishment in China, its agent in China or the Chinese purchaser should act as the
tax withholding party and calculate the amount of tax to be withheld using the following formula:

Amount of tax to be withheld = Price paid by the service recipient/(1 + VAT rate) × VAT rate

Simplified Calculation Method

Under the simplified calculation method, no Input VAT is creditable and a uniform 3% levying
rate applies:

VAT payable = Sales Turnover × VAT levying rate (3%)

VAT Invoices (‘Fapiao’)

The selling price of the goods or services and the applicable VAT rates and amounts are shown
separately on ‘VAT Invoices’ (Exhibit 9.10). For the seller, the VAT on the invoice is treated as
Output VAT while for the buyer, it is treated as Input VAT.

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General VAT fapiao Special VAT fapiao

EXHIBIT 9.10 Example of VAT invoices

As shown in Exhibit 9.10, China has two types of VAT invoices:

(i) a general VAT fapiao and

(ii) a special VAT fapiao.

General VAT Payers can claim Input VAT based on a general or special VAT fapiao, while
Small-Scale VAT Payers are not allowed. In the case where the buyer requests a special VAT
fapiao, these Small-Scale VAT Payers are required to go to the tax bureau to purchase it before
issuing such an invoice to their customers.

Prevention of Fraudulent VAT Invoices

The STA issued the ‘Announcement of State Taxation Administration on the Issues Relating to
the Issuance and Administration of the Special Value-Added Tax Invoice’ (STA Announcement
[2012] No. 33) in order to prevent tax fraud due to fraudulent VAT invoices (e.g. claiming Input
VAT based on fraudulent VAT invoices to reduce VAT liability).

The above tax circular requires that companies supplying goods, services or transportation
services must be the same companies that issue VAT invoices to the purchasers, in order for
the purchaser to be able to claim an Input VAT credit. Where a written agreement between
a purchaser and a seller is available, the name of both parties should be consistent with the
details stated in the VAT invoices.

Improvement of the Internal Control and In-house VAT Invoice Administration

Under the China VAT regulations, taxpayers who knowingly issue fraudulent VAT invoices will be
severely punished. Apart from facing criminal charges, which carry heavy penalties, taxpayers
will also be denied when claiming the Input VAT credit. The stricter penalties should serve as a
good reminder for all taxpayers when setting up their internal control system and policies.

The disclosures in the invoice described above, such as details of both seller and purchaser,
description of goods and services provided, and amount subject to each VAT rate, would
enhance transparency and assist both seller and buyer in reporting the correct amount of
Output and Input VAT respectively.

Mixed Sales vs Concurrent Operation

Since China’s BT to VAT reform was fully implemented on 1 May 2016, the issue of determining
applicable tax rates for ‘mixed sales’ and ‘concurrent operation’ has been further clarified.

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For example, if a company sells and installs fire safety equipment, is the transaction taxed by
the VAT rate on sale of goods or sale of service?

Mixed Sales
Simply put, a sales transaction that involves both goods and services is defined as a ‘mixed
sale’. For example, a fire safety equipment manufacturer sells equipment to a client and, at the
same time, provides an installation service for the sold equipment. The applicable VAT rate in
this case depends on the main business activity that the entity is engaged in.

This can be analysed in two ways:

(a) First, the scope of business as outlined in the enterprise’s business license can
be verified.

(b Second, the proportion of annual sales revenue can be used as a good indicator. If
the revenue derived from sales of goods is more than 50% of the enterprise annual
income, then the total revenue should be taxed according to the applicable VAT rate for
those particular goods. The ancillary services that are provided in connection with the
sale of such goods will attract the same VAT rate as that particular category of goods
itself. However, if the revenue derived from sales of services is more than 50% of the
enterprise annual income, then the VAT rate applicable to the total revenue is based on
that particular category of services performed.

Concurrent Operation
An enterprise selling goods and/or providing services that are subject to VAT at the same time
is known as a ‘concurrent operation’. If the goods and taxable services are subject to different
applicable VAT rates, then the enterprise must account for the sales revenue and the respective
VAT rate for the goods and services separately. If not, the entire sales revenue will be subject to
the highest applicable VAT rate.

Illustrative Example 2
ABC Co. Ltd is a General VAT Payer. It sells edible vegetable oil which attracts a VAT rate of
9% and household appliances which attracts a VAT rate of 13% in its store. The selling price
of a bottle of vegetable oil is RMB 20. The refrigerator sells for RMB 5,000.

Where the sales amount and applicable VAT rates are shown separately, the invoice
would look like this:

Sales of edible vegetable oil (100 bottles) RMB 2,000

VAT 9% RMB 180
Sub Total (A) RMB 2,180
Sales of refrigerator (1 unit) RMB 5,000
VAT 13% RMB 650
Sub-Total (B) RMB 5,650
Grand Total (A+B) RMB 7,830

To the extent that ABC Co Ltd shows the detailed breakdown of the items in its VAT
invoice, the total Output VAT paid by the customer is RMB 830 (180 + 650). If not, the
higher rate, i.e. 13%, will apply to the total sales revenue.

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Apply and Analyse 1

Using the above example, Mrs. Chan, who is the accountant for ABC Co. Ltd, was very
busy that day and forgot to provide details of the items sold and their respective prices.
The invoice she issued to the customer reads 100 bottles of edible vegetable oil and
1 refrigerator for a total of RMB 7,000 (exclusive of VAT).

Analysis

Where there are sales for different types of goods with different VAT rates and the sales
price is consolidated as a single revenue, the seller is required to pay VAT based on the
higher rate, in this case 13%. In this situation, the customer will have to pay a total VAT of
RMB 910 (i.e. RMB 7,000 × VAT 13%). The VAT paid by the customer is higher by RMB 80
(i.e. RMB 910 – RMB 830).

Therefore, it is important for ABC Co. Ltd to ensure that the VAT invoice shows a proper
description of the items sold, separate prices and applicable VAT rates to ensure that its
customers are not paying excessively for the same items. This is especially critical when the
final consumers are not able to claim any VAT rebate, as the extra amount will represent a
final cost in that situation.

VAT Rate for Small-Scale VAT Payers

The applicable VAT rate is 3% for Small-Scale VAT Payers. However, unlike the General VAT
Payers, no input VAT can be claimed as credit.

For example, CAN China Limited is a Small-Scale VAT Payer and purchased a printer to use
in its business for a cost of RMB 1000 + 13% VAT for a total cost of RMB 1,130. Since CAN China
Limited is a Small-scale VAT Payer, it is not entitled to claim the VAT cost of $130 as Input VAT
credit. Instead, CAN China Limited will treat the total cost of RMB 1,130 as a business expense.

Import VAT
For the purpose of computing the VAT payable on goods imported into China, a taxpayer has to
determine the composite taxable value which includes the following:

(i) Customs dutiable price, including insurance and freight charges, if any, on which the
custom duty is paid;

(ii) Applicable custom duty; and

(iii) CT (where applicable).

VAT Exemptions
The following items are some examples of goods that are exempted from VAT:

• Agricultural products, such as crops, poultry, forestry, fisheries produced and sold by
agricultural producers

• Historical and second-hand books

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• Imported equipment for the purpose of scientific research, experiment and education

• Imported equipment and materials donated by foreign governments and international

organisations

• Imported goods for use by the disabled

• Contraceptive drugs and devices

Non-creditable Input VAT and other Input VAT Related Matters

Pursuant to Article 10 of the RPRVAT, Input VAT that is incurred in the following transactions is
not creditable or refundable:

• Transactions that are exempt from VAT

• Transactions that relate to goods or taxable services for personal consumption

or charity

• Expenses that result in extraordinary losses due to poor management

However, Circular 39 has provided the following three changes to reclaiming Input
VAT credit:

1. Accelerating the reclaim of Input VAT credit incurred by acquiring immovable properties

°° It overrides the original treatment of splitting the reclaim of Input VAT credit
incurred by acquiring the immovable properties in two-year’s time to have a one-off
recovery of the entire amount of Input VAT in the month of purchase.

2. Removing the restrictions imposed on reclaiming the Input VAT credit associated with
the purchase of passenger transportation services

°° With effect from 1 April 2019, the related Input VAT should be creditable so long the
creditable Input VAT amount is indicated on a VAT Special Invoice or VAT Electronic
General Invoice issued by the transportation service provider. If a VAT Special
Invoice or VAT Electronic General Invoice is not available but there are e-ticket
receipts of air transportation; or railway ticket; road, water and other transportation
tickets, with passenger’s personal identify information shown on the tickets, then
the creditable Input VAT amount would be determined by:

–– The ticket par value/(1 + VAT rate) × VAT rate

3. Introducing a Pilot Scheme to enable the qualifying General VAT Payers to claim partial
refund of excessive Input VAT credit

°° The current VAT regime of the PRC does not generally allow a refund of excessive
Input VAT credit incurred in a reporting period. Instead, such excessive Input VAT
credit amount may be carried forward to offset against Output VAT for future
reporting periods.

°° To be able to qualify for this Pilot Scheme, a General VAT Payer/exporter must not
have adopted the ‘Exempt and Refund’ as its export VAT refund method, and it must
meet all of the following conditions:

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–– Commencing from the VAT filing period of April 2019, the incremental excessive
Input VAT credit is more than zero for six consecutive months (or a consecutive
of two quarters if it is on a quarterly filing basis) and the incremental excessive
Input VAT credit at the end of the sixth month is RMB 500,000 or more. The
incremental excessive Input VAT credit refers to the incremental amount by
comparing the Input VAT credit balance at the end of a VAT filing period against
that on 31 March 2019.

–– The General VAT Payer has a VAT compliance credit rating of A or B.

–– There is no offence of tax fraud and tax non-compliance in association with the
handling of excessive Input VAT credit, the export VAT refund, and the issuance
of VAT Special Invoice for the 36-month period prior to the application.

–– The General VAT Payer has not been penalised for two or more times by the tax
authorities in respect of any tax evasion within the 36-month period prior to the
submission of the application.

–– The General VAT Payer has not enjoyed any VAT preferential treatments since
1 April 2019.

°° The formula for computing the permissible refundable amount of excessive input
VAT credit is:
–– Incremental amount of excessive input VAT credit × Input VAT Ratio × 60%.

–– Where the Input VAT Ratio is defined to be the percentage of (a) to (b), where:

(a) Is the aggregate of the creditable Input VAT supported by the following
documents:

–– VAT Special Invoices (including the unified invoice for the sale of motor
vehicles),

–– customs import VAT certificates; and

–– withholding tax payment receipt.

(b) Is the total amount of creditable input VAT for the period from 1 April 2019
till the end of the VAT assessment period prior to the application of the
Pilot Scheme.

Timing of Output VAT Payment

The legal obligation to remit VAT payment relating to the supply of goods and taxable services
largely depends on the methods of payment, which are outlined below:

(i) Supply of goods for commercial use

(a) Cash on Delivery (Direct payment) – when the payment is received or legal title to
the goods has passed from seller to buyer, whichever is the earlier.

(b) Payment by credit or instalment – when the instalment payment is received in

accordance with the written contract.

(c) Advance payment – when the goods are delivered.

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(ii) Supply of goods for personal consumption – when the goods are delivered for
personal use.

(iii) Supply of labour services – when such services are provided and payment is received or
the date stated in the written contract when such payment is legally due for collection,
whichever is earlier.

(iv) Supply of imported goods – on the declaration date at the point of entry at the customs.

(v) Deemed sales – on the date when the legal title to the goods is transferred from the
seller to the buyer.

Timing of Input VAT Payment

There are two conditions which the General VAT Payer has to satisfy when claiming the
Input VAT:

(i) Tax authority has verified the electronically issued VAT invoice; and

(ii) The Input VAT is claimed within 180 days from the date of the invoice.

Group VAT Registration

On 31 December 2012, the MOF and the STA published new details of how businesses
operating multiple VAT-registered subsidiaries may apply for VAT grouping for the purposes of
reporting and payments (Caishui [2012] No.84) (Circular 84).

The aim of this tax circular was to help improve the Chinese VAT compliance environment
and improve cash flows for VAT registered companies.

The new procedures will consolidate the VAT administration where companies have
divisions of branches located in any of the 30+ administrative or provincial areas. It will also
enable the off-setting of VAT liabilities in one jurisdiction against any credits due in another
region. The reporting obligations are assigned to the head office of the group, which will report
all VAT transactions to its local STB.

On 16 November 2013, the STA issued Caishui [2013] No.74, which superseded Circular 84.
Where each branch of a company is considered as an independent VAT taxpayer, subject
to the approvals from the MOF and STA, the designated company may apply for Group VAT
registration status and consolidate its Output and Input VAT between all its branches and
subsidiaries in China. The said company is then required to remit the net VAT payable (if any) at
the STA office where the head office is located.

9.2.1.5 VAT Filing
Most taxpayers submit monthly VAT returns by the 15th of the following month. However,
some are required to file more regularly when involved in certain business activities.

Taxpayers have the option to file VAT returns either every 1 day, 3 days, 5 days, 10 days,
15 days, monthly or quarterly, depending on their activities. While these timeframes may be
imposed, in reality the authorities generally agree to a reasonable request by a company.

Taxpayers should note that the main VAT filing form and the five appendices are mandatory
forms to be submitted:

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• VAT filing return (main form);

• Appendix 1 – Details of sales for current period;

• Appendix 2 – Details of Input VAT for current period;

• Appendix 3 – Details of deductible items for taxable services, immovable property and
intangible assets;

• Appendix 4 – Details of prepaid and reduced VAT; and

• Appendix 5 – Details of immovable property subject to phased VAT credit approach.

Key Learning Point

The primary target in a VAT regime is the end consumer who should bear the final tax as
they consume these taxable goods and services. Therefore, VAT is seen as a pass-through
cost to VAT registered taxpayers other than the administration costs of issuing Special VAT
invoices and meeting its filing obligations.

9.2.2 Consumption Tax (CT)

As mentioned briefly in the opening paragraph of Section 9.2, upon the finalization and
implementation of the China VAT reform on 1 May 2016, CT has become one of the two major
indirect taxes in China. It is imposed on all individuals and enterprises that manufacture
and import taxable products, process taxable products under consignment or sell
taxable products.

The current CT regime is governed by the Revised Provisional Regulations on CT of the PRC
promulgated by the State Council on 10 November 2008 (State Council Order No. 539), the
Revised Implementing Rules jointly issued by the MOF and STA on 18 December 2008 (MOF and
STA Joint Order No. 51) and the relevant tax circulars issued subsequently. Both the Revised
Provisional Regulations on CT and the Implementing Rules were effective from 1 January
2009 onwards.

In an attempt to elevate the legislative form of the current CT regime, the MOF and STA
jointly released a Public Consultation Document for the PRC CT Law on 3 December 2019.
The consultation period was opened to the general public until 2 January 2020. It is expected
that the draft CT Law will be fine-tuned with the comments received before finalisation for
enactment by the NPC, although no clear timeline for completing the enactment procedures
has yet been indicated.

9.2.2.1 Taxable Products
There are five categories of products on which CT is levied:

• Products whose over-consumption is harmful to health, social order and the

environment (e.g. tobacco, alcohol and fireworks)

• Luxury and non-essential goods (e.g. cosmetics and precious jewelry)

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• High-end products or products with high energy consumption (e.g. road vehicles)

• Non-renewable and non-replaceable petroleum products (e.g. gasoline and diesel oil)

• Environmentally unfriendly goods (e.g. tyres for motor vehicles)

CT, which are levied only once, applies whenever the above categories of goods are
manufactured, processed or imported. The tax paid is computed directly as a cost and cannot
be refunded. The exception, in rare cases, is upon the receipt of a CT special invoice from the
domestic supplier for CT paid for exported goods.

In addition, CT is part of the base upon which VAT is levied. A company processing taxable
goods for others is liable to withhold and pay CT based on the value of the raw materials used.
CT is usually filed and paid monthly.

9.2.2.2 Tax Rates and Computations

CT is generally imposed on manufacturers and the importation of certain types of consumer
goods, including tobacco and alcohol, high-end cosmetics, jewelleries, gasoline and many
others. Some of the common items that are subject to CT in China can be found in the
table below.

In October 2016, the MOF and the STA jointly announced that the CT on higher-end
products would be reduced from 30% to 15%. The majority of these high-end cosmetic
products are generally sold by foreign manufacturers in China. Most domestically produced
cosmetic products, however, enjoy as little as zero CT.

Tax rates vary considerably with the type of product in question (Exhibit 9.11).

Taxable items Tax rate

Alcohol
Beer (Type A) RMB 250/ton
Beer (Type B) RMB 220/ton
White spirits 20% + RMB 0.5 per 500g/ton
Yellow spirits RMB 240/ton
Other alcoholic drinks 10%
Alcohol 5%
Tobacco
Grade A cigarettes (includes imported) 56% or RMB 150 per box (250 cartons)
Grade B cigarettes (includes imported) 36% or RMB 150 per box (250 cartons)
Cigars 36%
Cut tobacco 30%
Precious jewellery, stones and metals
Gold, silver, platinum, diamonds 5%
Other precious jewellery, stones and metals 10%

EXHIBIT 9.11 CT rates in China

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Taxable items Tax rate

Luxury products
Luxury cosmetics (including high-end skincare products) 15%
Luxury watches 20%
Golfing equipment 10%
Yachts 10%
Wood products
Solid wood flooring 5%
Disposable wooden chopsticks 5%
Refined oil
Gasoline (leaded and unleaded), naptha, solvent naptha, RMB 1.52/litre
lubricant oil
Diesel oil, fuel oil RMB 1.20/litre
Aviation kerosene RMB 1.20/litre (temporarily exempted)
Vehicles
Motorcycles (cylinder capacity of over 250 ml) 10%
Small to medium-sized commercial vehicles 5%
Passenger cars (by cylinder capacity)
1 litre and below 1%
1 to 1.5 litres 3%
1.5 to 2 litres 5%
2 to 2.5 litres 9%
2.5 to 3 litres 12%
3 to 4 litres 25%
Above 4 litres 40%
Others
Firecrackers and fireworks 15%

EXHIBIT 9.11 (Continued)

CT is calculated ad valorem or based on quantity. The formulae are:

(a) Ad valorem:

CT payable = Taxable sales amount × Tax rate

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Illustrative Example 3
RMB 10 million worth of motor vehicles was sold by a car manufacturer in a month. The
applicable CT rate is 5%:

CT payable = RMB 10 million × 5% = RMB 500,000

(b) Quantity-based:

CT payable = Taxable sales quantity × Tax amount per unit

Illustrative Example 4
100,000 liters of unleaded gasoline was sold by a gas company in a month. The applicable
consumption tax rate is RMB 1.52/liter.

CT payable = 100,000 liters × RMB 1.52/liter = RMB 152,000

9.2.2.3 CT Rebate
No CT is payable on export of goods. The CT paid upon goods that were previously imported
into China is refundable. For goods that are VAT exempt, CT is also exempt. However,
previously paid CT is neither refundable nor creditable from CT payable for domestically
sold goods.

Knowledge Check Questions

Question 4
ABC China Limited (‘ABC’) is a General VAT Payer and sells mobile phones to domestic
customers in China. For the month of March 2020, ABC sold mobile phones worth RMB
500,000 exclusive of VAT. ABC’s production costs for these sales were RMB 200,000 before
VAT. Assume a VAT rate of 13%.
(i) Calculate the total Output VAT on the sales for the month of March 2020.

(ii) Calculate the net VAT payable or credit for the month of March 2020.

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9 . 3 CORPORATE INCOME TAX

For the purpose of this chapter, please note that the words ‘enterprise’ and ‘corporate’ are used
interchangeably.

Effective from 1 January 2008, all enterprises (resident and non-resident enterprises,
referred to as enterprises only from here) deriving income within the territory of mainland
China are subject to income tax under:

• Law of the PRC on Corporate Income Tax (CITL) (Presidential Order No. 63); and

• Implementing Rules of the Corporate Income Tax Law (CITLIR) (State Council
Order No. 512).

Essentially, the 2008 CITL combines the previous sets of separate income tax laws for
the domestic-invested enterprises and FIEs respectively into a single income tax regime
(Exhibit 9.12).

Standard CIT rate 25%

Branch tax rate 25%
Capital gains tax rate 25%
Basis of taxation Worldwide (For tax resident enterprises)
Tax year Calendar
Participation exemption No
Loss relief
• Carry forward 5 years
• Carry backward No
Double tax relief Yes
Tax consolidation No
Transfer pricing rules Yes
Controlled foreign companies (CFC) rules Yes
Thin capitalisation rules Yes
Advance payment of tax Yes
Tax return due date 5 months from end of the tax year

EXHIBIT 9.12 Quick summary of China tax facts

STA has issued various notices and circulars to clarify the transitional rules for the old
income tax system as well as to assist the interpretation of the CITL and the CITLIR (both of
which came into effect on 1 January 2008).

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9.3.1 Tax Resident Enterprise

Tax resident enterprise (TRE) is a new concept under the 2008 CITL. Basically, if an enterprise is
established in China, it is treated as a TRE in China. Moreover, if a foreign enterprise is established
in accordance with its applicable foreign laws but the actual place of effective management is in
China, such a foreign enterprise is deemed to be a TRE in China for China tax purposes.

The CITLIR defines the ‘place of effective management’ as the place where the substantial
and overall management and control of the production and business operations, personnel,
accounting, properties and so on are located.

The standard CIT rate for TRE is 25% unless it enjoys tax incentives that may reduce such
rate accordingly.

9.3.2 Non-tax Resident Enterprise

Pursuant to Article 2 of CITL, a ‘non-tax resident enterprise’ (non-TRE) is defined as an
enterprise that is established under the laws of a foreign country and whose place of effective
management is located outside China but which:

1. Has an establishment or place of business operation in China; or

2. Does not have an establishment or place of business operation in China, but derives
income from sources within China.

Notwithstanding that a foreign enterprise is established under its foreign laws and the
place of effective management is outside of China, it may still be exposed to China’s income
tax liability if it derives China-sourced income regardless of whether it has an ‘establishment’ in
China or not.

Pursuant to Article 5 of the CITLIR, an ‘establishment’ in China is defined as follows

(Exhibit 9.13):

• A place of management or operation.

• A farm, factory or place of extraction of natural resources.

Place of management and control Place where services are performed

Farm, factory, mine Establishment Construction and installation

Manufacturing site Business operation site

Business agent

EXHIBIT 9.13 Places defined as ‘establishments’

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• A place where services are rendered and performed.

• A place of construction, installation, assembly, repair and exploration.

• Business agents.*

• Other similar place which is used for manufacturing and business operation activities.

* The term ‘business agent’ is specifically defined as any enterprise or individual who is commissioned by
a non-tax resident enterprise to carry out production and business activities in China, including:

• Regularly signing contracts on the non-tax resident enterprise’s behalf; or

• Regularly storing products or goods owned by the principal and delivering the products or goods
to other parties on the non-tax resident enterprise’s behalf (CITLIR, Art. 5).

9.3.3 Scope of Tax Liability

9.3.3.1 Tax Resident Enterprises
Pursuant to CITL, Article 3, a TRE is subject to CIT for income derived from within and
outside of China.

9.3.3.2 Non-tax Resident Enterprises

The income of a non-TRE is subject to CIT if the following conditions are met:

1. Has an establishment in China and derives China-sourced income and/or offshore

income that is effectively connected with the establishment in China;

2. Has an establishment in China, and derives China-sourced income which is not

effectively connected with the establishment in China (subject to tax by way of
withholding); and

3. Has no establishment in China, but derives China-sourced income (subject to tax by way
of withholding).

9.3.4 Withholding Tax on Non-tax Resident Enterprise

Under the prevailing CITL, China-sourced passive income earned from China by non-TREs
(i.e. non-TREs under items 2 and 3 of Section 9.3.3.2 above) would be subject to a withholding
tax rate of 20%. However, under the CITLIR, this rate is unilaterally reduced to 10%. The rate
may be further reduced if the recipient is a resident of a jurisdiction that has entered into
an avoidance of double taxation agreement/arrangement with mainland China (i.e. DTA or
tax treaty).

The concessionary tax rate of 10% is applicable to the following common types of
passive income:

1. Dividends;

2. Interest;

3. Royalties;

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4. Rental; and

5. Gains from sale or transfer of real property in China, land use right and shares in a
China incorporated company.

The tax payable on income derived by non-TRE should be withheld at the source, with
the payer (i.e. the Chinese enterprise who remits the income to the overseas non-TRE) as the
withholding tax (WHT) agent.

The formula for calculating the WHT liability is:

Tax payable Taxable income WHT rate

Dividends distributed by an FIE out of its pre-2008 profit is exempted from WHT. However,
for dividend distribution out of its post-2008 profit, a reduced WHT may apply under the
relevant tax treaties with China.

9.3.4.1 Filing Procedure for Withholding Corporate Income Tax

The STA released Announcement (2017) No. 37 on ‘Issues Concerning the Withholding of
Corporate Income Tax at Source of Non-resident Enterprises’ (Announcement 37), which
replaced a series of circulars and provisions in respect of WHT on non-TREs, which came into
effect on 1 December 2017.

Record Filing Procedure

Previously, the WHT agent was required to complete a record filing procedure with the relevant
tax authority in charge in the location where the business transaction was carried out (known
as the ‘supervising tax authority’), including registration of the relevant contract within 30 days
of the contract being executed. This filing requirement has been removed unless specifically
requested by the supervising tax authority or otherwise required by law.

Payment by Instalments
Previously, WHT agents were required to obtain tax authority clearance at least 15 days before
the final instalment payment was due for payment. However, Announcement 37 abolishes
the requirement for WHT agents to conduct final clearance and settlement procedures for
contracts with multiple instalment payments. This certainly alleviates most of the compliance
burden imposed on the WHT agents.

Timing of Withholding Tax Payments

With regards to dividend distribution to non-resident parent, WHT obligations arose on the
date on which a board decision was made to declare dividends. Announcement 37 now clarifies
that a WHT obligation only arises on the date of actual payment of dividends out of China.

Where payment relating to an asset sale is paid in instalments, the tax law will treat the
investment cost as being recovered first, followed by the disposal gains if any. Therefore, since
WHT is applicable on the gains from such disposal, there is a possibility that WHT obligation will
be deferred accordingly.

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Withholding Tax Settlement Periods

Where the WHT agent fails to pay the correct amount of WHT, Announcement 37 abolishes the
requirement for the non-TRE to file and pay any underpaid tax within seven days of the original
WHT obligation arising. The new guidance provides that the non-TRE is permitted to settle the
WHT owing when he or she receives the instruction from the tax authorities.

In addition, where a WHT agent fails to withhold tax when payment is made to a non-TRE,
the supervising tax authorities may make the WHT agent liable for the unpaid tax rather than
the non-TRE.

Exhibit 9.14 shows an overview of the new WHT procedures.

Contract registration
(Not required from 1 January 2018 3–5 working days
except for onshore service contract)

Tax assessment 15–20 working days

Treaty benefit application

7–10 working days*
(if applicable)

WHT filing and payment 2–3 working days*

Payment registration
(if applicable, depending on 3–5 working days
the payment amount)

*Procedures might be subject to variation in different regions.

EXHIBIT 9.14 New withholding tax compliance

procedures

9.3.5 Corporate Income Tax Calculation

In calculating the ‘taxable income’ of TRE, or non-TRE that has an establishment in China
and derives China-sourced income and/or offshore income that is effectively connected
with the establishment in China, the CITL and CITLIR specifically prescribe those items that
may be deducted from the ‘gross income’ and clarify the scope of deduction permitted for
certain items.

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This section is not intended to look exhaustively at all kinds of taxable income and
deductions. However, we do look at common types of taxable income, expenses that have
certain deduction limits and the loss carry forward rules.

9.3.5.1 Calculation of Net Taxable Income

Pursuant to CITL, Article 5, CIT is charged on an annual basis on a taxpayer’s net taxable
income, which is calculated as follows:

Gross income
Less: Non-taxable income (Non-TI)
Less: Tax-exempt income
Less: Permitted deductions
Less: Losses brought forward from prior years
= Net taxable income

Illustrative Example 5
ABC Enterprise Ltd is established in China and has a gross income of RMB1 million for
the year ended 31 December 2020. Included in the above gross income are an approved
government subsidy of RMB200,000 (see Caishui (2011) No. 70) and interest income of
RMB50,000 from bonds issued by local government (see Caishui [2013] No. 5). Salary,
general operating expenses and other permitted deductions amounted to RMB500,000.
Accumulated losses brought forward from 2019 amounted to RMB100,000.

For China CIT purposes, ABC’s taxable income for the year ended 31 December 2020 is
calculated as follows:

RMB
Gross income 1,000,000
Less: Approved government subsidy (200,000)
Interest income from government bond (50,000)
Deductible expenses (500,000)
Taxable income 250,000
Less: Prior year’s losses b/f (100,000)
Net taxable Income 150,000
China CIT payable at 25% 37,500

Tax rate and applicable deductions are subject to changes in accordance with
prevailing tax policy.

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Apply and Analyse 2
Using the preceding example, included in the deductible expenses of RMB500,000 is
interest expense of RMB100,000 that ABC Enterprise Ltd paid to its Hong Kong-related
company, LKS (Hong Kong) Ltd (LKS). During the year in which the interest payment was
made, LKS held 10% common shares of ABC Enterprise Ltd. Mr. Chan, who is the finance
director of ABC Enterprise Ltd, is required to determine the appropriate WHT amount to be
remitted to the China tax authority.

In order to determine the applicable WHT rate on the above interest payment,
Mr. Chan needs to refer to Article 11 of the Hong Kong–China DTA. There are a few
facts to note:

(a) Unlike dividend WHT rate under the DTA, there is no limitation on the percentage
of shareholding held by LKS in ABC Enterprise Ltd.

(b) LKS has to be a tax resident company in Hong Kong for the purpose of the DTA.
This is generally the location of management and control of LKS.

(c) LKS has to be the beneficial owner of the interest income it receives from ABC
Enterprise Ltd, in order to benefit from the specific article of the DTA. Generally,
the beneficial owner of such income means that LKS has the full authority and
discretion to utilise such proceeds in a manner it deems fit, and it is not set up as a
conduit vehicle to take advantage of the lower treaty rate.

If the above requirements are satisfied, the applicable WHT rate under the Hong Kong–
China DTA is 7%.

9.3.5.2 Gross Income
Pursuant to CITL, Article 6 and CITLIR, Article 14 to Article 22, the following items are included in
a taxpayer’s ‘gross income’:

• Revenue from sales of goods.

• Revenue from provision of labour services.

• Gross proceeds from the transfer of property.

• Dividend income and other distributions with respect to equity interests.

• Interest income.

• Rental income.

• Royalty income.

• Revenue from donations (monetary and non-monetary assets) received from other
enterprises, organisations and individuals without any consideration in exchange.

• Other income – All income other than those listed above are to be included in the
taxpayer’s gross income. For example, recovery of bad debts, subsidies, income from
breach of contracts (e.g. penalty), exchange gains, etc.

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9.3.5.3 Non-taxable Income
Examples of non-taxable income referred in the CITL shall include:

• Regulated governmental funding as provided in the state budget unless stipulated

otherwise by the State Council;

• Official receipts and administrative charges collected by an enterprise on behalf of the

government for special purpose in accordance with relevant laws and included under a
governmental budget system;

• Other non-taxable income as stipulated by the State Council (CITL, Art. 7; CITLIR, Art. 26).

To the extent that all of the following requirements are satisfied, such funding is treated as
tax-exempt income and shall be deducted from gross income when taxable income is calculated:

• Documentary proof issued by government authorities that state the purpose of

such funding;

• Relevant administrative measures are available for the application of such funding; and

• Enterprises keep a separate, proper bookkeeping on the funding and related expenses.

While the government funding is treated as tax exempt, the related expenses are treated
as non-deductible against the enterprise’s taxable income, including any depreciation of fixed
assets acquired using such funds.

9.3.5.4 General Deductions
Pursuant to CITL, Article 8, actual costs and expenses that are reasonably incurred directly
in connection with the income generated by the enterprise are deductible when computing
taxable income, including certain type of taxes and losses.

The following are some examples of permitted deductions mentioned above:

• Costs – Cost of sales, services and other expenditures related to manufacturing or

business operation (CITLIR, Art. 29).

• Expenses – Selling expenses, finance charges, general and administrative expenses

related to manufacturing or business operation (CITLIR, Art. 30).

• Taxes – Various taxes and surcharges other than CIT and creditable VAT (CITLIR, Art. 31).

• Losses – Losses from ordinary course of business, losses from natural disasters

or other force majeure and other losses incurred during production and business
operations (CITLIR, Art. 32).

Capital expenditure is not deductible on a current year basis, but should be capitalised and
subject to depreciation or amortisation (CITLIR, Art. 28).

9.3.5.5 Other Limited Deductions

In order to ensure the reasonableness of certain expenses that are incurred in the ordinary
course of business and claimed as deduction, there are certain limitations imposed on some
common types of expenses:

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1. Entertainment, advertising and promotional expenses

• Entertainment expenses – 60% of entertainment expenses are deductible subject to

a maximum of 0.5% of the sales revenue for the current tax year (CITLIR, Art. 43).

• Advertising and promotional expenses – Deductible up to 15% of the sales revenue

for the current tax year, unless stipulated otherwise by the relevant tax authority.
Any excessive amount is allowed to be carried forward to the following tax years for
deduction within the deduction limit (CITLIR, Art. 44).

2. Management fees

Management fees that are related to corporate reorganisation and stewardship

functions are not deductible.

However, expenses paid by the Chinese establishment or place of business of a foreign

enterprise to its overseas head office in connection with the production or business
operations of such establishment or place of business may be permitted for deduction.

To qualify for the deduction, the taxpayer must have supporting documents from
its overseas head office certifying the scope of the expenses involved, the total amount,
and the basis and method of allocation.

3. Interest expenses

a. Interest payments on loans from financial institutions,

• Deductible when incurred for the purpose of production and business operation.

b. Interest payments on loans from non-financial institutions,

• Deductible when incurred for the purpose of production and business

operation and interest rates do not exceed the rates charged by financial
institutions for similar loan terms and conditions (CITLIR, Art. 38).

c. Interests incurred on purchases of fixed assets and intangible assets prior to

such assets being put into use, or inventories that are unlikely to be sold within
12 months,

• Not deductible and should be capitalised as part of the asset value and
depreciated over its economic useful life (CITLIR, Art. 37).

4. Exchange losses

These are deductible under the following situations:

a. Exchange losses incurred due to trading in foreign currency transactions.

b. Exchange losses incurred due to conversion of assets and liabilities denominated in

foreign currency into Renminbi at the end of the tax year provided it uses the year-
end middle spot exchange rate.

Please note where exchange losses are incurred as a result of profit distribution to
shareholders, these are not deductible for China tax purposes (CITLIR, Art. 39).

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5. Charitable donations

Pursuant to CITL Article 9, an enterprise may claim qualified donations of up to 12% of

its annual profit as deductible expenses.

‘Annual profit’ is defined as the accounting profits for the year before income tax
calculated in accordance with the relevant accounting standards (CITLIR, Art. 53).

‘Qualified donations’ are defined as those contributed by an enterprise through

public interest social organisations as stipulated by the ‘Public Welfare Donation Law of
the PRC’ (CITLIR, Art. 51).

6. Research and development expenses (R&D)

In order to encourage enterprises established in China to carry out advanced

technological development, including intellectual property ownership, a ‘super
deduction’ of 175% of R&D expenses incurred during the development of new
technologies, new products or new production techniques is available to taxpayers
(CITL, Art. 30; CITLIR, Art. 95).

If the R&D expenses are capitalised as intangible assets, a 175% of actual costs are
allowable for amortisation purposes (CITLIR, Art. 95).

7. Tax losses

Tax losses incurred by enterprises in a tax year may be carried forward for five
years to set off against its future taxable profits. Carry back of losses is not allowed
(CITL, Art. 18).

8. Foreign tax credit (FTC)

A foreign tax credit is available to TRE for the foreign tax paid on income derived from
overseas based on a ‘country-basket’ principle. However, the FTC is limited to the
amount of China tax that otherwise would have been payable in China in respect of the
foreign-sourced income. Excessive FTC can be carried forward for five years to offset
CIT liability (CITL, Art. 23; CITLIR Art. 79).

9. Controlled foreign corporation (CFC)

A CFC is an enterprise established or incorporated outside of China by a TRE in China

(e.g. an overseas subsidiary of a China parent company). CFC rules are introduced to avoid
the China parent company from ‘parking’ its undistributed profits (e.g. dividends from
its overseas subsidiaries) offshore hence avoiding the imposition of China income tax.
This is particularly common where the CFCs are located in those lower-taxed jurisdictions
than China.

Therefore, under the China CFC regime, where an overseas subsidiary has
undistributed profits generated in a low tax jurisdiction with an effective tax rate lower
than 12.5%, such profits will be taxed in China as deemed distribution to the parent
company in China.

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10. Thin capitalisation rule

Thin capitalisation or debt–equity rule refers to the disallowance of interest expense

arising from excessive related party loans compared to the invested equity in the China
enterprise. This helps to prevent profit stripping from a higher to lower tax jurisdiction.

The safe harbour debt–equity ratio in China is 5:1 for financial industry and 2:1 for
other industries. However, if there is sufficient proof and documentation to support
the higher amount of debt permitted and the transaction is carried out at arm’s length,
the interest expense may still be fully deductible, notwithstanding that the debt–equity
ratio is exceeded.

Apply and Analyse 3
For the purpose of this analysis, each of the following is a separate transaction carried out
by Merlion Singapore Pte Ltd (MSPL), a company incorporated in Singapore. Its place of
effective control and management is in Singapore.

Identify which portions of the profit from the transactions below are subject to tax in
China and calculate the CIT liability.

a. MSPL manufactured watches in Singapore and sold them to its Chinese customers
for RMB10,000,000 and earned a profit of RMB3,000,000. MSPL does not have a
permanent establishment (PE) in China.

b. BigWatch China Limited acquired the technical know-how from MSPL to

manufacture luxury watches in China and paid an annual royalty to MSPL of
RMB1,000,000. Assume WHT rate of 10%.

c. In 2010, MSPL purchased the shares of a Shanghai-based company which

manufactures the spare parts for the watch sold by MSPL. In 2019, MSPL sold
the shares held in the above company for RMB10,000,000 and made a gain of
RMB3,800,000.

d. As there were some technical problems in BigWatch China Ltd, MSPL was required
to send two of its technicians to China and assist BigWatch China Ltd. MSPL created
a PE in China as a result of this technical assistance.

MSPL was paid a fee of RMB500,000 (tax inclusive) on the provision of services in
China and was assessed a deemed profit rate of 30% on the service fee by the China
tax authority.

Analysis

a. The profit of RMB3,000,000 is not subject to tax in China as MSPL is incorporated

and a tax resident company in Singapore. MSPL does not have a PE in China.

b. The royalty payable to MSPL is subject to CIT

RMB1, 000, 000 10% RMB100, 000

c. The gain on the disposal of the China company’s shares is subject to CIT

RMB3, 800, 000 10% RMB380, 000

d. CIT on the provision of service = (RMB500,000 × 30%) × 25% = RMB37,500

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Apply and Analyse 4
Concrete China Ltd (CCL) is in the business of developing spa and entertainment complex
in China. Its income is subject to CIT at 25%. CCL’s parent company, Concrete BVI Inc (CBVI)
is incorporated and a tax resident in the British Virgin Islands. In 2020, CCL’s average net
equity for the year amounted to RMB10,000,000.

You are the in-house tax specialist of CCL and have made a recommendation to the
management to maximise the debt of CCL by borrowing a loan from CBVI. In order to meet
the arm’s length test, the inter-company loan will bear an interest rate of 7%.

Assume a WHT rate of 10% on interest payment between China and BVI and thin
capitalisation rule of 2 : 1 (debt/equity).

Required:

a. Calculate the maximum amount of loan CCL can borrow from CBVI.

b. Calculate the WHT on the annual interest income payable by CCL to CBVI if the
maximum amount of loan is borrowed.

c. Assuming CCL took a loan of RMB25 million, calculate the non-deductible interest
payable by CCL in 2020.

Analysis

a. Maximum amount of loan = RMB10 million × 2 = RMB20 million

b. Annual interest income (RMB20 million × 7%) = RMB1.4 million

WHT = 10% × RMB1.4 million = RMB140,000

c. Non-deductible interest = RMB5 million × 7% =RMB350,000

11. General anti-avoidance rule (GAAR)

China implements a GAAR provision as part of its tax laws that gives the tax authority
the power to adjust taxpayers’ taxable income or revenue where it believes that the
taxpayers carried out their business arrangement with a primary motive to avoid,
reduce or defer their tax liability.

Subject to the approval of STA, the relevant tax authorities may launch the GAAR
audit and investigation if they believe the taxpayers are suspected of abusing the
following:

• Preferential tax treatments;

• Tax treaties;

• Corporate structure;

• Use of tax havens to avoid or reduce taxes; and

• Absence of commercial intent.

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Apply and Analyse 5
High Tech China Ltd (HTCL) is engaged in the development and manufacture of
cutting-edge sonar equipment for underwater exploration projects. For China CIT
purposes, HTCL has been granted a high-tech status and it qualifies for a reduced
CIT rate of 15% for all of its income.

HTCL has two overseas subsidiaries in Singapore (SG Ltd) and Canada (CAD Ltd) that
act as its main distributors for the Asian and North American markets, respectively.

On 21 February 2020, HTC received dividend income from these overseas subsidiaries:

SG Ltd CAD Ltd

RMB RMB

Net assessable income before tax 10,000,000 8,000,000

Overseas corporate tax paid (1,700,000) (2,120,000)
Net income after tax 8,300,000 5,880,000
Dividend paid to HTCL 5,000,000 3,000,000
WHT paid in foreign countries (250,000) (150,000)
Dividend (net of tax) received by HTCL 4,750,000 2,850,000

Required:

You are the in-house tax specialist of HTCL and have been asked to determine the CIT
payable for the tax year ended 30 June 2020 with regard to overseas dividend income
received above. Please indicate any foreign tax credit available to HTCL and the amount
carried forward.

Analysis

SG Ltd

Gross-up dividend received from SG Ltd (before WHT rate of 5%)

RMB4 , 750, 000 0.95 RMB5, 000, 000

Additional gross-up dividend (net of underlying Singapore corporate tax rate of 17%)

RMB5, 000, 000 0.83 RMB6, 024 , 096

Total overseas tax paid in Singapore = RMB6,024,096 − 4,750,000 = RMB1,274,096.

RMB
CIT payable (RMB6,024,096 × 15%) 903,614
Less: Foreign tax credit (1,274,096)
CIT payable NIL
Tax credit carried forward (370,482)

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Apply and Analyse 5 (continued)

CAD Ltd

Gross-up dividend received from CAD Ltd (before WHT rate of 5%)

RMB2, 850, 000 0.95 RMB3, 000, 000

Additional gross-up dividend (net of underlying Canada corporate tax rate of 26.5%)

RMB3, 000, 000 0.735 RMB4 , 081, 633

Total overseas tax paid in Canada = RMB4,081,633 − 2,850,000 = RMB1,231,633

RMB
CIT payable (RMB4,081,633 × 15%) 612,245
Less: Foreign tax credit (1,231,633)
CIT payable NIL
Tax credit carried forward (619,388)

9.3.6 Tax Incentives

Compared to the previous set of CIT laws applicable only to FIEs and foreign enterprises (FEIT
Law), CITL does not provide any tax preferential treatments for corporations classified as export-
oriented because such tax incentives were perceived to be in violation of the WTO principles.
Furthermore, the reinvestment tax refund provisions under the FEIT Law were abolished in CITL.

The CITL also indicates a shift of policy to providing tax incentives targeted at corporations
engaged in certain designated sectors, rather than on the basis of their geographical locations.
Instead, the CITL provides qualifying corporate taxpayers other tax incentives in the form
of exemption or reduction of CIT, reduction in taxable income, CIT credits and subsidies or
accelerated expenditure deductions, etc.

Generally, the CITL provides tax incentives in the following forms (with examples provided):

(a) Reduction of tax rate

• E.g. qualified new/high-tech enterprises are eligible for a reduced CIT rate of 15%.

• E.g. qualified key software entities and integrated circuits design corporations,
which are not subject to any tax exemption treatments, are eligible for a reduced
CIT rate of 10%.

(b) Tax reduction or exemption

• E.g. income derived from qualified projects engaged in agriculture, forestry,
animal-husbandry and fishery sectors is eligible for either CIT exemption or 50%
reduction.

• E.g. income derived from qualified projects of public infrastructure is eligible for a
‘3+3 tax holiday’ (which means the first three years of CIT exemption followed by the
subsequent three years of 50% reduction of applicable CIT starting from the first
income generating year).

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(c) Reduction in deemed assessable income

• E.g. where an enterprise uses major raw materials as specified by the state to
produce non-restricted and non-prohibited products, only 90% of the income from
such activities may be deemed as assessable to CIT.

(d) Venture capital investment offset

• E.g. where a venture capital makes a direct equity investment in a non-listed,

small to medium size new high-tech enterprise for at least two years, 70% of its
direct equity investment may be used to offset against its taxable income after the
minimum two-year holding period has been fulfilled.

(e) Investment tax credit

• E.g. where an enterprise purchases certain capital equipment as specified by the

state for the purpose of energy and water conservation, it may claim 10% of the
capital investments to offset against its CIT liability.

9.3.7 Annual Tax Returns and Final Settlement

The tax year in China is the calendar year. The annual CIT return is due on or before 31 May of
the following year.

Notwithstanding whether an enterprise makes a profit or incurs a loss in a tax year, the
CIT returns must be filed together with the final tax payment, where applicable, on or before
31 May after the end of each tax year. The monthly or quarterly provisional CIT paid in advance
is set off against the annual tax payment. Any overpayment shall be refunded.

Pursuant to CITL Article 54, financial statements and other relevant information must also
be submitted together with the CIT returns in accordance with regulations.

An extension of time to file the annual tax return is available subject to the approval by the
tax authorities.

9.3.8 Common Issues Relating to Cash Repatriation Out of China by

Foreign-invested Enterprises
For foreign companies with subsidiaries in China, profit repatriation generally remains a priority
and a challenging issue at the same time. This is due to the strict foreign exchange controls
policy and procedures since funds flowing into and out of China are tightly regulated.

Prior to setting up an operation in China, it is important for foreign companies to

incorporate a profit repatriation strategy in their business model. This would help foreign
investors appreciate the foreign exchange control environment in China and execute its
strategies in accessing the profits earned and to achieve significant cost savings.

In this section, we are going to look at some common issues involving cash repatriation
out of China.

9.3.8.1 Service Fees
It is common for an FIE to be charged a service fee for the support provided by its overseas
parent, affiliated company or a third party service provider. Such support would include
services such as accounting, treasury, taxation, information technology as well as senior
management’s leadership to provide strategic advice on the business in China.

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To the extent such services benefit FIE directly and contemporaneous documentation
(such as invoices, service agreement, records of time spent to assist the business operation in
China, consistent application of key allocation methods year after year) is available, and such
charges meet the arm’s length test, the FIE should be able to repatriate the service fee charged
by its overseas parent, affiliated company or third party service provider, subject to any WHT
obligation.

Apply and Analyse 6 – China Tax – Withholding Tax on Service Fees

Smart IT Canada Ltd (SITC) is a company incorporated and a tax resident in Canada.
It employs a number of software developers and engineers who provide technical services
and ancillary support to telecom companies around the world.

In 2019, High Way Mobile Limited (HWM), a company incorporated and a tax resident
in China, decided to engage the services of SITC to develop a secure network infrastructure
for its mobile services in China. The contract negotiation was concluded over the phone
and each party signed the service agreement in its home country, respectively.

Below is the summary of the service agreement between SITC and HWM:

1. Fees for technical services rendered in Canada = RMB500,000

2. Fees for technical services rendered in China = RMB600,000

3. Travel expenses (airfare, hotel, local transport and meals) = RMB50,000

It is expected that SITC’s engineers would spend up to four weeks in China for
consultation, implementation and testing.

The China tax authority imposed a deemed profit rate of 30% on services earned
by SITC in the event that it has a PE in China. If SITC has no PE in China, assume a WHT
rate of 10%. In addition, assume VAT at 6% is applicable on the preceding imported
services by HWM.

Required:

a. Calculate the WHT amount to be remitted to the China tax authority and input
VAT, where applicable. Assume that SITC provided a breakdown of the above items
(1)–(3) when issuing an invoice to HWM.

b. SITC hired a new accountant who decided to invoice HWM in one lump sum for a
total fee of RMB1,150,000. Calculate the applicable WHT amount and VAT.

Analysis

a. The first step is to determine whether SITC has a PE in China. Based on the
preceding information, SITC does not have a PE in China since the physical
presence of its employees in China is only 4 weeks (less than 6 months in any
12-month period). Furthermore, SITC’s employees did not carry on activities such
as negotiating and concluding contracts in China.

To the extent that relevant documentation (such as time sheets, receipt of expenses
for hotel, airfare, local transport and meals) is available to support each of the items
outlined in (1)–(3), China WHT is imposed on the services rendered in China.

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Apply and Analyse 6 (continued)

China WHT payable RMB600, 000 10% RMB60, 000

China WHT does not apply to services rendered outside of China as well as
reimbursement of actual expenses when such items are invoiced separately.

VAT on imported services RMB1100

, , 000 6% RMB66, 000

HWM may claim the VAT on imported services as its Input VAT.

b. If the invoice shows a lump sum service fee of RMB1,150,000, the China WHT is
applied on the entire amount.

China WHT payable RMB1150

, , 000 10% RMB115, 000

VAT on imported services RMB1150

, , 000 6% RMB69, 000

9.3.8.2 Royalties
Where an FIE is required to remit royalty payments to either its offshore affiliated or non-
affiliated company, the following conditions have to be met:

• Documentary proof that the offshore company possesses both the legal and economic
ownership of the intellectual property used by the FIE in China.

• Royalty agreement.

• Arm’s length royalty rate.

• Evidence that the FIE benefits from the use of the said intellectual property (e.g.
increase in sales revenue, reduction in manufacturing costs due to increased efficiency
of production from the technical know-how).

Similarly, the FIE has to meet its WHT obligation under the applicable tax treaty with China
as well as comply with the foreign exchange control procedures as outlined by SAFE.

9.3.8.3 Dividends
One of the most common strategies of cash repatriation is by way of dividends. For China tax
purposes, an FIE has to observe the following:

• Only profits that have undergone annual audit can be repatriated.

• Dividends are subject to a 10% WHT when distributed to foreign shareholders subject
to a reduced rate or exemption available under tax treaties between foreign tax
jurisdictions and China.

• For treaty WHT rates to apply, China will apply the beneficial ownership test (BOT).
Please note that BOT is also applicable in applying a reduced WHT rate for royalties
and interest.

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Exhibit 9.15 shows a quick illustration of the associated costs when repatriating profits to
its overseas shareholders. For the purpose of this section, we have not considered any foreign
exchange loss or gain on such distribution.

Item Formula Amount (example)

HK$
Gross profit (1) 100.00
CIT (1) × 25% = (2) 25.00
Net profit (1) – (2) = (3) 75.00
Surplus reserves (3) × 10% = (4) 7.50
Maximum dividend (3) – (4) = (5) 67.50
WHT (5) × 10% = (6)
a
6.75
Net payment (5) – (6) = (7) 60.75
a
 A preferential dividend WHT rate of 5% may apply if a DTA is available and
the parent company qualifies as the beneficial owner.
EXHIBIT 9.15 Tax burden and reserve requirements on dividends

9.3.8.4 Interest
Interest on loans is generally deductible to the extent that the transactions is carried out at arm’s
length and the interest rate charged does not exceed the prevailing commercial interest rate.

Where a company borrows money to purchase capital equipment, the interest expenses
should be capitalised as part of the equipment costs and amortised over its useful life.

For interest paid by an FIE where the lender is an offshore related company, the interest
expense that is deductible for China tax purposes is subject to thin capitalisation rules.

The purpose of the thin capitalisation rule is to disallow foreign companies from stripping
down the profits of its related companies in China by way of excessive interest charges.
Currently, the prevailing safe harbour debt/equity ratio for non-financial institutions is 2 : 1
(See Section 9.3.5.5, item 10).

9.3.8.5 Foreign Exchange Control

China maintains a strict foreign exchange control policy that is administered by the State
Administration of Foreign Exchange (SAFE) in conjunction with the People’s Bank of China
(PBOC), which is the designated central bank in China. However, in recent years, China has
moved to gradually ease its foreign exchange control policy and controls over outbound
payments for companies as well as individuals.

It is a common knowledge among both corporate taxpayers and individuals that they
are required to comply with China’s ‘closed’ capital account policy. In order to monitor the
currencies flow in and out of China, SAFE together with PBOC implement strict rules such
as proper documentation, benefits and necessity tests among others, before approving the
outbound payments from China. SAFE’s approval or record filing is required for a range of
transactions involving inbound and outbound forex payments.

In keeping its promise to gradually liberalise its foreign exchange policy, the Shanghai Pilot
FTZ has been designated as the pilot project to test full currency convertibility with the aim to
further ease the above foreign exchange restriction for foreign investors.

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Under the China foreign exchange system (Exhibit 9.16), there are two main accounts:

• Current account

This is applicable to activities including but not limited to day-to-day transactions in the
normal course of business such as trading receipts and payments, interest payment on
loans from foreign lenders, dividend distribution to non-resident parent companies as
well as repatriation of retained earnings.

• Capital account

This is applicable for transactions that involve the movement of capital such as loan
principal repayment to non-resident lenders, repatriation of foreign investments such as
reduction of paid-up capital and payment relating to import/export of capital equipment.

Foreign exchange system

Current account Capital account

Foreign
Trade in Current Foreign Overseas
Service Income direct
goods transfer loan investment
investment

EXHIBIT 9.16 China’s foreign exchange system

Key Learning Point

In this section, you learned how to calculate the CIT payable for both FIE and domestic
enterprise under the new 2008 CITL. In taking advantage of the available tax incentives
and the pilot FTZs, it is important for foreign investors to consider its cash repatriation
strategies at the outset in order to minimise its tax cost burden as well as comply with
China foreign exchange rules administered by SAFE.

Knowledge Check Questions

Question 5
Bubble (Hong Kong) Ltd (Bubble) is a company incorporated in Hong Kong since 2010. It
manufactures herbal drinks for sale in the region, including China. Since the founder of the
original herbal drinks recipe resides in China, the management of Bubble believes that it is
more efficient for the management to hold the meetings that discuss and execute strategic
decision in China. Key personnel, production and major corporate functions such as
finance, human resources and payroll are based in China. Please identify which statement
below is correct.
A Bubble is a tax resident company in Hong Kong.
B Bubble is a tax resident company in China.
C Bubble is a tax resident company in both Hong Kong and China.
D None of the above is correct.

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Knowledge Check Questions (continued)

Question 6
Finco (Hong Kong) Ltd is a company incorporated in Hong Kong and a tax resident of
Hong Kong for the purpose of a DTA. It is the treasury centre of the Finco Group (Finco
Singapore) with headquarters in Singapore. Finco (China) Ltd, which is a wholly-owned
subsidiary of Finco (Hong Kong) Ltd, is incorporated in China and is a tax resident of
China. Finco (China) Ltd borrows RMB10 million from Finco (Hong Kong) Ltd at an annual
interest rate of 8% and interest is paid at the end of each calendar year. Assume the WHT
rate for interest payments from China to Hong Kong is 7%. The same applies to the WHT
rate for interest payments from China to Singapore. Please state which statement
is correct.
A Finco (China) Ltd is required to remit the WHT of RMB56,000 to the China tax authority.
B Finco (China) Ltd is required to remit the WHT of RMB56,000 to the Singapore tax
authority.
C Finco (China) Ltd does not have to remit the WHT since it is within the same group of
companies.
D The DTA between Hong Kong and China provides WHT exemption on interest payments
to related parties.

9 . 4 INDIVIDUAL INCOME TAX

Consistently with the globalisation of the world economy, China has opened its border to
welcome foreign companies to set up operations in China. As a result, you will see an increasing
trend of expatriates working in China as well as overseas visitors who are coming to China
for various business meetings. Generally, these expatriates and visitors range from middle to
senior management level employees. On the same note, there is also an increasing number of
Chinese residents deriving both offshore and China-source income. In this section, we discuss
the implications of the Chinese IIT Law (the IIT Law or 2018 IIT Law), which was enacted on 31
August 2018 and effective from 1 January 2019, tax liability and filing obligations for both a tax
resident and non-resident of China.

The 2018 IIT Law, which supersedes the previous version enacted in 1994 (1994 IIT Law),
has the following key features:

1. It aligns with international practice by introducing the concept of resident and non-
resident for IIT purposes, which creates substantial changes to the assessment method
of tax residents from having resided in mainland China for one full year (one-year test)
to having resided in mainland China for 183 days or more within a tax year (183-day
test) (Article 1, IIT Law).

2. It revises the scope of chargeable income by introducing the concept of a comprehensive

income category to be taxed on an aggregate taxation system while the other ‘schedular
income’ categories continue to be taxed according to their respective schedules (Article 2,

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IIT Law). (Note: Pursuant to Article 2 of the IIT Law, the comprehensive income category
covers the first four chargeable income items, that is, wages and salaries; remuneration
for labour services; manuscripts; and royalty. Schedular income categories refer to the
remaining five chargeable income items as stipulated in Article 2 of the IIT Law, that is,
income from business operations; interest, dividends and bonuses; income from leasing
of property; income from transfer of property; and contingent income.)

3. In addition to the monthly reporting obligations, the comprehensive income category

for tax resident is also required to undergo an annual clearance procedure for a
tax year that runs on a calendar year basis, that is, from 1 January to 31 December
(Article 2, IIT Law).

4. It adjusts the tax brackets by widening the brackets with applicable tax rates of 3%, 10%
and 20% and narrowing the 25% tax bracket so as to reduce the tax burden on low- and
middle-income earners (Article 3, IIT Law). (Please note that the revised tax rate tables
were effective from 1 October 2018 onward.)

5. It increases the standard personal deduction on comprehensive income to

RMB60,000 per annum (i.e. RMB5,000 per month) for all taxpayers, regardless of
whether they are tax residents or non-tax residents for China IIT purposes (Article 6, IIT
Law). (Please note that the standard personal deduction was effective from 1 October
2018 onward.)

6. It introduces six specific additional deduction items for expenditures incurred in the
following aspects (Article 6, IIT Law):

a. Dependent children’s education;

b. Taxpayer’s self-continuing education;

c. Medical treatments of critical illnesses;

d. Housing mortgage interest;

e. Housing rental; and

f. Elderly care.

7. It incorporates the general anti-avoidance rule (GAAR) for individual taxpayers

and empowers the tax authorities to impose tax adjustments if transactions
(Article 8, IIT Law):

a. Are not being conducted on an arm’s length basis;

b. Involve controlled foreign companies; and

c. Are regarded as commercially unreasonable, that is, artificial and/or pre-ordained

transactions.

Following the enactment of the IIT Law by the Standing Committee of the National People’s
Congress in August 2018, the China State Council promulgated the Detailed Implementing
Rules of the IIT Law (the IIT Rules) through the State Council Order No. 707 on 18 December
2018. The IIT Implementing Rules, which were effective from 1 January 2019, set forth a detailed
framework for the consistent implementation of the IIT Law on a nationwide basis.

Furthermore, the State Council, the Ministry of Finance (MOF) and the State Taxation
Administration (STA) of China (hereinafter collectively referred to as ‘the China tax authorities’)

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have individually and jointly issued the following tax circulars further clarifying some of the
uncertain issues that have arisen from the enactment and implementation of the IIT Law and
the IIT Rules. Given the fact that the China tax authorities will continue to issue tax circulars
clarifying the remaining uncertain issues, only those relevant tax circulars issued before 31 May
2020 are listed below and covered in the IIT sections of this chapter.

1. Guoshuifa (2018) No. 164: Notice of issues concerning the transitional policies on
preferential tax treatments under the IIT Law (Circular 164).

2. STA Announcement (2018) No. 56: STA announcement on the transitional measures
relating to tax collection and administration for implementing the IIT Law (Circular 56).

3. Guofa (2018) No. 41: Notice of the State Council on interim measures for administration
of specific additional deductions (Circular 41).

4. STA Announcement (2018) No. 59: STA announcement on matters concerning the
identification number of individual taxpayers (Circular 59).

5. STA Announcement (2018) No. 60: STA announcement on the issuance of the
administrative measures for implementing the specific additional deductions for IIT
purposes (trial scheme) (Circular 60).

6. STA Announcement (2018) No. 61: STA announcement on the issuance of the
administrative measures for withholding reporting for IIT purposes (trial scheme)
(Circular 61).

7. STA Announcement (2018) No. 62: STA announcement on the matters concerning
self-reporting for IIT purposes (Circular 62).

8. MOF and STA Joint Announcement (2019) No. 34: MOF and STA’s joint announcement
on standards for determining the length of residence of non-Chinese-domiciled
individuals for IIT purposes (Circular 34).

9. MOF and STA Joint Announcement (2019) No. 35: MOF and STA’s joint announcement
on tax treatments of non-residents and non-Chinese-domiciled individuals for IIT
purposes (Circular 35).

10. MOF and STA Joint Announcement (2019) No. 74: MOF and STA’s joint announcement
on IIT treatments of certain types of income received by individuals (Circular 74).

We are going to discuss the important concepts provided by, and the critical parts of, the IIT
Law, the IIT Rules and the aforesaid tax circulars in the following sections of this chapter.

Because the 2019 IIT Law has introduced a number of new provisions as compared to the
1994 version, it is anticipated that the Chinese tax authorities will continue to issue further tax
circulars clarifying the actual implementation procedures of the new provisions. Some of the
notable pending circulars include the following:

• Claiming foreign tax credits (Article 7, IIT Law);

• Tax adjustments related to GAAR (Article 8, IIT Law);

• The mechanism for refunding tax overpayments to taxpayers after the annual
adjustment filing (Article 14, IIT Law);

• Exchange of taxpayer’s information among various governmental departments for

enhancing common reporting standards and tax compliance purposes (Article 15, IIT Law);

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• Whether a separate interest tax is to be imposed or not (Article 18, IIT Law); and

• The State Council will promulgate a separate set of regulations governing the IIT to be
levied on gains derived from the transfer of shares/securities (Article 7, IIT Rules).

Accordingly, it is recommended that candidates follow the official website of the STA
(http://www.chinatax.gov.cn/chinatax/n810341/n810755/index.html) in order to keep
themselves abreast of the latest developments of the IIT Law.

9.4.1 Tax Residence

You should have learned the differences between a territorial tax system and a residence tax
system from Chapter 1 of this module. The IIT Law of the mainland of China is a typical example
of a tax regime under a residence tax system.

Based on Article 1 of the IIT Law, the following two groups of individuals shall be treated as
tax resident for IIT purposes:

1. Those individuals who are domiciled in mainland China; and

2. Those non-Chinese-domiciled individuals who stay in China for more than 183 days
within a tax year. (Pursuant to Article 1 of the IIT Law, a tax year follows the calendar
year and runs from 1 January to 31 December.)

Given that mainland China imposes income tax on individuals on a residence basis, a
Chinese tax resident shall be subject to IIT on their worldwide income, that is, both onshore
Chinese-sourced income and offshore non-Chinese-sourced income.

In contrast, non-tax-residents will be subject to IIT only on their Chinese-sourced

income. We discuss the definition and rules governing non-tax-residents in detail in the
following section.

Article 2 of the IIT Rules further elaborates that the concept of domiciliation under the
framework of the IIT Law refers to those who have habitually resided in mainland China due to
their residency registration, family ties and/or economic interests.

In conclusion, all Chinese nationals, foreign nationals who are regarded as tax resident
in mainland China, and foreign nationals who are non-tax resident of China but derived
Chinese-sourced incomes, will fall under the IIT Law net.

9.4.2 Non-tax Resident

Article 1 of the IIT Law defines a non-tax resident as a non-Chinese-domiciled individual who
does not habitually live in China; or the individual’s stay in China does not exceed 183 days
cumulatively in a tax year. A non-tax resident is subject to tax under the IIT Law on only their
Chinese-sourced income. Article 1 of the IIT Law has substantially changed the assessment
method of determining the tax residency of a foreign national from the previous one-year
test to a 183-day test, which has created a great deal of concern and sensitivity among the
expatriates currently working in mainland China since the release of the draft version of the IIT
Law for public consultation.

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With the promulgation of the IIT Rules in December 2018 and the issuance of Circular 34
in March 2019 but retroactively effective from 1 January 2019 onward, the detailed rules on
tackling the aforementioned concerns and sensitivities have been addressed as follows:

1. According to Article 4 of the IIT Rules, a non-Chinese-domiciled individual with their

days of residence in mainland China for 183 days or more in a tax year (a Chinese year)
but for less than a consecutive period of six years (six-year test) may be exempt from
IIT on his or her non-Chinese-sourced income paid by foreign units or individuals after
filing the appropriate notification with tax authorities. Should the individual have any
leave from mainland China for 30 days or more in one departure during any time within
a Chinese year, the count of the six-year test will be reset.

2. Further, Article 5 of the IIT Rules provides that a non-Chinese-domiciled individual will
be exempt from IIT on their Chinese-sourced income, which is not ultimately borne by
a Chinese resident company, organisation or establishment, if the individual’s stay in
mainland China is less than 90 days in a tax year.

3. Circular 34 provides the following explicit guidance on the resident-day-count rules for
determining a Chinese year and how the six-year test is to be applied for non-Chinese-
domiciled individuals to be eligible to claim IIT exemption on non-Chinese-sourced
income in a particular tax year:

a. If a non-Chinese-domiciled individual is physically present in mainland China for

24 hours in a given calendar day, that day will be counted as a day of residence in
mainland China.

b. However, if a non-Chinese-domiciled individual’s presence in mainland China is

less than 24 hours in a given calendar day, that day will not be counted as a day of
residence in mainland China (resident-day-count rule).

c. A non-Chinese-domiciled individual is subject to IIT on his or her worldwide income

if during a period of six consecutive years immediately preceding the year of
assessment (i.e. the six-year test), the individual:

i. Resides in mainland China for 183 days or more in each of the six tax years; and

ii. Has not been away from mainland China on any single trip for more than 30
consecutive days in any of the six tax years.

d. The count of the six-year test commences from 1 January 2019 onward.

Exhibit 9.17 summarises the respective personal tax treatment for a tax resident (TR) and a
non-tax resident (NTR) for IIT purposes under different scenarios as discussed in Sections 9.4.1
and 9.4.2.

9.4.2.1 Specific Rules on Taxation of Non-Chinese-domiciled Individuals

Circular 35, issued on 14 March 2019 but effective retroactively from 1 January 2019, provided
specific rules and calculation formulas for the taxation of non-Chinese-domiciled individuals,
including senior management executives whose original country of residence has not entered
into a Comprehensive Double Taxation Agreement (CDTA) with China. The details are discussed
in the following section.

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Tax treatment for Tax treatment for non-

Chinese-sourced income Chinese-sourced income
Domicile/length Tax Borne by Borne Borne by Borne by
of residence in residency Chinese by non- Chinese non-Chinese
mainland China status employer Chinese employer employer
employer
A Chinese-domiciled TR Taxable Taxable Taxable Taxable
individual.
Non-Chinese-domiciled NTR Taxable Exempt Exempt Exempt
individual with stays
in China for less than
90 days in a tax year.
Non-Chinese-domiciled NTR Taxable Taxable Exempt Exempt
individual with stays in
China for more than
90 days but less than
183 days in a tax year.
Non-Chinese-domiciled TR Taxable Taxable Taxable Exempt
individual with stays in
China for more than
183 days in each tax
year for not more than
six consecutive years in
total.
Non-Chinese-domiciled TR Taxable Taxable Taxable Taxable
individual with stays in
China for more than
183 days in each tax
year for more than six
consecutive years and
has not been absent
from China for more
than 30 consecutive days
in any tax year during
that six-year period.

EXHIBIT 9.17 Summary of tax treatment for tax resident and non-tax resident

Non-Chinese-domiciled Non-tax Resident

As discussed in Section 9.4.2, a non-tax resident individual who is not domiciled in China and
stays in China for less than 90 days in a tax year would only be assessable for IIT on his or her
Chinese-sourced income that is borne by a Chinese employer. Circular 35 further elaborates
that the term ‘Chinese employer’ includes Chinese entities and individuals as well as any
domestic organisations and sites constituted by foreign entities or individuals. In the event
that a Chinese employer is subject to income tax on a deemed basis or does not generate
any income for tax purposes, the wages and salaries derived by a non-tax resident should be
deemed to be borne by a Chinese employer regardless of whether such expenses are booked
in the accounts of the Chinese employer.

If a non-Chinese-domiciled non-tax resident individual holds employment positions both

inside and outside of China, or only holds an employment position outside China, and such
individual works both inside and outside of China during the same period of time in a tax year,

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he or she should apportion the aggregated employment income based on the number of days
spent inside and outside China in a given month to determine the Chinese-sourced income,
that is, income derived during the actual course of working in China. The Chinese IIT payable is
then calculated based on such Chinese-sourced income.

A workday in mainland China is a calendar day that is spent in China for business purposes.
A stay in China for less than 24 hours on a calendar day should be counted as a half workday in
this regard (workday rule). Workdays in China include: calendar days spent in mainland China
for business purposes; public holidays; personal leave; and other days spent attending training
courses that relate to the individual’s Chinese employment, regardless of whether they are
conducted inside or outside China.

As such, the monthly taxable income of a non-Chinese-domiciled non-tax resident

individual should be ascertained, first, by classifying whether their position in a company is
regarded as being senior management and, second, by applying the applicable formula as
illustrated below:

• Apportionment Formula #1

For a non-Chinese-domiciled, non-tax resident and non-senior management executive

whose physical presence in China does not exceed 90 days in a tax year, his or her
monthly taxable income is determined by the following formula:

Monthly taxable income Total monthly employment income earn ned both inside
and outside China ((Monthly employment income paid
or borne inside China Total monthly emplo oyment
income earned both inside and outside mainland Ch hina)
( Workdays in China during the month Total number of
calendar days in the month))

• Apportionment formula #2

For a non-Chinese-domiciled non-tax resident and non-senior management executive

whose physical presence in China exceeds 90 days but does not exceed 183 days in a
tax year, his or her monthly taxable income is determined by the following formula:

Monthly taxable income Total monthly employment income earn ned both inside
and outside China ( Workdays in China during the month
Total number of calendar days in the monthh)

Illustrative Example 6
Assume that Mr. Kwok, Director of Business Development of CLA-HK is a Hong Kong
citizen and has been tasked to set up a new subsidiary in Xiamen, mainland China.
Hence, he is required to travel frequently between Hong Kong and Xiamen in the last
quarter of 2018. At the beginning of 2019, he began working in Xiamen. He takes the
High Speed Rail from Hong Kong to Xiamen on every Monday morning and commutes
back to Hong Kong on every Friday evening in the 2019 tax year. He does not hold any
other employment or office outside China. Assess Mr. Kwok’s number of resident days

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Illustrative Example 6 (continued)

and workdays in China and advise his tax residency status for IIT purposes for the 2019
tax year. Ignore any six-year test for this question.

Resident day: G
 iven that Mr. Kwok’s stays in Xiamen on every Monday and Friday are less
than 24 hours, respectively, these two days will not be counted as resident
days in accordance with the resident-day-count rule. In addition, he does
not stay in China on every Saturday and Sunday. Hence, his resident days in
China should only be three days per week. As a result, his total number of
resident days in China should be 156 days for a 52-week cycle in 2019.

Workday: Given that Mr. Kwok only has one employment location in Xiamen, China,
there is no need to apply any apportionment in this regard. Hence, his total
number of workdays in China is 365 days for 2019 tax year.

Tax residency status: Since his total number of resident days in China is 156 days for
2019 tax year, which does not exceed 183 days, he should be treated as a non-tax resident
for IIT purposes for the 2019 tax year.

Non-Chinese-domiciled Tax Resident

Based on the concepts of Chinese year and six-year test that you have learned in Section 9.4.2,
you should be aware that the following two categories of individuals are classified as tax
resident for IIT Law purposes:

A. Non-Chinese-domiciled individuals who have stayed in China for 183 or more days in
a tax year but for less than six (6) consecutive years. For these types of tax residents
(Type A), they would be taxed only on their Chinese-sourced income and the non-
Chinese-sourced income borne by a Chinese employer.

B. Non-Chinese-domiciled individuals who have stayed in China for 183 or more days in
a tax year and have not been absent from China for more than 30 consecutive days in
any tax year during the immediate past six-year period. For these types of tax residents
(Type B), they would be subject to IIT on their worldwide income, that is both Chinese-
sourced and non-Chinese-sourced incomes, regardless whether it is borne by Chinese
employer or non-Chinese employer. Thus, no apportionment should be applied.

Accordingly, the following apportionment formula should be applied to Type A

non-Chinese-domiciled tax residents for determining their monthly taxable income:

• Apportionment Formula #3

Monthly taxable income Total monthly employment income earn ned both inside
and outside China (1 ((Monthly employment income paid
or borne outside China Total monthly emplloyment
income earned both inside and outside China)
(W
Workdays outside China during the month
Total number of calendar days in the month)))

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Non-Chinese-domiciled Senior Management Executives

As inherited from the 1994 IIT Law, a set of special tax treatments applies to a senior
management executive of a company working in mainland China. Circular 35 provides the
definition of ‘senior management executive’ to include directors, supervisors, managers, chiefs
of different functions and other management level personnel of a company.

Where senior management executives are non-Chinese-domiciled non-tax resident

individuals for IIT purposes, their monthly taxable income should be computed by the following
formula if their total stays in China are less than 90 days in a tax year.

• Formula #4

Monthly taxable income Employment income earned and borne by Chinese employer

For senior management executives whose physical presence in China exceeds 90 days but
is less than 183 days in a tax year (i.e. non-Chinese-domiciled non-tax resident individuals for
IIT Law purposes), and senior management executives whose stays in China are more than
183 days in a tax year but for less than six consecutive years (i.e. non-Chinese-domiciled tax
residents for IIT Law purposes), the aforementioned Apportionment Formula #3 should be
applied for determining their monthly taxable income.

Illustrative Example 7
Assume that Mr. Kwok of CLA-HK is a Hong Kong citizen working as the general manager
of CLA’s subsidiary in Xiamen (CLA-Xiamen), in addition to his director of business
development role based in Hong Kong. He takes the High Speed Rail from Hong Kong to
Xiamen on every Monday morning and commutes back to Hong Kong on every Friday
evening in the 2020 tax year. His total monthly incomes for the 2020 tax year for his
positions held in Hong Kong and Xiamen are RMB100,000 and RMB80,000, respectively,
after converting into Chinese Yuan using the appropriate foreign exchange rate.

Assess Mr. Kwok’s number of resident days and workdays in China, advise his tax
residency status for IIT purposes, and determine his monthly taxable income for the
2020 tax year. Assume that Mr. Kwok had a single absence from China for more than
30 days in 2019 tax year.

Resident day: Given that Mr. Kwok’s stays in Xiamen on every Monday and Friday are
less than 24 hours, respectively, these two days will not be counted as
resident days in accordance with the resident-day-count rule. In addition,
he does not stay in China on every Saturday and Sunday. Hence, his
resident days in China should only be 3 days per week. As a result, his
total number of resident days in China should be 156 days for a 52-week
cycle in 2020.
Workday: Given that Mr. Kwok holds employment positions both inside and
outside of China, his workdays in China are to be determined by the
apportionment basis provided by Circular 35. Accordingly, every Monday
and Friday for 2020 should be counted as half workdays, respectively.
As a result, his total number of workdays in China should be 4 days per
week and 208 days per annum for 2020.

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Illustrative Example 7 (continued)

Tax residency Since his total number of resident days in China is 156 days for the 2020
status: tax year, which does not exceed 183 days per year, and he had one
absence from China for more than 30 days in 2019 which qualified for the
six-year test to be reset from 1 January 2020 onward, he should continue
to be treated as a non-tax resident for IIT purposes for the 2020 tax year.
Monthly Based on Mr. Kwok’s positions held in both Xiamen and Hong Kong, he
taxable should be treated as a senior management executive for IIT purposes.
income: Since his position for the 2020 tax year should be a non-Chinese-domiciled
and non-tax resident individual and he should be treated as a senior
management executive, his monthly taxable income should be determined
by applying Apportionment Formula #3, which is illustrated as follows:
Monthly Total monthly employment income earned both inside and outside
taxable China × (1 − ((Monthly employment income earned outside China ÷ Total
Income = monthly employment income earned both inside and outside China) ×
(Workdays outside China during the month ÷ Total number of calendar
days in the month)))
= RMB180,000 × (1 − ((RMB100,000 ÷ RMB180,000) × (156 ÷ 365 ÷ 12)))
= RMB176,438

Summary
Exhibit 9.18 captures all the scenarios that we have discussed in Section 9.4.2.1 and the specific
tax treatments stipulated by Circular 35 for non-Chinese-domiciled individuals whose original
country of residence has not entered into any CDTA with China.

9.4.3 Types of Taxable Income

In this section, we are going to learn about the scope of chargeable income under the new IIT
Law by looking into the types of income that fall within the IIT Law net.

Pursuant to Article 2 of the IIT Law, income received by an individual, which falls under the
following nine income schedules, is assessable under the IIT Law:

1. Wages and salaries;

2. Remuneration for labour services;

3. Remuneration for manuscripts;

4. Royalty income;

5. Income generated from business operations;

6. Interest, dividend income and profit sharing;

7. Income generated from leasing of property;

8. Income generated from transfer of property; and

9. Contingent receipts.

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Number Tax Non-senior management Senior management

Chinese residency executive employee executive
days (D) status
Taxable income Applicable Taxable Applicable
formula income formula
D ≤ 90 days NTR Chinese-sourced Apportionment Employment Formula #4
employment Formula #1 income earned
income earned and borne
that is borne by by Chinese
Chinese employer employer
90 days < D NTR Employment Apportionment Total Apportionment
< 183 days income earned Formula #2 employment Formula #3
representing the income earned
actual period of except for the
work deployed in portion paid by
China non-Chinese
employer
183 days ≤ D TR Total employment Apportionment
representing
≤ 6-year test income earned Formula #3
the actual
except for the
period of work
portion paid by
deployed
non-Chinese
outside China
employer
representing the
actual period of
work deployed
outside China
D > 6-year TR Worldwide income No Worldwide No
test apportionment income apportionment
is allowed is allowed

EXHIBIT 9.18 Tax treatment of non-Chinese-domiciled individuals

The IIT Law introduces the respective concepts of ‘comprehensive income’ and ‘schedular
income’ that are subject to IIT under different calculation methods and separate tax rates
(Articles 2 and 3, IIT Law).

Accordingly, the preceding income schedules numbers 1 to 4 are consolidated as

comprehensive income. A tax resident is liable for IIT in aggregate and on an annual basis
on the receipt of comprehensive income. However, a non-tax resident is not liable for IIT on
this reporting basis. Rather, a non-tax resident should continue to report his or her IIT on a
schedular basis in each month or as and when receiving the respective schedular income.

In addition, income schedules numbers 5 to 9, that is, schedular income, will continue to be
taxed on a schedular basis.

9.4.3.1 Detailed Scope of Chargeable Income

Article 6 of the IIT Rules has further elaborated the detailed descriptions of each of the nine
income schedules as follows:

1. Wages and salaries – Income derived by individuals for holding a position or performing

an employment contract including wages, salaries, bonus, year-end salary increment,
bonuses for labour services provided, allowances, subsidies, and any other income
related to the individual’s position or employment.

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2. Remuneration for labour services – Income generated from the provision of labour

services in respect of designing, decorating, installation, mapping, assaying, testing,
medical, legal, accounting, consulting, lecturing, translating, editing, drawing,
sculpturing, movie production, audio recording, video recording, casting, performing,
advertisement, exhibition, technical services, referral services, agency services,
outsourcing services and any other labour services-related income.

3. Remuneration for manuscripts – Income generated by publishing their work in the form

of a book, newspaper or periodicals, and so on.

4. Royalty income – Income derived from granting the use of a patent, a trademark, a

copyright, non-patented technology and any other receipt earned due to granting
of a royalty. Income received from the use of a copyright excludes remuneration for
manuscripts.

5. Income generated from business operations – This schedule covers income generated

from the following business activities:

a. Income derived by sole proprietor engaging in production and trading activities,

income derived by sole proprietary investor and individual partner from
any Chinese-registered sole proprietary business and partnership business,
respectively;

b. Income derived by an individual engaging in the provision of services in the areas of

education, medical and healthcare, consultancy and others;

c. Income derived by an individual in respect of insourcing services from different

types of enterprise and any subsequent outsourcing of these insourced
services; and

d. Income derived by an individual in respect of other production and trading

activities.

6. Interest, dividend income and profit sharing – income under this schedule refers to
the interest and dividend received by an individual due to his or her holding in the
respective debt and equity instrument.

7. Income generated from leasing of property – income derived by an individual from leasing

out property, machinery and equipment, vehicles, vessels and other properties.

8. Income generated from transfer of property – income derived by an individual from

the transfer of securities, options, shareholding in a partnership, immovable assets,
machinery and equipment, vehicles, vessels and other properties.

9. Contingent receipts – income derived from lottery winnings and other similar types of
‘windfall’ gains. According to Circular 74, the following types of income received by an
individual should also be classified into this schedule for IIT purposes:

a. Income derived from providing guarantees to corporations or individuals;

b. Deemed income in respect of property ownership granted by others with no

consideration, unless such transfer of property ownership is exempt as per Tax
Circular Guoshuifa (2009) No. 78; and

c. Gifts randomly received from a corporation with which no employment relationship

is in existence.

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For income that does not fall within the aforesaid schedules, the classification should be
determined by the Chinese tax authorities.

9.4.3.2 Ascertaining the Chinese-sourced Income

Article 3 of the IIT Rules, supplemented by Circular 35, stipulates the income sourcing principles
to be applied to each of the nine schedules of income streams. Exhibit 9.19 summarises the
key principles for determining the sources of income for IIT purposes, unless there is any
exceptional treatment identified by the Chinese tax authorities.

Schedule of income Source of income

1. Wages and salaries Location of employment services rendered
2. Remuneration for labour services Location of labour services rendered
3. Remuneration for manuscripts Location of the payer
4. Royalty income Location of where the intellectual property is used
5. Income from business operations Location of where the business operates
6. Interest, dividend incomes and profit sharing Location of the payer
7. Income from leasing of property Location of where the leased property is used
8. Income from transfer of property Location of where the transfer has taken place
9. Contingent receipts Location of the payer

EXHIBIT 9.19 Key principles for determining sources of income

9.4.3.3 Exemptions and Reliefs
The following types of income received by an individual is exempt from IIT in accordance with
Article 4 of the IIT Law:

1. Monetary awards granted by the Provincial People’s Governments, ministries and

commissions of the State Council, units at army level or above of the People’s
Liberation Army, and by foreign or international organisations for achievements in
science, education, technology, culture, public healthcare, sports and environmental
protection, etc.;

2. Interest generated from state treasury bonds and other financial instruments issued by
the state;

3. Subsidies and allowances received as prescribed by the state;

4. Social welfare funds, disability funds and relief funds for poverty;

5. Insurance indemnities;
6. Payments for re-employment assistance, severance payments and gratuity payments
received by military personnel upon completing military services;

7. Payments for resettlement, severance compensation, retirement and other special

subsidies to applicable senior retired civil servants according to the unified regulations
promulgated by the state;

8. Income received by diplomatic representatives of foreign countries, which is exempt

from taxes under the relevant laws;

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9. Income exempt from taxes pursuant to the relevant international conventions or

agreements; and

10. Other exempt incomes as prescribed by the State Council.

In respect of item 10, the State Council is required to notify the detailed operations to the
Standing Committee of the National People’s Congress.

In addition, Article 5 of the IIT Law also provides relief for charging IIT should any of the
following circumstances arise:

1. Income received by the disabled, single elderly citizens and family members of
martyrs; and

2. Substantial losses incurred due to natural catastrophes.

The detailed implementation of the aforesaid reliefs for charging IIT should be governed by
the People’s Government at the provincial, autonomous region and municipality levels, which
should notify the NPC at the same level.

The State Council is empowered to regulate other reliefs as and when there is such a
necessity and by notifying the Standing Committee of the National People’s Congress.

9.4.4 Tax Rates and Computation

As mentioned in Section 9.4.3, there are different tax rates applicable to the following types of
income derived by individuals as provided by the IIT Law:

• Comprehensive income;

• Income generated from business operations; and

• Schedular income (i.e. items 6 to 9 in Section 9.4.3).

9.4.4.1 Tax Rates – Comprehensive Income

Based on Clause 1, Article 3 of the IIT Law, comprehensive income derived by a Chinese
tax resident in a tax year is taxed at the progressive rates ranging from 3% to 45%, which is
illustrated as the ‘annual IIT rate table’ in Exhibit 9.20.

Band Cumulative annual Marginal Quick calculation

taxable income tax rate deduction
(RMB) (%) (RMB)
1 < 36,000 3 0
2 36,000–144,000 10 2,520
3 144,000–300,000 20 16,920
4 300,000–420,000 25 31,920
5 420,000–660,000 30 52,920
6 660,000–960,000 35 85,920
7 > 960,000 45 181,920

EXHIBIT 9.20 Annual IIT rate table

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Please note that the ‘cumulative annual taxable income’ mentioned in Exhibit 9.20 refers
to the amount of comprehensive income after deducting: the standard personal deduction
of RMB60,000 per annum; specific deductions; specific additional deductions; and other
deductible items permitted by law. The detailed rules on ascertaining the taxable income
under each individual schedule are discussed in Section 9.4.4.5.

Given that the comprehensive income derived by a non-tax resident continues to be taxed
at the progressive rates ranging from 3% to 45%, but on a monthly basis instead of the annual
basis applied to a tax resident, we have reproduced the following ‘Monthly IIT rate table’ from
Circular 164 for monthly IIT reporting purposes for your easy reference in Exhibit 9.21.

Band Monthly taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 3,000 3 0
2 3,000–12,000 10 210
3 12,000–25,000 20 1,410
4 25,000–35,000 25 2,660
5 35,000–55,000 30 4,410
6 55,000–80,000 35 7,160
7 > 80,000 45 15,160

EXHIBIT 9.21 Monthly IIT rate table

Meanwhile, Circular 56 provides the IIT rate table in Exhibit 9.22, applicable to the
provisional withholding and reporting of a Chinese tax resident who generates income related
to the schedule of remuneration for labour services during a tax year.

Band Annual taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 20,000 20 0
2 20,000–50,000 30 2,000
3 > 50,000 40 7,000

EXHIBIT 9.22 Schedule 2 IIT rate table

9.4.4.2 Tax Rates – Income Generated from Business Operations

In accordance with Clause 2, Article 3 of the IIT Law, income generated by an individual
from business operations is taxed at the progressive rates ranging from 5% to 35%, which is
illustrated in Exhibit 9.23.

Please note that the ‘annual taxable income’ mentioned in Exhibit 9.23 refers to the amount
after deducting costs, expenses and losses incurred in a tax year.

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Band Annual taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 30,000 5 0
2 30,000–90,000 10 1,500
3 90,000–300,000 20 10,500
4 300,000–500,000 30 40,500
5 > 500,000 35 65,500

EXHIBIT 9.23 Tax rates for income generated from business operations

9.4.4.3 Tax Rates – Schedular Income

Based on Clause 3, Article 3 of the IIT Law, income relating to the following schedules is
assessed at a flat rate of 20%:

• Interest, dividend income and profit sharing;

• Income generated from leasing of property;

• Income generated from transfer of property; and

• Contingent receipts.

9.4.4.4 Ascertainment of Taxable Income

General Rules
The following general rules must be applied in determining the taxable income for IIT
Law purposes:

• IIT must be computed in Chinese Yuan (i.e. Renminbi (RMB)), the Chinese currency.
Should a taxpayer receive monthly income in a foreign currency, such income should be
converted into the equivalent RMB amount based on the foreign exchange middle rate
quoted by the People’s Bank of China on the last day of the month. In respect of the
additional tax due under the annual adjustment mechanism, the quoted middle rate on
the last day of the year should be adopted (Article 16, IIT Law, and Article 32, IIT Rules).

• Income earned by an individual includes money and money’s worth. Should

commodities, securities and/or other types of assets have been earned in lieu of
money, they have to be converted into money at their respective fair market price
(Article 8, IIT Rules).

Determining the Taxable Income per Schedule of Income

Based on Article 6 of the IIT Law, the taxable income derived by an IIT payer is to be determined
according to each individual schedule of income. Exhibit 9.24 summarises the relevant rules.
Please note that deductions are available for certain types of incomes in calculating taxable
incomes, which are discussed in Section 9.4.4.5.

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Schedule of income Rules on determining the taxable income

1. Wages and salaries Total income – allowable deductions
2. Remuneration for labour services Total income – 20% of allowable expenses
3. Remuneration for manuscripts (Total income – 20% of allowable expenses) × 70%
4. Royalty income Total income – 20% of allowable expenses
5. Income from business operations Total income – allowable deductions
6. Interest, dividend incomes and profit sharing Total income
7. Income from leasing of property Total income – allowable deductions
8. Income from transfer of property Total income, i.e. the selling price – allowable deductions
9. Contingent receipts Total income

EXHIBIT 9.24 Determination of taxable income based on schedule of income

Apply and Analyse 7
Determine the taxable income and IIT payable in the following cases:

1. Dr. Chen, a Chinese national and a retired professor of the accounting faculty of
Xiamen University, generated a fee of RMB170,000 by writing a set of lecture notes on
the 2018 IIT Law published by the National Accounting Academy in Xiamen in July 2019.

2. Mrs. Chen, a Chinese national and a professional civil engineer and wife of Dr.
Chen, who has also retired from her teaching role in the engineering faculty of
Xiamen University, generated income of RMB250,000 by providing her professional
comments on the feasibility study report of the construction of the underground
metro system in Xiamen City to the city government. She has incurred immaterial
expenses for this assignment as most of the expenses have already been covered
directly by the service recipient.

Analysis

Dr. Chen: The RMB170,000 earned by Dr. Chen falls under the schedule of remuneration
for manuscripts, that is, one of the comprehensive income schedules. Hence, the annual
IIT rate table is applicable. Since he has retired, let us assume that he has no other
income generated for the 2019 tax year. His taxable income and IIT payable are illustrated
as follows:

Taxable income

(Fully earned amount 20% of allowable expenses) 70%

(RMB170, 000 (1 20%)) 70%
RMB95, 200

IIT Payable

Taxable income Applicable marginal IIT rate Quick calculattion deduction

(RMB95, 200 10%) RMB2, 520

RMB7, 000

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Apply and Analyse 7 (continued)

Mrs. Chen: The RMB250,000 earned by Mrs. Chen falls under the schedule of
remuneration for labour services. Although this is one of the comprehensive income
schedules, Circular 56 has provided a separate Schedule 2 IIT rate table to this schedule
for a Chinese tax resident’s provisional IIT withheld by a withholding agent, that is, Xiamen
City government in this case. Since she has retired, let us assume that she has no other
income generated for the 2019 tax year. Her taxable income and IIT payable are illustrated
as follows:

Taxable income

Fully earned amount 20% of allowable expenses

RMB250, 000 0

RMB250, 000

Provisional IIT withheld

Taxable income Applicable marginal IIT rate Quick calculation deduction

(RMB250, 000 40%) RMB7, 000

RMB93, 000

Since remuneration for labour services is one of the income schedules under
comprehensive income that is subject to the Annual Reconciliation IIT Filing and Mrs. Chen
is a Chinese tax resident, the annual IIT rate table (as illustrated in Exhibit 9.20) should
be applied. The IIT position of Mrs. Chen for the 2019 tax year to be documented in the
Annual IIT Return to be lodged between 1 March and 30 June of 2020 should be as follows:

Annual IIT payable

(Total comprehensive taxable income Applicable marginal IIIT rate

Quick calculation deduction) Provisional IIT With
hheld

((RMB250, 000 20%) RMB16, 920) RMB93, 000

RMB33, 080 RMB93, 000

(RMB59, 920) ( Tax repayable)

Thus, Mrs. Chen should be eligible to receive a tax refund of RMB59,920 after the
lodgement of her annual IIT return for the 2019 tax year.

Unlike the salaries tax regime in Hong Kong SAR, there is no joint assessment provided
under the IIT Law. Hence, Dr. Chen and Mrs. Chen have to be separately assessed for
IIT purposes.

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9.4.4.5 Allowable Deductions/Reliefs
The IIT Law provides a uniform set of allowable tax deductions that are applicable to all
taxpayers, that is, both Chinese nationals and foreign expatriates alike. Generally speaking, the
eligibility of these tax deductible items or expenses can be classified into two categories, that is,
for comprehensive income and schedular income respectively.

Comprehensive Income Earned by Tax Resident

In respect of the allowable tax deductions for comprehensive income, the following four groups
are available to a Chinese tax resident (Article 6, IIT Law and Articles 13 and 19, IIT Rules):

1. Standard personal deduction (Group 1) – The available deductible amount

under this group is RMB60,000 per person per annum, which is equivalent to
RMB5,000 per person per month for monthly provisional IIT withholding reporting
calculation purposes.

2. Specific deductions (Group 2) – This group covers the contributions made or premiums
paid by taxpayers to their statutory pension fund, statutory medical insurance,
unemployment insurance and housing provident fund.

3. Specific additional deductions (SADs) (Group 3) – This group is newly provided by the
2018 IIT Law and covers a taxpayer’s expenditure incurred in the aspect of:

a. Children’s education;
b. Continuing education;

c. Medication for critical illnesses;

d. Mortgage loan interest or housing rental; and

e. Elderly care.

4. Other deductible items permitted by law (Group 4) – This group covers recognised
charitable donations; contributions made to qualified corporate annuity and/or
qualified professional annuity; premiums paid to qualified commercial health insurance
and tax deferrable commercial pension insurance; and other deductible items
stipulated by the State Council.

Comprehensive Income Earned by Non-tax Residents

Based on Article 6 of the IIT Law, a non-tax resident’s wages and salaries are eligible for Group 1
deductions on a monthly basis (i.e. RMB 5,000 per month).

A non-tax resident is not eligible for Group 3 deductions. As a result, the China tax
authorities issued Circular 164 to provide a three-year transitional measure for the application
of IIT preferential treatment for tax-exempt fringe benefits for foreign nationals under the 1994
IIT Law. Please refer to Section 9.4.5.1 for the details in this regard.

From a practicality standpoint, a non-tax resident may only be able to claim deductions
on any recognised charitable donations made among all the allowable deduction items under
Groups 2 and 4.

Schedular Income
Regarding the tax deductions available for the schedular incomes, please refer to Exhibit 9.25
for details (Article 6, IIT Law).

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Schedule of income Deductions permitted

5. Income from business operations Costs, expenses and losses
6. Interest, dividend income and profit sharing None
7. Income from leasing of property RMB800 if the earned income amount is
RMB4,000 or less; 20% flat-rate deduction if the
earned income amount is more than RMB4,000
8. Income from transfer of property The original purchase price of the property and
reasonable amount of expenses incurred
9. Contingent receipts None

EXHIBIT 9.25 Tax deductions for schedular incomes, Groups 5–9

We now consider the details of the deductible items available in Groups 2, 3 and 4 above,
given that the deductions available in Group 1 are straightforward.

Specific Deductions (Group 2)

As previously mentioned, specific deductions include the contributions made to, or premiums paid
by taxpayers to, their statutory pension fund, statutory medical insurance, unemployment insurance
and housing provident fund. The deductible threshold for each of these four items is based on the
local standards promulgated by the city level government where the taxpayers are located.

Specific Additional Deductions (Group 3)

The six special additional deductible items are provided by IIT Law to Chinese tax residents.
Exhibit 9.26 summarises the detailed rules for claiming these deductible items as stipulated in
the relevant Articles of the IIT Law and IIT Rules, and Circulars 41 and 60.

Name of Deductible threshold Qualifying conditions Eligibility

SADs
Children’s RMB1,000 per child per month. Pre-school education and Each parent is eligible
education full-time comprehensive to claim 50% of the
education in recognised deductible limit, or
academic institutions 100% by either parent.
located both inside and
outside China from the
month the child turns age
three until the completion
of doctorate education.
Continuing RMB400 per month during the The degree/diploma Eligible to taxpayer
education period for pursuing degree/ programme takes place in attending education
diploma education. The China. at undergraduate
relevant deductible period is level or below, or
capped at 48 months in total to their parent(s)
for the same degree/diploma. under the category of
children’s education, as
mentioned above.
RMB3,600 per year to be Qualifying continued Eligible to taxpayer who
claimed in the tax year during education for vocational attains the qualified
which the certificate of the personnel/professional vocational/professional
vocational/professional personnel. certificate.
qualification is attained.

EXHIBIT 9.26 Rules for claiming specific additional deductions

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Name of Deductible threshold Qualifying conditions Eligibility

SADs
Medication The balance of the actual The actual medical Eligible to taxpayer
for critical expenses borne by the expenses incurred, after (i.e. the patient or either
illnesses taxpayer exceeds RMB15,000, deducting the claims parent of the minor
capped at RMB80,000 per year received from the medical patient), or spouse
insurance under the during the IIT annual
social security systems, reconciliation filing.
for the taxpayer, spouse
and minors of the family
respectively.
Mortgage RMB1,000 per month for a The mortgage loan interest Eligible to claim 50%
loan maximum of 240 months for the first residential of the deduction per
interest property of a taxpayer or spouse, or 100% per
their spouse. Mortgage spouse if the mortgage
loan concluded under loan was concluded
commercial loans or prior to their marriage.
housing fund loans are both
acceptable.
Housing RMB1,500 per month For leased property located Eligible to either
rental in a municipality. taxpayer or spouse
who is the lessee of the
RMB1,100 per month For leased property located
leased property during
in a medium size city with
the actual leased period,
registered population of
provided that the
over 1 million.
taxpayer and spouse
RMB800 per month For leased property are working in the same
located in a small city with city but do not own a
registered population of residential property in
less than 1 million. that city.
 
This deduction item and
mortgage loan interest
deduction cannot be
claimed simultaneously.
Elderly care RMB2,000 per month for single For parents of age 60 or Eligible to the
child above and grandparents taxpayer(s) from the
if children of the month that the elderly
RMB2,000 per month to be
grandparents are deceased. reaches the age of 60.
apportioned among siblings
with a maximum claim of
RMB1,000 per person per
month.

EXHIBIT 9.26 (Continued)

Other Deductible Items Permitted by Law (Group 4)

Please refer to Exhibit 9.27 for details of the other deductible items falling under Group 4.

9.4.4.6 IIT Computations
To this point, we have learned the following:

• Who is subject to IIT;

• What income schedules are chargeable to IIT;

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Other deductible items Deductible threshold

Recognised charitable donation Capped at 30% of the taxpayer’s gross taxable
income
Qualified corporate annuity Not in excess of 4% of the taxable income
Qualified professional annuity Not in excess of 4% of the taxable income
Qualified commercial health insurance RMB200 per month
(i.e. RMB2,400 per annum)
Tax deferrable commercial pension insurance 6% of monthly income, capped at RMB1,000 per
month (i.e. RMB12,000 per annum)
Other deductible items stipulated by the State To be further determined by the State Council.
Council

EXHIBIT 9.27 Group 4 deductible items permitted by law

• What is comprehensive income and schedular income;

• What kind of deductions are eligible under each schedule of income;

• How to ascertain the taxable income as per the relevant rules under each schedule of
income; and

• Which IIT rate or rate table should be applied for computing the IIT payable.

In this section, we learn how to compute the IIT payable by an individual taxpayer. The
following are the steps involved in tackling an IIT computational question:

Step 1: Applying Exhibit 9.17 in identifying the individual’s Chinese domicile and tax
residency status in order to determine the related tax treatments.

Step 2: If the individual is a non-Chinese-domiciled individual, then we will need to

assess if any of the apportionment formulas mentioned in Exhibit 9.18 are applicable for
determining the taxable income. Please pay special attention to the specific rules applied to
senior management executives.

Step 3: Classifying the income according to the schedules of income explained in

Section 9.4.3.1.

Step 4: Classifying whether the income is comprehensive income or schedular income

based on the schedule of income identified.

Step 5: Ascertaining the taxable income based on the rules under the identified schedule of
income, as illustrated in Exhibit 9.24.

Step 6: Determining the deductions eligible in accordance with the identified schedule of
income, as illustrated in Section 9.4.4.5.

Step 7: Identifying the applicable IIT rate or rate table for computing the IIT payable.

Step 8: Determining the IIT filing requirements and due dates in accordance with
Exhibits 9.29 and 9.30.

Let us now work through the following Apply and Analyse question by applying the
aforementioned steps.

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Apply and Analyse 8
Mr. Lin is the finance manager of CLA-Xiamen. He reports to Mr. Kwok who is the general
manager of the entity. He is a Chinese national and domiciled in Xiamen. He is therefore
a tax resident for IIT purposes. The additional information regarding the employment
income and expenses incurred by Mr. Lin for the 2019 tax year are as follows:

• His monthly employment income is RMB38,000, net of Group 2 deductible items.

• He is eligible to claim Group 3 deductions of RMB3,000 per month.

• He made a donation of RMB5,000 to a recognised charitable organisation (i.e. a

Group 4 deductible item) before the Chinese New Year Holidays in February 2019.

• He has no other income earned for the 2019 tax year.

• Since the Xiamen entity is a newly formed one, no bonus nor any other incentive
payment has been paid in 2019.

Required:

Compute the monthly and annual IIT liability of Mr. Lin for 2019.

Analysis

Step 1: Since Mr. Lin is a Chinese national and is domiciled in China, he should be subject
to IIT on his worldwide income.

Step 2: Not applicable.

Steps 3–8: Salary income is classified in Schedule 1, which is one of the schedules of
income falling under the comprehensive income category. His IIT is required to be withheld
by CLA-Xiamen (as the withholding agent) on a monthly and provisional basis. His monthly
provisional IIT positions for the 2019 tax year are illustrated in the following table (in RMB):

Month Monthly Groups 1, 3 Cumulative Applicable Quick Cumulative Net

employment and 4 provisional marginal calculation provisional provisional
income (net deductions taxable IIT rate deduction IIT withheld monthly
of Group 2 allowed income (QCD) IIT paid
deductions) reported

1 38,000 8,000 30,000 3% 0 0 900

2 38,000 13,000 55,000 10% 2,520 900 2,080

3 38,000 8,000 85,000 10% 2,520 2,980 3,000

4 38,000 8,000 115,000 10% 2,520 5,980 3,000

5 38,000 8,000 145,000 20% 16,920 8,980 3,100

6 38,000 8,000 175,000 20% 16,920 12,080 6,000

7 38,000 8,000 205,000 20% 16,920 18,080 6,000

8 38,000 8,000 235,000 20% 16,920 24,080 6,000

9 38,000 8,000 265,000 20% 16,920 30,080 6,000

10 38,000 8,000 295,000 20% 16,920 36,080 6,000

11 38,000 8,000 325,000 25% 31,920 42,080 7,250

12 38,000 8,000 355,000 25% 31,920 49,330 7,500

Total: 456,000 101,000 56,830

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Apply and Analyse 8 (continued)

Once the monthly provisional IIT compliance obligations have been fulfilled, Mr. Lin
is subject to the annual reconciliation IIT filing after the end of a tax year. For the 2019
tax year, his annual reconciliation filing is required to be lodged with the Chinese tax
authorities during the period from 1 March until 30 June 2020. Please refer to Section 9.4.6
for details of various tax filing due dates.

For the purposes of preparing the annual reconciliation IIT filing, Mr. Lin has to, first,
re-compute his taxable income on an annual and overall basis as follows:

Annual taxable income Applicable marginal IIT rate QCD

((RMB456, 000 RMB101, 000) 25%) RMB31, 920

(RMB355, 000 25%) RMB31, 920

RMB56, 830

Based on the annual reconciliation computation, the annual IIT due for Mr. Lin for
the 2019 tax year equals the total net provisional monthly IIT paid and withheld by his
withholding agent (i.e. his employer CLA-Xiamen) for 2019. Thus, he will not be required to
make any further IIT payment when the annual reconciliation IIT return is lodged nor apply
for any tax repayment in this respect.

9.4.5 Tax Incentives

The IIT Law does not provide much in the way of tax incentives to either tax residents or
non-tax residents. The rebate from the Chinese tax authorities to a withholding agent
computed on 2% of the total amount of IIT payable withheld by the withholding agent possibly
serves as the only incentive provided by 2018 IIT Law (Article 17, IIT Law).

9.4.5.1 Three-year Transition Period Provided by Circular 164

In respect of the preferential tax treatments provided by the 1994 IIT Law, Circular 164 issued
by the Chinese tax authorities provided a three-year transitional measure for the application of
IIT preferential treatment for tax-exempt fringe benefits for foreign nationals, annual bonuses,
equity-based compensation, severance payments and so on. This three-year clock commenced
from 1 January 2019 and lapses on 31 December 2021. The following discusses the application
of Circular 164 for each relevant type of income.

Tax-exempt Fringe Benefits for Foreign Nationals

Foreign nationals who are tax residents for IIT purposes are eligible to elect either:

1. To commence claiming specific additional deductions under the 2018 IIT Law; or

2. Continue to claim exemptions on the following fringe benefits as prescribed under Tax
Circular Guoshuifa (1997) No. 54:

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a. Children’s education allowance;

b. Housing allowance;

c. Allowance received for attending Chinese language courses;

d. Allowance received for home leave trips;

e. Relocation allowance; and

f. Meal and laundry allowances.

Upon the lapse of the three-year transition period, the aforementioned fringe benefit items
a, b and c will be replaced by respective specific additional deductions of a similar nature.
However, Circular 164 has not addressed the validity of the fringe benefit items d, e and f
from 1 January 2022 onward.

Annual Bonus
IIT payers and their withholding agents are provided to elect to apply either of the following
treatments for computing the IIT due on the annual bonus received during the three-year
transition period:

1. Continue to apply the preferential treatments provided by Tax Circular Guoshuifa

(2005) No. 9, that is, the applicable IIT rate and the quick calculation deduction amount
are identified by dividing the annual bonus by 12 with reference to the monthly IIT rate
table. As a result, the IIT computation formula is illustrated as follows:

IIT due Annual bonus applicable IIT rate Quick calculation deduction

2. Aggregate the annual bonus with the comprehensive income earned during the
same tax year.

Equity-based Compensation
Gains realised from qualified equity-based compensation is eligible to be treated as a separate
source of income instead of aggregating into the taxpayer’s comprehensive income for
IIT purposes.

If a taxpayer receives multiple instalments of gains in one tax year, all instalments have to
be aggregated for the purposes of enjoying this IIT preferential treatment.

Taxpayers should refer to the annual IIT rate table for identifying the applicable IIT rate and
quick calculation deduction amount. The calculation formula is illustrated as follows:

IIT due Total gains (if multiple instalments in existence) applicable IIT rate
Quick calculation deduction

Circular 164 states that the relevant IIT preferential treatment to be applied after the lapse
of the three-year transition period will be announced in due course.

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Withdrawals from Qualified Annuity

Gains realised on withdrawing from a qualified annuity are eligible to be treated as a
separate source of income instead of aggregating into the taxpayer’s comprehensive income
for IIT purposes. The applicable IIT rate and quick calculation deduction are illustrated in
Exhibit 9.28.

Withdrawal intervals Applicable IIT Rate Table

Monthly basis Monthly IIT rate table
Quarterly basis Gains divided by three then apply
the monthly IIT rate table
Annual basis/permanent departing Annual IIT rate table
from China/death case

EXHIBIT 9.28 IIT rates for qualified annuity

Severance Payments
Any qualified severance payment that is in excess of three times of the local average wages
for the immediate past year is eligible to be treated as a separate source of income instead of
aggregating into the taxpayer’s comprehensive income for IIT purposes.

Any one-off compensation payment for early retirement is also eligible to be treated
as a separate source of income and amortised over a period equivalent to the numbers
of years between the date of early retirement and the mandatory retirement date for
IIT purposes.

The annual IIT rate table applies to both of the aforesaid income items.

9.4.5.2 Greater Bay Area

To attract more foreign talents to work in the Guangdong-Hong Kong-Macau Greater Bay Area
(GBA), the MOF and STA jointly issued Caishui (2019) No. 31 in March 2019. It grants IIT subsidy
to eligible overseas talents (including Hong Kong, Macau and Taiwan) working in the GBA.

Eligible persons working in the GBA can obtain financial subsidies from the local
governments in the form of IIT rebate, calculated as the difference between the actual IIT paid
by the persons and 15% of their taxable incomes. The subsidies will not be treated as taxable
incomes in the hands of the taxpayers.

This IIT incentive in the form of subsidy applies to IIT paid on the following incomes in
accordance with the IIT Law:
(1) Wages and salaries;

(2) Remuneration for labour services;

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(3) Remuneration for manuscripts;

(4) Royalty income;

(5) Income generated from business operations; and

(6) Subsidies income obtained from designated government talent projects or

programmes.

9.4.6 Tax Filing and Payment

9.4.6.1 General Rules
• For Chinese-domiciled taxpayers, their Taxpayer Identification Number (TIN) should
be their respective Chinese Citizen Identity Card Number. For those taxpayers who
do not have a Chinese Citizen Identity Card Number, the Chinese tax authorities will
assign a TIN to them after a duly executed IIT Basic Information Form (Form A) has
been filed to the Chinese tax authorities by the withholding agent (Article 9, IIT Law
and Circular 59).

• While a withholding agent is obligated to report the full amount of the income and
withhold the full amount of tax payable in compliance with the relevant laws, a taxpayer
is obligated to provide the correct and genuine personal and tax-related information to
the withholding agent and is entitled to retrieve the relevant information on his or her
tax reporting and tax compliance matters from the withholding agent. Meanwhile, it is
the taxpayer’s obligation to report for IIT purposes any of the following circumstances,
should they arise (Articles 10 and 11, IIT Law):

°° Required to lodge annual reconciliation filing as a result of deriving

comprehensive income;

°° No withholding agent is in existence after deriving taxable income;

°° Failure of withholding tax payable by withholding agent after deriving

taxable income;

°° Earned non-Chinese-sourced income;

°° Deregistering domiciliation because of emigrating out of China;

°° Non-tax resident earning wages and salaries from two or multiple Chinese
employers;

°° Other circumstances ruled by the State Council.

• If a tax resident earns any income outside China, they should complete the relevant IIT
filing between 1 March and 30 June of the following tax year (Article 13, IIT Law).

• If a non-tax resident generates employment income from two or multiple Chinese

employers, their IIT filing should be lodged by the 15th day of the month following the
receipt of such income (Article 13, IIT Law).

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9.4.6.2 Specific Rules
Regarding the specific rules on tax filing and payment as provided by the IIT Law, IIT Rules and
the relevant circulars, please refer to Exhibits 9.29 and 9.30.

Schedule of Provisional Due date Annual Due date for

income withholding for filing of reconciliation filing of annual
filing provisional filing IIT return and
IIT return and remitting of IIT
remitting of tax payment
payment
Comprehensive YES, for tax 15th day of the YES, for tax Between 1 March
income resident and on month following resident and 30 June of the
monthly basis the receipt of the following tax year
income
YES, for non-tax 15th day of the NO, for non-tax Not applicable
resident month following resident (N/A)
the receipt of the
income
5. Income YES, and on 15th day of the YES By 31 March of the
from business either monthly or month following following tax year
operations quarterly basis the month/quarter
of the receipt of
the income
6. Interest, On monthly or 15th day of the N/A N/A
dividend income transactional basis month following
and profit sharing the receipt of the
income
7. Income from On monthly or 15th day of the N/A N/A
leasing of property transactional basis month following
the receipt of the
income
8. Income from On monthly or 15th day of the N/A N/A
transfer of transactional basis month following
property the receipt of the
income
9. Contingent On monthly or 15th day of the N/A N/A
receipts transactional basis month following
the receipt of the
income

EXHIBIT 9.29 Withholding agent in existence

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Schedule of Provisional Due date Annual Due date for

income filing for filing of reconciliation filing of annual
provisional filing IIT return and
IIT return and remitting of IIT
remitting of tax payment
payment
Comprehensive YES, on monthly 15th day of the YES Between 1 March
income basis month following and 30 June of the
the receipt of the following tax year
income
5. Income YES, and on 15th day of the YES By 31 March of the
from business either monthly or month following following tax year
operations quarterly basis the month/quarter
of the receipt of
the income
6. Interest, On monthly or 15th day of the N/A N/A
dividend incomes transactional basis month following
and profit sharing the receipt of the
income
7. Income from On monthly or 15th day of the N/A N/A
leasing of property transactional basis month following
the receipt of the
income
8. Income from On monthly or 15th day of the N/A N/A
transfer of transactional basis month following
property the receipt of the
income
9. Contingent On monthly or 15th day of the N/A N/A
receipts transactional basis month following
the receipt of the
income

EXHIBIT 9.30 Withholding agent NOT in existence

Key Learning Point

The new set of rules for assessing the tax residency of foreign nationals working in China,
that is, Chinese year and six-year test, and the new group of specific additional deductible
items are the key features of the new IIT Law regime. Candidates should also be familiar
with the details of the three-year transition rules for the application of the IIT preferential
treatments provided under the previous IIT regime.

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Knowledge Check Questions

Question 7
In reference to Mr. Kwok’s case in the Illustrative Examples, assume that he was present
in China for 190 days between 1 January 2019 and 31 July 2019 and still holds his Director
of Business Development position with CLA-HK and General Manager of CLA-Xiamen
concurrently. For China IIT purposes, identify which of the following statements is correct.
A Mr. Kwok was a tax resident in China for 2019 because he was present for more than
183 days in China.
B Mr. Kwok was a tax resident in China in 2019 because he has already started to establish
economic ties and accommodation in China in anticipation of his relocation after taking
up the General Manager role of CLA-Xiamen.
C Mr. Kwok was not a tax resident in China for 2019 and also not a tax resident of Hong
Kong for the same tax year. Therefore, no HK salaries tax is payable in 2019.
D None of the above is correct.

Question 8
During Mr. Wong’s two year secondment period to China that commenced on 1 January
2019, he planned to visit his office in Hong Kong for business and meet his relatives in
Singapore for a Christmas holiday. His travel schedule is shown as follows:
Hong Kong trips: 1 March 2019–15 March 2019 (14 non-Chinese workdays), 1 August
2019–20 August 2019 (19 non-Chinese workdays)
Singapore trips: 22 December 2019–31 December 2019 (9 non-Chinese workdays)
Let us assume that Mr. Wong completed his travel schedule as above. Mrs. Wong who
helps to file his China IIT return for 2019, is asking for advice if the time apportionment
method is applicable in this case. Please note that Mr. Wong still holds management
oversight responsibility for CLA-HK during this secondment term and receives Hong Kong-
sourced income in this regard. Identify which of the following statements is correct.
A The time apportionment method is not applicable because Mr. Wong’s individual
absence from China is less than 30 days, while his total number of days absent from
China in 2019 is less than 90 days.
B The time apportionment method is not applicable because Mr. Wong is a Hong
Kong citizen.
C Mr. Wong’s total China remuneration in 2019 is fully subject to China IIT as this is treated
as China-sourced income.
D None of the above is correct.

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SUMMARY

• Unlike Hong Kong, China imposes a wide variety of taxes, both direct and indirect, on both
corporations and individuals. Examples of direct taxes are CIT and IIT while indirect taxes are
VAT and CT. Other common taxes are land appreciation tax, real estate tax, land occupation
tax and stamp duties.

• It is important to understand the tax objection process in China, namely, tax administrative
review and litigation, to ensure that taxpayer observes the key timeline involved in
each process.

• BT has been abolished in China with the full implementation of VAT reform as of 1 May 2016.
As such, there are currently two main types of indirect taxes in China, namely, VAT and CT.
With respect to VAT, it is generally seen as a pass-through cost for VAT general taxpayers
as the VAT burden is borne by the final consumer. Alternatively, CT is an added cost to both
business and individuals for certain category of products. When computing output VAT, it is
important to remember that CT, where applicable, forms part of the VAT cost base.

• If an enterprise is established in China, it is treated as TRE for China tax purposes and is
subject to CIT on income derived from within and outside of China. However, an enterprise
established outside China is deemed as TRE for China tax purpose if the place of effective
management is exercised in China.

• The CITLIR defines the ‘place of effective management’ as the place where the overall
management and control of the production and business operations, personnel, accounting,
properties, etc. is located.

• Notwithstanding that a non-TRE does not have an establishment in China or its place
of effective management is outside of China, it may still be subject to CIT if it derives
China-source income by way of WHT. The issuance of Announcement 37 effectively reduces
the compliance burden on withholding agents when remitting WHT to the China tax authority.

• In computing the net taxable income for CIT purposes, taxpayers should note that there
are deduction limits on certain business expenses such as entertainment and charitable
donations. However, qualifying R&D expenses may enjoy ‘super deduction’ (150% of actual
qualifying expenses incurred). Please note for certain qualified small and medium technology
enterprises, super deduction at 175% of qualifying R&D expenses is available.

• Tax losses from previous years can only be carried forward for five years from the year that
such a loss arises. Therefore, when utilising tax losses to offset against a current year’s taxable
income, a taxpayer is encouraged to use the ‘oldest’ tax loss first to reduce the risk of loss
expiration. Tax losses cannot be carried back to preceding years under China CIT.

• Management fee expenses are generally scrutinised by the China tax authority in greater
detail especially when charged by a related party. When claiming a deduction, the taxpayer

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must be able to provide relevant supporting documents such as service agreements and
invoices and to demonstrate that such a management fee does not relate to stewardship or
shareholder activities, is incurred in the production of the enterprise income and the amount
is calculated on arm’s length basis.

• China implements strict foreign exchange control procedures. An enterprise in China needs
to understand the compliance process when remitting funds out of China as outlined by
SAFE and PBOC, whether it is in the form of dividend distribution, interest, royalties or
management fees.

• The updated IIT Law came into effect in 1 January 2019. It provides a new set of rules for
assessing an individual’s tax resident status for IIT purposes. In this regard, the respective
concepts of the 183-day test, Chinese year and six-year test are important.

• The IIT Law revises the scope of chargeable income by introducing the concept of
comprehensive income categories to be taxed on an aggregate taxation basis, while the other
schedular income categories remain to be taxed according to their respective schedules.

• The IIT Law increases the standard personal deduction on comprehensive income to
RMB60,000 per annum (i.e. RMB5,000 per month) to all taxpayers, regardless of whether the
taxpayer is a Chinese national or a foreign national.

• The IIT Law introduces six specific additional deduction items for expenditures by tax
residents. A three-year transition period is offered for non-tax residents to migrate from the
IIT preferential treatments provided by the previous IIT regime to the current regime.

• The IIT Law introduces a new set of apportionment formulas for non-Chinese-domiciled and
non-tax resident individuals, as well as for senior management executives, to quantify the
appropriate taxable income for IIT purposes.

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MIND MAP

TYPES OF TAXES TAX ADMINISTRATION

Value added tax (VAT) Tax collections by state versus local tax
Consumption tax (CT) bureaus
Corporate income tax (CIT) Key items and timeline under TAR and TAL
Individual income tax (IIT) Foreign investment restriction
Others (e.g. land appreciation tax, real Free trade zones and high-tech status
estate tax) CONSUMPTION TAX (CT)
VALUE ADDED TAX (VAT) TAX SYSTEM AND
Applicable to both individuals and
ADMINISTRATION IN
General versus small scale taxpayer businesses
MAINLAND CHINA
VAT is a pass-through cost for general VAT Unlike VAT, CT is levied only once when
payer goods are manufactured, processed or
imported
VAT rates (basic, reduced, zero-rated and
exempt) for domestic and international sales No refund of CT so it is part of business costs
VAT reform: how it creates a better Rates of CT vary depending on type of
business environment products
VAT special invoice and filling obligation INDIVIDUAL INCOME TAX (IIT)
CORPORATE INCOME TAX (CIT) Tax resident vs non-tax resident
Concept of tax residency for TRE vs non-TRE Specific tax rules for non-PRC domiciled
Tax deductions and carry forward of losses individuals
Importance of substance and Nine schedules of income chargeable to IIT
contemporaneous documentation for Comprehensive income vs schedular income
cross-border inter-company payments Tax rates
(management fee, royalties, interest, Four groups of allowable deductions/reliefs
dividends)
Three-year transition period provided by
Forex procedures for remittance outside Circular 164
of China
Specific rules on tax filing and payment
requirements

LIST OF FORMULAS

VAT

• General Calculation Method:

VAT payable Current Output VAT Current Input VAT

Output VAT Sales revenue * VAT rate

*
  Sales revenue refers to the entire price and other charges obtained by the taxpayer from
providing taxable goods and services.

Where the taxpayer’s pricing combines sales revenue with Output VAT, the taxpayer should
use the following formula to calculate the sales revenue:

Sales Revenue Tax-inclusive sales revenue (1 VAT rate)

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• Simplified Calculation Method:

VAT payable Sales Revenue from Sales of Goods VAT levying rate (3%)

• VAT withholding for non-residents:

Amount of tax to be withheld Price paid by the service recipiient

(1 VAT rate) VAT rate

Consumption tax

a. Ad valorem:

Consumption tax payable Taxable sales amount Tax rate

b. Quantity-based:

Consumption tax payable Taxable sales quantity Tax amount per unit

Withholding tax for tax treaty purposes:

Tax payable Taxable income Applicable withholding tax rate

Appendix 9.A Annual Individual Income Tax Rate Table for Chinese Residents
(Applicable to Comprehensive Income)

Band Cumulative annual Marginal tax rate Quick calculation

taxable income (RMB) (%) deduction (RMB)
1 < 36,000 3 0
2 36,000–144,000 10 2,520
3 144,000–300,000 20 16,920
4 300,000–420,000 25 31,920
5 420,000–660,000 30 52,920
6 660,000–960,000 35 85,920
7 > 960,000 45 181,920

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Appendix 9.B Schedule 2 Individual Income Tax Rate Table (Applicable to Tax Resident
Generating Income Related to Remuneration for Labour Services)

Band Annual taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 20,000 20 0
2 20,000–50,000 30 2,000
3 > 50,000 40 7,000

Appendix 9.C Monthly Individual Income Tax Rate Table for Non-residents

(Applicable to Comprehensive Income)

Band Monthly taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 3,000 3 0
2 3,000–12,000 10 210
3 12,000–25,000 20 1,410
4 25,000–35,000 25 2,660
5 35,000–55,000 30 4,410
6 55,000–80,000 35 7,160
7 > 80,000 45 15,160

Appendix 9.D Individual Income Tax Rate Table for Income Generated from
Business Operations

Band Annual taxable Marginal tax rate Quick calculation

income (RMB) (%) deduction (RMB)
1 < 30,000 5 0
2 30,000–90,000 10 1,500
3 90,000–300,000 20 10,500
4 300,000–500,000 30 40,500
5 > 500,000 35 65,500

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Answers to Knowledge Check Questions

Question 1
Answer A is correct. When determining which tax authority has the responsibility to collect
CIT, students should first determine whether the taxpayer is an FIE (foreign-invested
enterprise) or a domestic enterprise. If it is the former, then the state tax bureau located
in the city where the FIE is established has the responsibility to collect such CIT from
the taxpayer. Understanding the right procedure about China’s tax administration is as
important as making the tax payment itself as it avoids unnecessary interest and penalties
on late payment if the taxpayer remits the tax payment to the wrong tax bureaus.
Answer B is incorrect. The state tax bureau in Beijing does not collect CIT from a FIE tax
resident enterprise in Shanghai.
Answer C is incorrect. A local tax bureau does not collect CIT from a FIE.
Answer D is incorrect. This is not the right procedure for tax administration.

Question 2
Answer A is incorrect. RMB30,000 is not an equal share.
Answer B is correct. For VAT revenue allocation purposes, this is shared equally between
the state tax bureau and the local tax bureau. Therefore, the local tax bureau is entitled to
collect RMB100,000 × 50% = RMB50,000.
Answer C is incorrect. RMB75,000 is not an equal share.
Answer D is incorrect. The local tax authority does not determine the tax rate on a
case-by-case basis.

Question 3
Answers A, B and C are incorrect. The tax authority has the right to refuse the objection if
the tax is not paid first.
Answer D is correct. Notwithstanding any objection, the taxpayer must settle the tax
owing plus any late payment surcharges before his or her objection is treated as valid and
reviewed by TAR. The taxpayer needs to understand that if the tax under dispute is not
paid or security/collateral is not received by the tax authority, the authority has the right to
refuse the objection and it will not be processed accordingly.

Question 4
(i) Output VAT on domestic sales = RMB500,000 × 13% = RMB65,000
(ii) Output VAT RMB65,000
Input VAT = RMB200,000 × 13% (RMB26,000)
Net VAT payable RMB39,000

Question 5
Answers A and C are incorrect. Hong Kong does not have the concept of tax residency
under its domestic tax law due to its territorial tax regime.
Answer B is correct. Based on the above information, the place of management and
control is in China. Therefore, Bubble is a tax resident in China.
Answer D is incorrect. Bubble is a tax resident in China.

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Question 6
Answer A is correct. Since Finco (Hong Kong) Ltd is the beneficial owner of the interest paid
by Finco (China) Ltd, it is entitled to a reduced treaty rate of 7% on the interest payments
from Finco (China) Ltd to Finco (Hong Kong) Ltd.
Answer B is incorrect. Finco (China) Ltd did not make interest payments to Finco Singapore.
Answer C is incorrect. Notwithstanding that Finco (China) Ltd is within the same group of
companies as Finco (Hong Kong) Ltd, withholding tax still applies.
Answer D is incorrect. There is no WHT exemption on interest payable on related party
loans under the Hong Kong–China DTA.

Question 7
Answer A is incorrect. The assessment rule for tax residency was reset on 1 January 2019.
Although 2019 will be treated as Mr. Kwok’s Chinese year because his stay in China has
exceeded 183 days in 2019, the 2019 tax year alone will not result in Mr. Kwok being
classified as a tax resident for IIT purposes due to the fact that he has not failed the
six-year test.
Answer B is incorrect. The assessment of the tax residency of a non-Chinese national
follows the concept of the Chinese year and six-year test. Any economic ties and
accommodation in China and any anticipation of future relocation should not be taken as
decisive factors for tax residency assessment purposes.
Answer C is incorrect. The Chinese tax residency status should be assessed by the concepts
of the Chinese year and six-year test. While Hong Kong imposes tax on a territorial basis
and Mr. Kwok continues to earn Hong Kong-sourced income from his position as Director
of Business Development of CLA-HK, he will continue to be subject to Hong Kong salaries
tax in this regard.
Answer D is correct. All the other options are incorrect.

Question 8
Answer A is incorrect. The eligibility of time apportionment depends on whether one is a
non-Chinese-domiciled individual and generates incomes both inside and outside China.
Given that the rules for assessing a non-Chinese national’s tax residency status were reset
on 1 January 2019, and Mr. Wong holds employment positions inside and outside China, he
should qualify for the time apportionment treatment for IIT purposes.
Answer B is incorrect. Eligibility for the time apportionment method does not depend on
the status of a taxpayer’s citizenship.
Answer C is incorrect. Mr. Wong should still be regarded as a non-Chinese-domiciled
individual based on the information provided. Given that he derived employment income
both inside and outside China and was qualified as a senior management executive, he
should be eligible for the time apportionment treatment for the 2019 tax year. His IIT
position should be ascertained based on Exhibit 9.18.
Answer D is correct. All the other options are incorrect.

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EXAM PRACTICE

QUESTION 1
Star Best Ltd is a company incorporated and tax resident in China. Its main business is to sell
coffee and other accessories in China and has become a major competitor to a well-known
US coffee company operating in China.

Star Best Ltd’s accounting profit before tax for the year 2019 is RMB3,800,000 and its
turnover is RMB15,000,000. During the year 2019, the following items were included in
arriving at the accounting profit before tax:

(a) Entertainment expenses = RMB500,000.

(b) Star Best Ltd is a qualified, medium-sized technology company. It incurred research and
development (R&D) expenses of RMB400,000.

(c) Due to the close similarity of Star Best Ltd’s name and logo to its US competitor, it
received a penalty of RMB100,000 for infringement of a trademark from the China
trademark bureau.

(d) Because of a major flood in 2019, Star Best Ltd lost some of its inventory totalling
RMB800,000. Fortunately, Star Best Ltd insured all its inventory and received insurance
compensation of RMB750,000.

(e) Provision for doubtful debts of RMB30,000.

(f) One of Star Best Ltd’s debtors owed RMB95,000 and went into liquidation in 2019. Star
Best Ltd has used all reasonable efforts to recover the debts but were unsuccessful.

(g) Star Best Limited received a government subsidy of RMB500,000 for its specific
research in growing new coffee beans in China. However, Star Best Ltd only incurred
operational expenses of RMB350,000.

(h) Treasury bond interest income of RMB250,000.

(i) VAT refund on export of goods for RMB1,500,000.

(j) Star Best Ltd received a net dividend income from its Singapore subsidiary of
RMB180,000 (gross dividend of RMB200,000).

Required:

Calculate the CIT payable by Star Best Ltd for the year 2019.

QUESTION 2
StreamFlix Entertainment Inc (SEI) is a Canadian incorporated company that distributes
popular movies over the internet on a monthly subscription basis. In order to expand its
customer base, SEI employs a number of regional sales and marketing managers to increase
its market share. The individuals below are employed under the following arrangements:

(a) Mr. Lam is a Canadian citizen and lives in Canada. Due to his knowledge of both
Canada and China markets as well as his appreciation of both cultures, he was hired
by SEI’s China subsidiary as Business Development Director since 1 January 2014. He
has not returned to Canada other than an annual vacation to visit his parents who live
in his house in Toronto. During the month of June 2019, Mr. Lam received dividend
income from his Canadian securities account which was deposited into his Canadian
bank account.

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(b) Mr. Cheung is a Chinese citizen who lives in China with his family. He works for SEI’s
China subsidiary and was recently seconded to work in the SEI’s Singapore subsidiary
to expand the South East Asia market. Mr. Cheung brought his family with him to
Singapore and he has not returned to China since 2016. Mr. Cheung’s salary is paid by
SEI Singapore.

(c) Mr. Smith is an Australian citizen and is employed by SEI’s Australia subsidiary. He
was seconded to China for a short period from 1 January 2019 while his family lived in
Australia. He stayed in China for 88 days in 2019. His salary was paid by SEI Australia
during his China secondment period.

Required:

Explain the IIT implications for each of the above employment arrangements.

QUESTION 3
I-Call Mobile Ltd (ICM) is a Korean company that manufactures mobile phones and sells
them at a very competitive price through its online platform, which enables ICM to reduce
expensive overhead costs by not having physical stores. Below are a series of transactions
that took place in 2020:

(a) In 2020, ICM sold mobile phones through its online ordering system to its Chinese
customers and generated revenue of RMB10 million with a net profit of RMB4 million.

(b) Due to its technological edge and designs, ICM agreed to allow Chit Chat Ltd, a Chinese
manufacturing company, to use its proprietary technology to manufacture mobile
phones in China under a licensing agreement. ICM received a royalty of 8% on the gross
domestic revenue. In 2020, Chit Chat Ltd generated revenue of RMB50 million. Assume
a royalty withholding tax rate of 10%.

(c) As part of the licensing agreement with ICM, Chit Chat Ltd is allowed to request
technical support at a rate of RMB1,000/hour. In 2020, ICM sent a team of engineers
to China to support Chit Chat Ltd’s operation for 7 months. ICM received a fee of
RMB1 million for the provision of services in China. ICM is responsible for any China
taxes. The China tax authorities have deemed ICM to have a PE in China and assessed a
deemed profit rate of 30% on the service fee.

Required:

Determine the applicable CIT liability in each of the preceding scenarios, ignoring any VAT
calculation.

QUESTION 4
Dragon Ltd is a company set up in Guangzhou. In 2020, Dragon Ltd made the
following payments:

(a) A consultancy fee of RMB3,800 for services provided in China paid to Mr. Long, who is a
Chinese tax resident.

(b) A consultancy fee of RMB100,000 for services provided in China paid to Ms. Goh, who is
not a Chinese tax resident.

(c) A royalty of RMB150,000 paid to Star Ltd, which is a tax resident enterprise of China.

(d) A royalty of RMB200,000 paid to Mooncake Singapore Pte Ltd, which is not a tax
resident enterprise of China. Assume a 10% WHT rate under the applicable DTA
with China.

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Required:

Please advise whether Dragon Ltd is the withholding agent for income tax for each of the
transactions above.

In the event that Dragon Ltd is the withholding agent, calculate the amount of income tax to
be withheld.

Note: Ignore any other taxes.

QUESTION 5
Mr. Schmidt, a non-Chinese national and a non-tax resident for IIT purposes, has derived the
following amounts of income in a tax year:

(a) Earned one-off manuscript income of RMB120,000, after converting from foreign
currency as per the appropriate foreign exchange rate, from a foreign publishing
company located in Jurisdiction A;

(b) Earned dividend income of RMB60,000, after converting from foreign currency as per
the appropriate foreign exchange rate, from a foreign company listed on the stock
exchange of Jurisdiction B;

(c) Earned annual rental income of RMB360,000 from a leased property located in
Jurisdiction B;

(d) Earned one-off consulting fee income of RMB80,000 from a Chinese oil and gas
company located in Dalian, China; and

(e) Generated a fee of RMB20,000 from Mr. Liu, his close friend in China, for providing him
with guarantees.

Required:

Compute the IIT liability of Mr. Schmidt in the following scenarios. Please disregard any
tax paid in foreign jurisdictions and any claim for foreign tax credits, and assume that Mr.
Schmidt is not a senior management executive.

(i) If this is Mr. Schmidt’s first year of stay in China and his total number of days stayed in
China is less than 90 days.

(ii) If this is Mr. Schmidt’s first year of stay in China and his total number of days stayed in
China is more than 90 days but has yet to exceed 183 days.

(iii) If this is Mr. Schmidt’s second year of stay in China and his stays in China are more than
183 days in both the current and previous tax years.

(iv) If Mr. Schmidt has stayed in China for more than 183 days in each tax year for more
than six consecutive years and has not been absent from China for more than 30
consecutive days in any tax year during that six-year period.

QUESTION 6
Mr. Cui, a Chinese national, works as a senior actuarial analyst at the shared services centre
of a reinsurance company located in Dalian, China. The following is a list of IIT-related
transactions that he has been involved in during the period from July to December 2019:

(a) Earned monthly salary of RMB20,000, net of all groups of deductions.

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(b) Disposed of an apartment located in Weihai with a selling price of RMB3,500,000. He

purchased this apartment for RMB2,000,000 and paid RMB50,000 for all the relevant
taxes and agency fees three years ago. The disposal transaction triggered taxes and
agency fees of RMB140,800.

(c) Received an award of RMB20,000 from the tax authorities for assistance provided in
tackling a tax evasion case.

(d) Received quarterly rental income of RMB15,000 from a leased property located
in Dalian.

Required:

Compute the IIT liability as per the preceding transactions of Mr. Cui for the 2019 tax year.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Accounting profit before tax 3,800,000
Entertainment expenses a
425,000
Research and development b
(300,000)
Penalty imposed by the China trademark bureau 100,000
Inventory loss and insurance compensation – no adjustmentc –
Provision for doubtful debts 30,000
Bad debt written off – no adjustment –
Government subsidy (specific) – Non-taxable (RMB500,000 − 350,000) (150,000)
Treasury bond interest income (250,000)
VAT refund on export of goods – no adjustment –
Singapore foreign tax paid on dividend income (gross-up dividend) 20,000
3,675,000
CIT at 25% 918,750
Less: Foreign tax credit: Singapore tax paid on dividend (20,000)
CIT payable 898,750
a
 Restriction on the deductibility of entertainment expenses, lower of:

RMB500, 000 60% RMB300, 000

Maximum deduction RMB15, 000, 000 0.5% RMB75, 000

Therefore, non-deductible entertainment expenses = RMB500,000 − 75,000 = RMB=425,000.

b
Super deduction on R&D expenses: an additional 75% on RMB400,000 = RMB300,000.
c
Since the incident is considered as part of the normal course of business, the loss on inventory is deductible
and the corresponding insurance compensation is taxable. Therefore, there is no further adjustment to the
accounting profit before tax.

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QUESTION 2
(a) ‘Domicile’ refers to habitual residence in China as a result of domiciliary registration,
family ties or economic interests. Habitual residence does not refer to actual physical
residence or residence of an individual for a particular period of time.

In practice, foreign individuals working in China (expatriates) are normally

considered as non-Chinese-domiciled individuals.

In the case of Mr. Lam, he is not considered to be domiciled in China as he still

keeps close ties with Canada. Therefore, Mr. Lam is only subject to tax on the income
that he derives from China, for example, his salary income. However, if Mr. Lam
continues to stay in China for the foreseeable future, he will be subject to China tax on
his worldwide income, including the dividend income he received in 2019 from the sixth
year onward (i.e. 2019 and onward).

(b) This domicile test refers to the taxpayer’s personal connections within the territory
of China. An individual who temporarily lives abroad (e.g. to undertake education,
employment, work assignments, visits to family or touring, etc.) and who will return
to China due to the above connections, is regarded as being usually resident or
domiciled in China.

In the preceding situation, Mr. Cheung is considered to be domiciled in China and is

subject to IIT on his worldwide income. His salary, even though derived in Singapore
and paid by a Singapore company, is subject to tax in China.

(c) Mr. Smith is not considered to be domiciled in China as he continues to maintain close
family ties and has an economic relationship in Australia. Since his physical presence in
China is less than 90 days in the calendar year (or 183 days under the tax treaty) and his
income was borne by SEI Australia, his proportionate salary for 88 days relating to his
work in China is not subject to IIT in China.

QUESTION 3
(a) If the China tax authority agrees that ICM does not have a PE in China in respect of its
sales of mobile phones to Chinese customers via online system, the net profit of RMB4
million is not subject to CIT under the DTA between China and Korea.

(b) Royalty income from China = RMB50,000,000 × 8% = RMB4,000,000.

Withholding tax on royalty = RMB4,000,000 × 10% = RMB400,000.

(c) China CIT on service fee = (RMB1,000,000 × 30%) × 25% = RMB75,000.

QUESTION 4
Tax withholding obligations:
(a) Dragon Ltd is the withholding agent for the payment made to Mr. Long, a resident
individual of China.

(b) Dragon Ltd is the withholding agent for the payment made to Ms. Goh, a non-resident
individual of China.

(c) Dragon Ltd is not the withholding agent for the payment made to Star Ltd, a resident
enterprise of China.

(d) Dragon Ltd is the withholding agent for the payment made to Mooncake Singapore Pte
Ltd, a non-resident enterprise of China.

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 T ax S ystem and A dministration in M ainland C hina

Withholding tax calculation by Dragon Ltd:

(a) For payment to Mr. Long:

IIT (Consultancy fee less standard allowance of RMB800) applicable tax rate

RMB (3, 800 800) 20% RMB600

(b) For payment to Ms. Goh:

IIT ((Consultancy fee less standard allowance at 20%) applicable tax rate)
Quick deduction factor

RMB ((100, 000 (100, 000 20%)) 40%) 7, 000 RMB25, 000

(c) No withholding tax is applicable.

(d) Dragon Ltd will withhold WHT of RMB200,000 × 10% = RMB20,000. Mooncake Singapore
Pte Ltd will receive a net royalty income of RMB180,000.

QUESTION 5
Based on the information provided, the taxable income for each of Mr. Schmidt’s income
streams are computed as follows if they are chargeable to IIT:
Taxable income for remuneration for manuscripts:

(Fully earned amount (20% of allowable expenses)) 70%

(RMB120, 000 (120, 000 20%)) 70%
RMB67, 200

Taxable income for dividend income:

Fully earned amount

RMB60, 000

Taxable income for property rental income:

Fully earned amount (20% of allowable expenses)

RMB360, 000 (360, 000 20%)
RMB288, 000

Taxable income for provision of consulting services (i.e. schedule of remuneration for labour
services):

Fully earned amount (20% of allowable expenses)

RMB80, 000 (80, 000 20%)
RMB64 , 000

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 TAXATION

Taxable income for provision of guarantees (i.e. schedule of contingent receipts):

Fully earned amount

RMB20, 000

(i) If this is Mr. Schmidt’s first year of stay in China and his total number of days stayed
in China is less than 90 days, then only his Chinese-sourced income which is borne
by a Chinese employer or entity is chargeable to IIT. In this regard, only his income
generated from the provision of consulting services and guarantees are chargeable
to IIT. His income for the provision of consulting services falls under the schedule of
remuneration for labour services, which is treated as comprehensive income. As a non-
tax resident generating no other stream of comprehensive income in the tax year, Mr.
Schmidt should be eligible to claim the annual standard personal deduction amount
of RMB60,000 before applying the applicable tax rate stipulated in the Monthly IIT rate
table. The related IIT payable should be as follows:
IIT payable:

( Taxable income Standard personal deduction) Applicable ma

arginal IIT rate
Quick calculation deduction
((RMB64 , 000 RMB60, 000) 10%) 210
RMB190

Mr. Schmidt’s income related to the provision of guarantees falls under the
schedule of contingent receipts in accordance with Circular 74 and no deduction is
allowed. The applicable IIT rate is flat rate of 20%. Hence,

IIT payable:

Taxable income 20%

RMB20, 000 20%

RMB4 , 000

Thus, his total IIT payable should be RMB4,190 for the tax year.

(ii) If this is Mr. Schmidt’s first year of stay in China and his total number of days stayed in
China is more than 90 days, but has yet to exceed 183 days, then he will be subject to
IIT on his Chinese-sourced income, regardless of whether the earned amount is borne
by a Chinese employer/entity or not. Hence, again, only his income generated from the
provision of consulting services and guarantees are chargeable to IIT with the same
rationale explained in the preceding (i). His total IIT payable for the tax year remains the
same at RMB4,190.

(iii) If this is Mr. Schmidt’s second year of stay in China and his stays in China are more than
183 days in both the current and previous tax years, then his non-Chinese-sourced
income borne by a Chinese employer/entity will also be chargeable to IIT in addition
to his Chinese-sourced income borne by and not borne by a Chinese employer/entity.

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 T ax S ystem and A dministration in M ainland C hina

Among the five streams of income generated in the tax year, again, only his income
generated from the provision of consulting services and guarantees fall under this
category and are chargeable to IIT. Therefore, his total IIT payable for the tax year
remains the same at RMB4,190.

(iv) If Mr. Schmidt has stayed in China for more than 183 days in each tax year for more
than six consecutive years and has not been absent from China for more than 30
consecutive days in any tax year during that six-year period, he will have met the
six-year test and be regarded as a Chinese-domiciled individual for IIT purposes.
Accordingly, he will be subject to IIT on his worldwide income, including non-Chinese-
sourced income, even borne by a non-Chinese employer/entity. As a result, all his five
streams of income will fall under the IIT Law net.

The respective incomes falling under the schedules of remuneration for labour
services and remuneration for manuscripts should be consolidated as comprehensive
income for computing the IIT. Given that no further information about his position
on claiming Groups 2, 3 and 4 deductions are available, we will make the assumption
that only the Group 1 deduction is available to him. Since the components of the
comprehensive income are not wages and salary, the Monthly IIT rate table should
be applied. The other three streams of income are regarded as schedular income
and should be taxed separately by applying the Monthly IIT rate table. The detailed
computations are illustrated as follows:
IIT Payable on comprehensive income

(Total taxable income of comprehensive income schedules

Standard personal deduction) Applicable marginal IIT rate
Quick calculation deduction
((RMB67, 200 RMB64 , 000 RMB60, 000) 35%) RMB7,160

RMB17, 760

Mr. Schmidt’s dividend income falls under the schedule of interest, dividend and profits
sharing. As such, there is no deduction eligible before applying the flat rate of 20%.

IIT Payable on dividend income:

Taxable income 20%

RMB60, 000 20%

RMB12, 000

His property rental income falls under the schedule of income from leasing of
property which is schedular income and needs to be taxed separately. Since the
amount of income exceeds the RMB4,000 threshold, a 20% standard deduction is
allowed before applying the flat rate of 20% for determining the IIT payable. Thus,

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 TAXATION

IIT Payable on property rental income:

( Taxable income (20% standard deduction)) 20%

(RMB360, 000 (360, 000 20%)) 20%
RMB57, 600

Therefore, Mr. Schmidt’s total IIT payable for the tax year should be:

RMB4 , 000 RMB17, 760 RMB12, 000 RMB57, 600

RMB91, 360

QUESTION 6
To answer this question, we first need to classify Mr. Cui’s four streams of income according
to the appropriate schedule of income in order to determine the related taxable income and
ascertain the applicable types of deductions and tax rates.
Step 1: Classification of income

Income Schedule Comprehensive Rules for Deductions Applicable

streams of income income or determining allowed tax rate
schedular taxable
income? income
Monthly Schedule 1 Comprehensive Fully All four groups As per the
salary earned Annual IIT
amount rate table
Net gains on Schedule 8 Schedular Price of The original Flat rate
the disposal disposal purchase of 20%
of property price and
reasonable
amount
of expenses
incurred
Award Exempt N/A N/A N/A N/A
received income
from tax
authorities
Property Schedule 7 Schedular Fully RMB800 Flat rate
rental income earned or 20% of 20%
amount of expenses

Step 2: Determining the taxable income and IIT payable

(a) Monthly salary income falls under schedule 1 and is a type of comprehensive income.
Since Mr. Cui is a Chinese-domiciled individual for IIT purposes, he is eligible to claim all
the four groups of deductions when deriving the taxable income. Also, his IIT payable
should be computed by applying the Annual IIT rate table.

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 T ax S ystem and A dministration in M ainland C hina

Annual taxable income for employment income:

RMB20, 000 6 months

RMB120, 000

Annual IIT payable for employment income:

(RMB120, 000 10%) RMB2, 520

RMB9, 480

(b) Income generated from the transfer of property falls under Schedule 8 and is regarded
as schedular income. Since the transferred property is located in China, the related
income is treated as Chinese-sourced income. Under the rules of Schedule 8, the net
gains on the disposal of property, that is, selling price minus purchase price and the
reasonable amount of the actual expenses incurred, should be the taxable income. The
applicable IIT rate is a flat rate of 20%.

Taxable income from transferring of property:

RMB3, 500, 000 RMB2, 000, 000 RMB50, 000 RMB140, 800

RMB1, 309, 200

IIT payable for income from transferring of property:

RMB1, 309, 200 20%

RMB261, 840

(c) Under current rules, monetary awards received from the tax authorities related to the
provision of assistance for tax compliance purposes is specifically exempt from IIT.

(d) Income generated from leasing of property falls under Schedule 7 and is regarded as
schedular income. Since the leased property is located in China, the related income
is treated as Chinese-sourced income. Under the rules of Schedule 7, the fully earned
rental receipts after deducting either RMB800 (if the gross rental income is less than
RMB4,000) or 20% of the gross rental income (if the gross rental income is RMB4,000 or
more) should be the taxable income. The applicable IIT rate is a flat rate of 20%.

Annual taxable income from leasing of property:

RMB15, 000 2 (1 20%)

RMB24 , 000

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 TAXATION

Annual IIT payable for income from leasing of property:

RMB24 , 000 20%

RMB4 , 800

Therefore, Mr. Schmidt’s total IIT payable for the tax year should be:

RMB9, 480 RMB261, 840 RMB4 , 800

RMB276,120

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 Part E
 ong Kong Tax Planning Ideas and
H
Strategies to Enhance Tax Efficiency

Chapter 10 Hong Kong Tax Planning Ideas and Strategies

Chapter 11 Transfer Pricing

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M14_c10.indd 826 1/26/2021 9:50:35 PM
 10
Hong Kong Tax Planning
Ideas and Strategies

CHAPTER TOPIC LIST

10.1 Overview of Tax Planning 10.4.2 Determining Organisational

Structure for Tax Planning
10.2 Anti-avoidance Provisions under
the Inland Revenue Ordinance 10.4.3 Tax Implications of
10.2.1 General Anti-avoidance Incorporating a Subsidiary or
Provisions Forming a Branch
10.2.2 Specific Anti-avoidance 10.4.4 Group of Companies Tax
Provisions Strategies
10.2.3 Summary of Anti-avoidance 10.4.5 Tax Implications of Asset Deal
Provisions and Share Deal under Merger
10.2.4 Application of the Ramsay and Acquisition Transaction
Principle in Hong Kong 10.4.6 The Implications of BEPS,
10.2.5 Penalty on Tax Avoidance FATCA and CRS
10.2.6 Tax Implications and 10.5 Double Taxation Agreements
Development of Tax Overview
Avoidance Cases 10.5.1 Double Taxation Agreements
Scope and Terminology
10.3 Advance Ruling System
10.5.2 Jurisdictions with which Hong
10.4 Hong Kong Tax Planning Kong Has Entered into a
Opportunities Double Taxation Agreement
10.4.1 Tax Planning on Provision of 10.5.3 Key Articles in the Double
Services by Individuals Taxation Agreement

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 TAXATION

10.5.4 Double Taxation 10.6 Tax Compliance and Tax

Agreements and the Inland Advisory Services
Revenue Ordinance 10.6.1 Professional and Ethical
10.5.5 Tax Credits Computations Considerations in Tax
and Application Compliance Engagements
10.5.6 Arrangement between the and Tax Planning Regarding
Mainland of China and Particular Business
the Hong Kong Special Transactions
Administrative Region for the 10.6.2 Legal Considerations in Tax
Avoidance of Double Taxation Compliance Engagements
and the Prevention of Fiscal and Tax Planning Regarding
Evasion with Respect to Particular Business
Taxes on Income Transactions
10.5.7 Tax Advantages of Using a
Hong Kong Incorporated
Company to Facilitate China’s
Inbound and Outbound
Investments

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 H ong K o ng T a x Pla nn i ng Id eas a nd Strategies

L E A R N I NG O U T C O M E S

PRINCIPAL LO: ADVISE ON HONG KONG TAX PLANNING IDEAS AND STRATEGIES TO ENHANCE
TAX EFFICIENCY
LO: Explain, apply and consider the anti-avoidance provisions in the IRO
LO1: Explain and apply the general and specific anti-avoidance provisions under the IRO
LO2: Describe the tax implications and development of tax avoidance cases
LO3: Consider and evaluate the tax implications of business transactions from anti-avoidance
perspective
LO4: Apply DIPN No. 15
LO: Explain and apply the Ramsay principle
LO5: Explain and apply the Ramsay principle
LO6: Apply DIPN No. 15
LO: Explain and apply the provisions on offences and penalties
LO7: Explain the exposure to penalty action due to tax avoidance
LO8: Apply DIPN No. 15
LO: Explain and apply the advance ruling system
LO9: Explain the application of the advance ruling system
LO10: Apply DIPN No. 31
LO: Advise on Hong Kong tax planning opportunities
LO11: A
 dvise on tax planning opportunities for individuals, partnerships, unincorporated businesses,
corporations and group restructuring
LO12: A
 dvise on tax planning opportunities for individuals under contracts of service or contracts
for service
LO13: Advise on service company ‘Type I’ arrangements
LO14: Advise on service company ‘Type II’ arrangements
LO15: R
 ecommend legitimate strategies to minimise tax exposure or defer the tax liability of a group
of companies
LO16: E
 valuate the differences between tax implications of an asset deal and those of a share deal
under a merger and acquisition (M&A) transaction
LO17: Advise on the common tax issues to the buyer and the seller for an asset deal or a share deal
LO18: Advise how a tax indemnity clause may address the tax uncertainties under a M&A transaction
LO19: Evaluate alternative business operations and transactions from a tax perspective
LO20: Illustrate the background of the introduction of BEPS, FATCA and CRS
LO21: E
 xplain the impacts of BEPS, FATCA and CRS on the entities in Hong Kong, and explain the
significance in relation to tax planning
LO22: Apply DIPN No. 24 and 25

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 TAXATION

LO: Explain and advise on the use of double taxation agreements/arrangements (DTAs) for tax
planning
LO23: List the countries with which the HKSAR has entered into a DTA
LO24: Explain the various articles and provisions under DTAs
LO25: Explain the relationship between the DTAs and the IRO
LO26: Explain what constitutes a resident in the context of DTAs
LO27: Explain and apply the concept of PE in the context of DTAs
LO28: Explain and apply the concept of business profits in the context of DTAs
LO29: E
 xplain and demonstrate how DTAs may reduce the tax on dividends, interests, royalties and
capital gains
LO30: Compare the terms royalties and capital gains under DTAs and the IRO
LO31: Calculate the amount of tax payable and credits under DTAs
LO32: Explain the article concerning the exchange of information under DTAs and its significance
LO33: E
 valuate the tax implications of setting up a holding company, a subsidiary or a branch in
Hong Kong for international tax planning considerations
LO34: E
 xplain the tax advantages of using a Hong Kong incorporated company to facilitate China’s
inbound and outbound investments
LO35: Advise on tax planning opportunities under DTAs
LO36: Apply DIPN No. 44, 45 and 47
LO: Advise on the professional, ethical and legal considerations in relation to tax compliance
engagements and tax planning
LO37: A
 dvise on the professional, ethical and legal considerations in tax compliance engagements
and tax planning regarding particular business transactions
LO: State, describe and apply the following key aspects of the tax system in Hong Kong: Board of
Inland Revenue
LO38: E
 xplain the difference between the PE definition under the IRR and that under double taxation
agreements/arrangements

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 H ong K o ng T a x Pla nn i ng Id eas a nd Strategies

O P E N I NG C A S E

ROTTWEILER FILMS

R ottweiler Films GmbH (RFB) is a Swiss film production company. After considering its film
portfolio in detail, it decided that it needed to produce a film that would appeal to the East
Asian market. For those purposes, it selected Hong Kong as an ideal destination to set up its
regional headquarters in the Far East. Hong Kong has excellent infrastructure and transport
links, a skilled and highly educated workforce, business friendly regulation, transparent
governance, a relatively stable social and political climate, and has a double taxation
agreement (DTA) with Switzerland. This naturally made Hong Kong an attractive investment
destination. RFB was, however, concerned about its tax exposure in Hong Kong. In particular,
its board of directors wanted to know at which point RFB would be required to register as a
taxable person in Hong Kong and at what point it might actually start having to pay Hong Kong
tax. The board was also concerned about whether it would be able to remit profits from Hong
Kong to RFB’s head office free from tax. Accordingly, the board decided to instruct a firm of
Hong Kong accountants, Chin, Pan & See (CPS), to advise them. CPS began to structure the
affairs of RFB in Hong Kong with a view to generating extensive tax savings. The board of RFB
was, however, concerned that CPS may have been too aggressive, and so sought follow-up
advice on the risk of the various tax planning structures proposed by CPS being challenged by
the Inland Revenue Department (IRD). CPS took RFB’s views into consideration, and suggested
evaluating whether seeking an advance ruling from the IRD would be a good way forward to
mitigate that risk.

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 TAXATION

OVERVIEW

In this chapter, we consider the very complex world of tax planning and tax avoidance. It is
important to note that this is first and foremost a practical skill. Tax professionals acquire the
essential skills in this context by doing as well as by learning. That being said, this chapter
provides a broad overview of the main concepts and strategies involved in tax planning. The
discussion ties together the knowledge you have acquired to date on profits tax, salaries tax,
stamp duty, tax administration in Hong Kong and international taxation.

1 0 . 1
OVERVIEW OF TAX PLANNING

Tax planning is a set of strategies, approaches and solutions utilised by tax practitioners
to advise clients to mitigate or eliminate tax liability arising from a given arrangement or
transaction. Historically, the judicial consensus was that taxpayers were free to structure
their affairs in such a way as to minimise their liability to tax (IRC v Duke of Westminster (1936)
AC 1). As tax planning strategies became more sophisticated and widespread, however, the
consensus in both domestic law in Hong Kong and in international tax law turned to preventing
tax bases from being eroded by aggressive tax avoidance or tax evasion.

Thus, there is an important distinction to be drawn on the one hand between tax
mitigation, which is both legal and considered to be consistent with the word and intent
of taxing statutes, and, on the other hand, tax evasion and tax avoidance. Tax evasion is a
criminal offence, and can give rise to administrative fines and/or a term of imprisonment for
the persons responsible under ss.80 and 82 of the Inland Revenue Ordinance (IRO). Conversely,
tax avoidance is legal, but it is nonetheless regarded as a social evil (see, e.g. Pitt v HMRC and
Futter v HMRC (2013) UKSC 26) that is inconsistent with the spirit and intent of tax statutes,
and is therefore undesirable conduct on the part of the taxpayer that should be countered
by specific or general anti-avoidance provisions. In advising on complex tax structures,
practitioners must bear in mind the risk of the structure failing as a result of the application of
such anti-avoidance provisions.

In addition to domestic anti-avoidance provisions, international taxation has become

increasingly important to tax practitioners in Hong Kong. Hong Kong is now party to
approximately 40 double taxation agreements (DTAs) and it is a stated priority of the
government of Hong Kong to increase this number. DTAs are international conventions that
allocate taxing rights between jurisdictions. In summary, the application of a DTA determines
which jurisdiction is entitled to tax a given income stream or capital gain. DTAs play a
crucial role in guaranteeing legal certainty in cross-border transactions because they enable
tax practitioners to predict precisely how the two jurisdictions involved in a cross-border
arrangement will allocate taxing rights as between themselves. That certainty is, in turn,
important in tax planning.

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 H ong K o ng T a x Pla nn i ng Id eas a nd Strategies

Tax planning does not merely require technical aptitude, and a broader understanding
of Hong Kong’s tax laws and how they fit into the international tax landscape. It requires an
understanding of the commercial exigencies of clients: that means, a solution that would as a
technical matter produce a much lower liability to tax for the taxpayer, or eliminate that liability
to tax entirely is not necessarily the most desirable solution. It may, for example, be expensive
to implement, difficult to administer, or likely to attract the attention of the IRD, which many
taxpayers seek to avoid given the cost of litigation in Hong Kong. Tax planning is based on tax
law, but it is ultimately a practical exercise.

1 0 . 2
ANTI-AVOIDANCE PROVISIONS UNDER
THE INLAND REVENUE ORDINANCE

The IRO contains two general statutory anti-avoidance provisions in ss.61 and 61A. These
cover a range of circumstances, though in practice s.61A is most often invoked by the IRO
because it is the provision that is drafted most broadly and flexibly and therefore tends to
favour the interests of the Commissioner. Anti-avoidance provisions in general provide that if
a transaction or arrangement is classified, as a statutory matter, as falling within the mischief
of the said provision, the transaction or arrangement in question may be disregarded for tax
purposes. That is, the transaction or arrangement, while being recognised as legally effective,
is not recognised as having the tax effect it was intended to produce. The purpose of anti-
avoidance provisions is therefore to negate a tax advantage that would otherwise have arisen
to a person entering into the tax avoidance arrangement. Ss.61 and 61A are not mutually
exclusive, and may be employed by the Commissioner in the alternative in challenging a given
transaction into which a taxpayer has entered. It is also important to note that they are not
independent charging provisions: taxpayers cannot charge income arising from a transaction to
tax if that income would not in any event have been chargeable to property tax, profits tax or
salaries tax on the terms of the IRO (Challenge Corporation Limited (1986) 8 NZTC 5,001 (CA)).

There are also specific anti-avoidance provisions. S.61B prohibits the tax-driven transfer
of unrelieved losses and the rules. S.9A contains a discrete anti-avoidance code specifically in
the context of salaries tax that seeks to prevent the use of personal service companies (PSCs)
as vehicles to mitigate or avoid the liability to salaries tax.

Throughout the IRO, there are anti-avoidance provisions aimed at preventing the misuse
or abuse of tax incentives, for example, the two-tiered profits tax rates regime for the first
HK$2 million of assessable profits or concessionary deductions in relation to expenditure for
research and development and the acquisition of intellectual property rights (IPR).

Key Learning Point

Aggressive tax avoidance is considered undesirable by the government and the legislature.
Accordingly, the IRO contains two general anti-avoidance provisions in ss.61 and 61A to
enable the Commissioner to disregard a tax advantage arising to a taxpayer by virtue of
certain tax avoidance transactions.

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 TAXATION

10.2.1 General Anti-avoidance Provisions

S.61 provides that where an assessor is of opinion that any transaction which reduces or would
reduce the amount of tax payable by any person is artificial or fictitious or that any disposition
is not in fact given effect to, he may disregard any such transaction or disposition and the
person concerned shall be assessable accordingly. This was the original general anti-avoidance
provision in Hong Kong, prior to the enactment of s.61A. It was and remains of limited
effectiveness in practice because its scope is narrow. DIPN No. 15 contains a section on the
IRD’s views and practices relating to s.61, paras 24–29. The department sets out the essential
factors for s.61 to apply as:

(a) There must be a transaction;

(b) The transaction must have the effect of reducing the tax payable by the taxpayer; and

(c) The transaction must be artificial or fictitious, or any disposition must not in fact be
given effect to.

There is, therefore, a very high threshold to be met. It is not sufficient that the transaction
be for the purposes of tax avoidance, though that is a requisite element, but it must be the case
that the transaction has some element of artificiality or fictitiousness or sham-like character
for the provision to apply: those characteristics are by their very nature not supported by
commercial drivers, but by a tax avoidance motive.

Although ‘fictitious’ has a very specific meaning in designating a transaction, that is, where
the ostensible parties to the transaction never intend to carry it out, ‘artificial’ has a broader
meaning of a transaction that is not the kind of transaction that parties acting commercially
would enter into; hence, it is artificial because it is a contrivance devised to avoid tax and not
a bona fide commercial operation (Seramco Ltd Superannuation Fund Trustees v ITC (Jamaica)
(1977) AC 287). That being said, in Cheung Wah Keung v CIR (2002) 5 HKTC 698 the Court of
Appeal held that whether a transaction which is commercially unrealistic must necessarily be
regarded as being ‘artificial’ depends on the circumstances of each particular case and that
commercial realism can be one of the considerations for deciding artificiality. To ascertain
whether a transaction is artificial, it is thus necessary to scrutinise the terms of the particular
transaction to be impugned and the circumstances in which it was made and carried out.

S.61A has a much broader application. S.61A enables the IRD to disregard a transaction
that has the effect of conferring a tax benefit on a person where, having regard for the various
factors enumerated in s.61A(1) it would necessarily be concluded that the transaction was
entered into for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit
in Hong Kong. The factors to be taken into consideration are as follows:

a. The manner in which the transaction was entered into or carried out;

b. The form and substance of the transaction;

c. The result in relation to the operation of (the IRO) that, but for this section, would have
been achieved by the transaction;

d. Any change in the financial position of the relevant person that has resulted, will result,
or may reasonably be expected to result, from the transaction;

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 H ong K o ng T a x Pla nn i ng Id eas a nd Strategies

e. Any change in the financial position of any person who has, or has had, any connection
(whether of a business, family or other nature) with the relevant person, being a change
that has resulted or may reasonably be expected to result from the transaction;

f. Whether the transaction has created rights or obligations which would not normally be
created between persons dealing with each other at arm’s length under a transaction of
the kind in question; and

g. The participation in the transaction of a corporation resident or carrying on business

outside Hong Kong.

The IRD will consider each of the matters enumerated in paragraphs (a) to (g) in turn;
however, they may not all be equally relevant in every case. Much will evidently depend on the
facts of the case. In DIPN No. 15, the IRD considers that each of the factors in (a) to (g) covers
different aspects of a potentially tax avoidant transaction. Thus, in (a) and (b), the manner in
which the transaction was entered into and the form and substance are in the nature of items
that form a background picture to the transaction and help to set the scene. The next three
matters, (c) to (e), involve monetary questions: the tax saving for taxpayers, how much they are
otherwise in or out of pocket, and the same for connected persons. In other words, these three
matters direct attention to the tax and non-tax economic realities of the transaction in question
and call for a contrast between them. Finally, there are matters (f) and (g), which, where they
are present, can be relevant as indicators of a purpose of obtaining a tax benefit; they are not,
however, conclusive.

Where s.61A(1) applies, s.61A(2) operates to provide that an assistant commissioner of

the IRD is empowered to assess the taxpayer to tax as if the transaction or any part thereof
had not been entered into or carried out or in such other manner as it considers appropriate
to counteract the tax benefit which would otherwise be obtained. In practice, s.61A(2) confers
upon the IRD a great deal of flexibility in negating the tax advantage that would otherwise arise
to the taxpayer.

One of the leading cases on the application of s.61A is Ngai Lik Electronics Co Ltd v CIR (2010)
2 HKC 1, where the taxpayer and three associated offshore companies had entered into a
number of interrelated agreements for the supply of goods and the relevant pricing provisions
were in general ascertained in a manner that reflected the financial exigencies of the group, as
opposed to an arm’s length price. The Commissioner asserted that s.61A was applicable and
issued additional assessments on that basis. The Court of Final Appeal (CFA) held that although
s.61A was applied in the sense that the pricing provisions were, factually, not arm’s length
prices and had been determined with a view to engineer a tax advantage, it also considered
that the Commissioner had exceeded his authority by assessing the taxpayers on a punitive
basis rather than raising additional assessments on the basis of an arguable arm’s length price.
It was unacceptable for the Commissioner to issue additional assessments on an arbitrary
basis, even if s.61A applies. Specifically, the court held that s.61A should only be invoked if the
following conditions are fulfilled: there must first be: (i) a transaction, (ii) a tax benefit and (iii)
a dominant purpose to obtain the tax benefit. Each of those facts must be clearly established
if the statutory anti-avoidance provision is to apply. Separately, it is noteworthy that before
the introduction of a comprehensive transfer pricing regime in Hong Kong in 2018, Ngai Lik
was taken to be the authority for the proposition that s.61A imported a transfer pricing regime
into the IRO.

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The decision in Ngai Lik, DIPN No. 15 (Revised) states that in order that s.61A may apply
to a taxpayer, there are three prerequisites: (a) there must be a transaction as defined; (b)
the taxpayer must obtain a tax benefit as defined and (c) having regard to seven specific
matters, the transaction must be entered into or carried out for the sole or dominant purpose
of enabling the taxpayer to obtain a tax benefit. If the three prerequisites are satisfied, s.61A
applies and the IRD may cancel the tax benefit.

10.2.1.1 A Transaction
As regards the existence of a transaction, that term is defined to include a transaction,
operation or scheme whether or not such transaction, operation or scheme is or is intended to
be enforceable by legal proceedings. The term will therefore cover situations involving single,
multiple or composite transactions. In Yick Fung Estates Limited v CIR, 5 HKTC 52, the Court
of Appeal held that a transaction can be carried out by a person alone and need not for two
parties to be involved. In other words, a transaction can be carried out by a sole protagonist
and includes a unilateral scheme, plan, etc.

10.2.1.2 A Tax Benefit

As regards the tax benefit criterion, that term is defined in s.61A(3) to mean the avoidance or
postponement of the liability to pay tax or the reduction in the amount thereof. DIPN No. 15
(Revised) states the IRD’s view that the definition contemplates the following situations: (a) The
avoidance of liability by getting out of the way of or escaping from or preventing an anticipated
liability to tax in respect of income which has ‘accrued’ to the taxpayer. (b) The postponing of
liability for tax by shifting the incidence of tax on an amount or stream of income to a later year
or years. (c) The reduction in the amount of tax by altering the quantum of assessable income
to a level lower than it would have been or might reasonably be expected to have been but for
the transaction.

10.2.1.3 Is the Obtaining of a Tax Benefit the Sole or Dominant Purpose?

Finally, as regards the sole or dominant purpose test, it is an objective test – the conclusion that
the tax benefit was the sole or dominant purpose of the transaction must reasonably follow
from the evaluation of the specific factors listed in s.61A. The meaning of ‘sole purpose’ is clear:
the transaction was exclusively motivated by a tax benefit. The acceptation of ‘dominant’ is
less clear, but it would in its everyday meaning connote a purpose that is more than merely
incidental or ancillary: the purpose must have a degree of prominence relative to other
ascertainable purposes – that is, a ‘ruling, prevailing, or most influential purpose’ (FCT v Spotless
Services Limited, 34 ATR 183). It is nonetheless important to note that the IRD has stated in its
own published guidance that where a taxpayer could have achieved a particular financial result
in two different ways, one of which would have attracted tax and the other not, there being no
abnormal features in either event, IRD accepts that taxpayers are not obliged to maximise their
tax liability.

In CIR v Tai Hing Cotton Mill (Development) Limited (2008) 2 HKLRD 40 and HIT Finance Ltd
& Another v CIR (2008) 2 HKLRD 52, the Court of Final Appeal held that s.61A requires that a
comparison be made between the transaction carried out by the taxpayer and some other
appropriate hypothetical transaction (not limited to the tax position if the transaction had not
been carried out) and if the taxpayer’s tax position under the transaction was more favourable
than under the hypothetical transaction, a tax benefit had arisen. The hypothetical transaction

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to be taken as a comparator is the transaction most likely to have been carried out if the
taxpayer had not been able to secure the tax benefit (Tai Hing Cotton Mill). Consequently, the
conclusion of a primary tax benefit motive is an objective one which a reasonable person would
necessarily draw on the basis of the seven matters enumerated in paragraphs (a) to (g) viewed
in their proper context.

Indeed, the words ‘would be concluded’, as opposed to ‘could be concluded’ or ‘might

reasonably be concluded’, suggest that s.61A is only applicable in cases where the sole or
dominant tax purpose is clearly evident. That said, the mere presence of a commercial
objective in a particular transaction does not mean that s.61A has no application. In Spotless
Services Limited, the court opined that a person may enter into or carry out a transaction for
the dominant purpose of enabling the relevant person to obtain a tax benefit where that
dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on
a business.

The subjective motive of the taxpayer may be relevant to the extent that it is apparent
from the evidence and that the evidence, taken in the round by reference to the factors in
paragraphs (a) to (g), leads to the reasonable and necessary conclusion that the transaction was
solely or prevalently effected to obtain a tax benefit.

Illustrative Example 1
Condor Legion Ltd (Condor) is an aircraft components manufacturer incorporated
in Hong Kong and carrying on its manufacturing and trading business in Hong Kong.
On advice from its accountants Chin, Pan & See (CPS), it entered into the following
arrangement with a related company, Condor GmbH (CG), a company incorporated and
resident in Liechtenstein:

• It disposed of all its intellectual property rights for the consideration of HK$1 to CG.

• CG in turn licenced the intellectual property rights back to Condor for an arm’s
length royalty of HK$25 million per year.

• Under s.21A, withholding tax on royalties paid by Condor to CG would be 16.5%

because the intellectual property rights with respect to which the royalty is payable
were previously owned by a person carrying on a trade or business in Hong Kong,
and the licence agreement is with an associate. That being said, Article 12(2) of the
Hong Kong – Liechtenstein DTA provides that the maximum rate of withholding
tax is 3%.

• Condor claims the full amount of the royalty as a deduction under s.16(1) of the
IRO. Its assessable profits for the year of assessment 2019/20 are HK$100 million.
As a consequence of the arrangement, those profits are reduced to HK$75 million.
Similarly, instead of paying HK$4.125 million on the HK$25 million, CG only pays
HK$750,000 leading to a net tax saving of HK$3.375 million, all other things
being equal.

• The royalty is not taxed in Liechtenstein.

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Illustrative Example 1 (continued)

Applying s.61A: (i) there is a transaction; (ii) having regard for the various factors
in s.61A(1) it is apparent that one of the dominant reasons for the arrangement was
a Hong Kong tax advantage – it is not credible to suggest that in the ordinary course a
company might part with evidently valuable intellectual property rights for HK$1 and there
appears to be no independent commercial justification for the licencing arrangement:
that is, if the manufacturer already owned the intellectual property rights, why would it
sell an essential component in the manufacturing process to another person? Arguably,
it would objectively be concluded that the transaction was therefore a transaction falling
within s.61A, enabling the IRD under s.61A(2) either to disregard the transaction or to
take such other steps as it considers appropriate to counteract the tax advantage. Given
the circumstances, it seems likely that the IRD would counteract the tax advantage by
disregarding the transaction entirely rather than levy withholding tax at the domestic
16.5% rate. The reason for that is that imposing a higher rate of withholding tax than 3%
may put it in breach of its obligations under the DTA.

Where s.61A applies, the IRD may respond by seeking to deny the tax benefit that
would otherwise accrue. In general, it will do so by issuing one or more additional
assessments. Such additional assessments must be made within the scope of the IRO and
on the basis of one or more charging provisions (Ngai Lik Electric). S.61A, it is important to
note, is not a separate charging provision.

In this case, the manner appropriate to counteract the tax benefit would be to make an
adjustment on the basis of disregarding the tax avoidant transaction to the extent that it
gives rise to a tax benefit and to make any corresponding adjustments to the assessments
of other persons affected by the transaction. This is a tax symmetry requirement.
Consequently, Condor can expect that the IRD will assess it on the basis that the royalty
is taxable at the standard rate of 16.5%, thus leaving Condor’s deduction untouched but
increasing the tax burden on CG, or otherwise disallowing the deduction to an extent
proportionate to the Hong Kong profits borne by CG on the royalty payment.

It does not necessarily follow that because a transaction or arrangement is impugned or

disregarded by an anti-avoidance provision that it thereby gives rise to taxable profits (Europa
Oil (NZ) Ltd v IRC (1976) 1 WLR 646). Further, anti-avoidance provisions shift the burden of proof
on the Commissioner to show, on the balance of probabilities, that ss.61 and/or 61A apply
(CEC v CIT (1971) MSTC 551).

Key Learning Point

S.61A is the most frequently used general anti-avoidance provision because it has a
broader application than s.61. It operates to deny a tax advantage that would otherwise
have arisen to a taxpayer by virtue of a transaction or an arrangement whereby the
dominant purpose or one of the dominant purposes was obtaining a tax advantage.

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10.2.2 Specific Anti-avoidance Provisions

Certain anti-avoidance provisions are not general in scope but address specific parts of the
tax code. These provisions operate only in their limited ambit; hence, they are known as
‘specific’. Some apply generally to a specific class of tax avoidance – such as s.61B applying
to the transfer of losses generally – while others are limited to discrete provisions or parts
of the IRO.

10.2.2.1 Utilisation of Loss to Avoid Tax (S.61B)

S.61B limits the set off of unrelieved losses in a tax avoidance scenario. Where the IRD is
satisfied that any change in the shareholding in any corporation has been effected and as a
direct or indirect result profits have been received by or accrued to that corporation during any
year of assessment and the sole or dominant purpose of the change was for the purpose of
utilising any loss or any balance of any loss sustained in a trade, profession or business carried
on by the corporation, in order to avoid liability on the part of that corporation or any other
person for the payment of any tax or to reduce the amount thereof, the set off of any such loss
or balance of loss against any such profits shall be disallowed.

S.61B is therefore aimed at the situation where companies with accumulated tax losses
are sold for their losses to the proprietors of businesses which are trading profitably. Once
ownership of the loss company has changed hands the profitable business is introduced
into the company and the losses brought forward are set off against profits derived. S.61B
will restrict this avoidance practice by authorising the IRD to refuse to set off losses brought
forward where they are satisfied that the sole or dominant purpose of a change in shareholding
was the utilisation of those losses to obtain a tax benefit. Again, it would appear that the words
‘sole or dominant purpose’ are to be construed objectively. The purchase of a loss-bearing
company for no apparent commercial or corporate reason, for example, would likely cause an
objective observer to infer that the purchase was primarily motivated by the contemplated tax
advantage on the part of the acquiring business.

In DIPN No. 15, the IRD sets out its published policy on how it would apply s.61B. The
starting point is that it considers the change of shareholding as having been effected whenever
shares are transferred from one person to another person. In other words, a change of
shareholding takes place when shares are transferred to a person who was not previously a
shareholder and also when shares are transferred from one existing shareholder, who may or
may not continue to be a shareholder, to another existing shareholder.

The second element to the application of s.61B is the Commissioner is satisfied that as
a direct or indirect result of the change in shareholding, ‘profits’ have been received by or
accrued to the company during any year of assessment. In order to decide whether profits have
been received as a result of the change of shareholding the flow of profits before and after
the change will be examined, having particular regard to matters such as: (a) the nature and
conduct of the company’s business; (b) income and expenditure patterns; (c) management and
control and (d) the background of the party to whom shares were transferred.

It should also be noted that s.61B refers to profits received during ‘any’ year of assessment.
Consequently, s.61B may apply even where profits are introduced in any year subsequent to
the change of shareholding.

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Key Learning Point

S.61B is a specific anti-avoidance provision, which operates in the restricted context of
the utilisation of losses in the context of the tax-motivated purchase of a loss-bearing
company. This is an important limitation on the general rules on the set off of unrelieved
losses carried forward in s.19C.

10.2.2.2 Other Specific Anti-avoidance Provisions in the Inland Revenue Ordinance

Specific anti-avoidance provisions are scattered throughout the IRO. Their role is usually to limit
the extent to which a concession to the taxpayer arising, for example, from the expansion of a
general rule such as to make it more advantageous to a taxpayer, may be utilised in order to
procure a tax advantage. The purpose behind such anti-avoidance provisions is to ensure that
tax regimes that are relatively more generous to the taxpayer are only utilised for the purpose
for which the Legislature enacted them. A good example of such provisions is the deduction
allowed for the acquisition of certain intellectual property rights (ss.16E and 16EA), prescribed
fixed assets (s.16G) and environmental protection facilities (s.16J).

S.16E grants a deduction for the purchase of patent rights or rights to any know-how
used in the trade, profession or business of the taxpayer. There would, however, exist a tax
asymmetry if the taxpayer claiming the s.16E deduction were subsequently able to sell the
patent right or right to know-how to another person realising a gain (i.e. a profit) and that profit
would, in the ordinary course, be exempt from profits tax as a gain arising from the sale of
a capital asset under s.14(1). The asymmetry lies in the fact that the taxpayer has obtained a
deduction, but has not been taxed on the corresponding gain when it, in turn, disposed of the
asset. To correct that asymmetry, s.16E(3) provides that gains arising from such a disposal are
indeed taxable notwithstanding anything in s.14(1). Similar rules exist with respect to specified
intellectual property rights, deductions with respect to the acquisition of which are allowable
under s.16EA, but with a corresponding deeming provision in s.16EB charging gains from any
disposals to tax. Similarly, s.16G, which allows an immediate 100% deduction on the acquisition
of a prescribed fixed asset, contains the anti-avoidance provision in s.16G(3) charging the gains
of any subsequent disposal of that asset to profits tax. Finally, s.16J provides for a deduction
for the acquisition of environmental protection facilities, notwithstanding these are in general
capital assets.

S.16EC is in and of itself an anti-avoidance provision, which, among other things, prevents a
deduction from being claimed with respect to the acquisition of a specified intellectual property
right where the relevant right was purchased by a person wholly or partly from an associate
of that person. The purpose of that provision is, therefore, to prevent intra-group transactions
from being utilised as a basis for aggressive tax planning.

In administering ss.16E, 16EA, 16G and 16J, the Commissioner is authorised to determine
the true market value of the intellectual property rights (ss.16E(8) and 16EA(9)), the prescribed
fixed asset (s.16G(3)(c)), and the environmental protection facilities (s.16J(4)), respectively.
Similarly, and as regards balancing charges arising from the sale of assets eligible for initial
and/or annual allowances, the Commissioner is authorised to determine the true value of the
asset being sold (s.38B). The computation prerogative granted to the Commissioner is evidently
to facilitate the implementation of the anti-avoidance provisions in those deduction regimes.

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You will recall that deductions for the acquisition of specified intellectual property rights,
prescribed fixed assets, and depreciation allowances are all exceptions to the general rule that
capital expenditure is not deductible (s.17(1)(c)).

As a practical matter, the transfer pricing code in Part 8AA of the IRO operates as a general
anti-avoidance provision in that it operates to prevent the use of a relationship of association
between parties to derive a tax advantage from arrangements or transactions in which such
associated persons are party. Arrangements or transactions that do not comply with the
transfer pricing rules, and which would otherwise give rise to a Hong Kong tax advantage
are subject to a transfer pricing adjustment on the part of the IRD, which has the effect of
negating the tax advantage that would otherwise have arisen, and so treating the transaction or
arrangement as an arm’s length transaction or arrangement for tax purposes. The two principal
transfer pricing rules are Rule 1 (s.50AAF relating to transactions or arrangements between
associated persons) and Rule 2 (s.50AAK relating to transactions or arrangements between a
head office and a PE).

10.2.2.3 Service Company Type I Arrangements

S.9A is an anti-avoidance provision, which renders ineffective certain tax avoidance
arrangements that were historically structured through personal services companies (PSCs).
The relevant IRD guidance is DIPN No. 25.

In essence, the use of PSCs involved disguising a relationship of employment between an

individual rendering services and the party receiving those services by way of arrangements
under which PSCs controlled by such individual rendered services in substance supplied by the
individuals in consideration for service fees payable to the PSC in question. Such arrangements
were advantageous because the PSC was able to use the consideration paid to it by the
recipient of its services to pay a much lower salary to the controller of the PSC (or no salary at
all), often with a salary paid to a relative for nominal company secretarial and administrative
duties, and to provide a range of benefits such as accommodation, domestic worker services,
utility payments, etc, which as you will recall are fiscally privileged under s.9. Such salaries
would usually be so low that they would only yield a nominal liability to salaries tax, with many
of the benefits being either tax-free, such as benefits in kind not convertible into cash, or taxed
on a privileged basis, such as accommodation provided by employers. Further note that the
deductions regime for profits tax is usually much more generous than it is for salaries tax –
contrast ss.12(1)(a) and 16(1) of the ordinance – and dividends may generally be received free
from tax in Hong Kong, such that operating through a PSC offered extensive fiscal benefits for
those with the resources to engage in such planning.

Briefly, the legislation has three main elements which are contained in s.9A:

a. There is a prima facie liability to salaries tax where: (i) remuneration for services
rendered by a ‘relevant individual’ is paid under an agreement (whether written or
implied) by a ‘relevant person’ to a PSC controlled by the individual and/or his or her
associate(s) or a trustee of a trust under which the individual or his or her associate is a
beneficiary; and (ii) the relevant individual has rendered services to the relevant person
or any other person with respect to which such remuneration was payable.

b. The scope of the provisions is restricted by excluding cases which satisfy specified
criteria (i.e. where particular indicators or hallmarks of an office or employment of
profit are not present under the arrangement).

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c. Under an ‘escape clause’ for the benefit of taxpayers, the Commissioner has
a discretionary power to exclude a case where, even though an indicator of
employment might be present, he is satisfied that in carrying out the services
under the agreement the relevant individual is not in substance holding an office or
employment of profit.

Where the preceding circumstances referred to are present, an arrangement is subject

to the operative provisions of s.9A(1)(i), (ii) and (iii) unless it falls outside their application
by virtue of the escape clauses provided in ss.9A(3) and (4). In essence, the effect of the
operative provisions is to treat the relevant individual and the relevant person as employee
and employer, respectively, and the remuneration for the services carried out by the relevant
individual as his income from an employment of profit, and therefore chargeable to salaries tax
and not to profits tax in the hands of the PSC.

S.9A(3) provides that an arrangement will escape the application of the operative provision
of s.9A(1) if:

• S.9A(3)(a) – this criterion will be satisfied if neither the agreement nor any related
undertaking provides for remuneration for the services carried out by the relevant
individual to include or to be the provision of any of the specified or similar
employment-type benefits or any benefit (including money) in lieu thereof.

• S.9A(3)(b) – no deeming of an employment relationship will subsist where the

agreement provides that the relevant services be carried out personally by the
relevant individual and the relevant individual carries out the same or similar services
for persons other than the putative employer (i.e. generally in the course of the
independent contractor company’s business).

• S.9A(3)(c) – this criterion will be satisfied if there is no control or supervision which may
be commonly exercised by an employer in relation to the performance of its employee’s
duties. In other words, where the putative employee is not actually under the degree
of supervision one would expect to find in an employment relationship, the deeming in
s.9A will not apply.

• S.9A(3)(d) – this criterion will be satisfied if the remuneration is not paid or credited
periodically and calculated on a basis commonly used in relation to the payment or
crediting and calculation of remuneration under a contract of employment. In true
independent contractor situations, the payments will generally be in relation to an
agreed sum for specified work under a contract, whereas for employment cases
payments are usually in respect of the time worked or position occupied and made on a
regular basis (e.g. weekly, fortnightly or monthly).

• S.9A(3)(e) – this criterion is concerned with the provisions under the agreement
relating to the termination of the arrangement between the parties. It will be satisfied
if the relevant person does not have the right to cause any of the services under the
agreement to cease to be carried out in a manner, or for a reason, commonly provided
for in relation to the dismissal of an employee under a contract of employment. In
this regard, the services of an employee can generally be terminated by providing the
relevant notice and/or meeting other requirements under an award or statute. By way
of contrast, under a relationship involving an independent contractor, the contract will

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usually be discharged by performance, but may also specify other circumstances, such
as default situations, under which it can be terminated.

• S.9A(3)(f) – this criterion will be satisfied where the putative employee is not held out to
the public to be an officer or employee of the putative employer. In other words, it will
not be satisfied where, notwithstanding the putative employee claiming he or she is
self-employed or otherwise operating as an independent contractor, he or she is held
out to the public as being, in effect, employed by or an officer of the putative employer.

Illustrative Example 2
Mr. Jason Lim is a seasoned investigations specialist who provides services through
a service company Eve 6 Ltd to Skinner & Co, a professional firm that advises on
matrimonial, family law and white-collar crime cases. An agreement to supply
investigations services is made between Skinner & Co and Eve 6 Ltd; however, Mr. Lim
will be the person actually discharging the relevant tasks. Mr. Lim and his wife Diana
Lim own 100% of the shares in Eve 6 Ltd. Had Mr. Lim supplied his services direct to
Skinner & Co, the terms of the contract are such that he would have been regarded as
a matter of Hong Kong law as an employee of Skinner & Co. Mr. Lim utilises Eve 6 Ltd
to pay his wife a salary that is disproportionate relative to her modest administrative
contribution of acting as company secretary and director. As an employee of the
company, he is entitled to tax-free health insurance and tax-privileged employer-supplied
accommodation.

On the basis of the foregoing, the arrangement would fall within the anti-avoidance
provisions in s.9A. It is unlikely that the IRD will exercise its discretion to treat the
arrangement as falling outside the ambit of the anti-avoidance rules because it is plain that
there is a tax-saving motive in the current structure. It would follow that Mr. Lim will by
operation of s.9A be treated as an employee of Skinner & Co for salaries tax purposes, and
any tax advantage as he may have derived from Eve 6 Ltd will thereby be negated.

10.2.2.4 Service Company Type II Arrangements

Type II PSC arrangements were arrangements engineered to yield a tax advantage by
exploiting relationships of control and association between individuals and corporations, for
example, to seek disproportionate and uncommercial deductions for companies such as to
depress their profits artificially or reallocate profits on an uncommercial basis to give rise to
favourable fiscal outcomes. Often, such arrangements or transactions were effected through
the payment of so-called management fees to individuals or PSCs, as the case may be. For
example, a PSC may pay an inflated management fee to the spouse or child of a controlling
person, notwithstanding that such a person has not actually rendered services commensurate
with the quantum of that fee, and claim the said fee as a deduction in computing its liability to
profits tax under s.16(1).

Arguably, the rules against Type II PSCs are now obsolete with the introduction of a full,
Organisation for Economic Co-operation and Development (OECD) compliant transfer
pricing regime in Hong Kong. In DIPN No. 24, the IRD sets out its position that while it does not

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dispute that PSCs may have legitimate commercial motivations, transactions and arrangements
between PSCs and associated or controlling persons are expected to be carried out on an
arm’s length basis – that is, on a basis that one would expect to find between two independent
persons acting commercially under the same or similar circumstances.

Key Learning Point

There are important specific anti-avoidance issues when it comes to PSCs: Type I and
Type II arrangements. Type I arrangements relate to PSCs that are used to disguise a
relationship of direct employment between a service provider and the person to whom the
services are rendered; Type II arrangements are in essence transfer pricing issues, which
have largely been superseded by the enactment of Part 8AA of the IRO.

10.2.3 Summary of Anti-avoidance Provisions

Anti-avoidance provisions in the IRO and Stamp Duty Ordinance (SDO) include, but not limited
to, the following:

Anti-avoidance Description Chapter discussed

provisions
IRO
Part 8AA Transfer pricing provisions Chapter 11
s.9(1)(b) and (c) Residence provided by an employer or Chapter 10, Section 10.2
associated corporation
s.9A Personal service companies (Type I) Chapter 10, Section 10.2.2.3
ss.16E(3), 16EB Proceeds from the sale of patent rights, specified Chapter 3, Section 3.5.2
and 16J intellectual property rights and environmentally Chapter 10, Section 10.2.2.2
friendly machinery chargeable to profits tax
under certain circumstances
ss.15(1)(m) and 15A Transfer of right to receive income Chapter 10, Section 10.4
s.17E, 17F and 17G Deductions of distributions for regulatory capital Chapter 3, Section 3.10.6
securities
s.18D(2A) Relevant profit of an old business to be assessed Chapter 3, Section 3.9.3
ss.20AE and 20AF Assessable profits of non-resident persons Chapter 3, Section 3.4
regarded as assessable profits of resident
persons
s.21A Computation of deemed assessable profits Chapter 3, Section 3.4
under ss.15(1)
s.38B Commissioner’s power to determine the true Chapter 10, Section 10.2.2
market value of an asset on sale
s.39E Depreciation allowances for leased machinery Chapter 3, Section 3.7.1
and plant
s.61 Certain transactions and dispositions to be Chapter 10, Section 10.2.1
disregarded

EXHIBIT 10.1 A summary of the anti-avoidance provisions described in this module

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Anti-avoidance Description Chapter discussed

provisions
s.61A Transactions designed to obtain tax benefit Chapter 10, Section 10.2.1
s.61B Utilisation of losses to avoid tax Chapter 10, Section 10.2.2
SDO
s.24 Stamp duty chargeable where conveyance and Chapter 7, Section 7.1.3
so on is in consideration of debt etc.
s.27 Voluntary dispositions inter vivos Chapter 7, Section 7.6
s.29C(10) Chargeable agreements for sale Chapter 7, Section 7.1.3
s.45 De-grouping charge where relief in case of Chapter 7, Section 7.7
conveyance from one associated body corporate
to another claimed

EXHIBIT 10.1 (Continued)

10.2.4 Application of the Ramsay Principle in Hong Kong

The so-called Ramsay principle is derived from the judgement of the House of Lords in
W.T. Ramsay Ltd v IRC (1982) AC 300. Although it is often labelled as an anti-avoidance provision,
it is, in reality, a principle of statutory construction or, more broadly, of statutory application.
The House of Lords in Ramsay opined that tax legislation is intended to apply to real-world
business or commercial transactions and events. As we have already seen, the current judicial
orthodoxy is that statutes must be construed purposively – that is, with a view to the mischief
the legislation was intended to cure. Thus, where there is a pre-ordained series of transactions
or a single composite transaction, any steps in the series or any components in the composite
transaction that have no real commercial or business purpose may be disregarded for all fiscal
purposes. The relevant tax legislation would, on that footing, focus on the commercial result of
the transaction, disregarding the effect of the uncommercial transactions or events. If the legal
position is that tax is imposed by reference to a commercial concept (such as profits, gains etc.),
then to have regard to the business ‘substance’ of the matter is not to ignore the legal position
but to give effect to it (MacNiven v Westmoreland Investments Ltd (2001) STC 237). Put another
way, assume that a transaction that is effected principally for commercial reasons has a step
interposed in it that is aimed at impairing the value of the asset that is the subject matter of
the disposal in order to reduce the amount of profits chargeable to tax when the transaction is
completed. There is no commercial basis for that operation; accordingly, the Ramsay principle
could, all other things being equal, apply to disregard the impairment and treat the asset as
having been realised at its actual market value for the purposes of computing any chargeable
profits arising from the said disposal.

In Hong Kong, the Court of Final Appeal in CSR v Arrowtown Assets Ltd (2004) 1 HKLRD 77
decided that the Ramsay principle was applicable in Hong Kong to revenue law matters and
clarified that the statute must be read purposively, that is, with regard to the apparent purpose
of the legislature in enacting a given taxing provision, and applied to transactions, viewed
realistically. Thus, the Ramsay principle is in reality simply the restatement of conventional
principles of purposive statutory interpretation in a tax law context. Where schemes involve
intermediate transactions having no commercial purpose inserted for the sole purpose of

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tax avoidance, it is quite likely that a purposive interpretation will result in such steps being
disregarded for fiscal purposes.

The Ramsay principle is not authority for the proposition that the legal effect of
transactions can be disregarded. A tax avoidance transaction is not necessarily a sham, nor
intended to defraud any given person. However, because a taxing statute was, it is assumed,
enacted to reflect transactions that are grounded in economic and commercial reality, the
application of their provisions must reflect that reality and not any steps that are inserted for
purposes that are not economically or commercially driven.

Because the Ramsay principle is a principle of statutory construction, it coexists with ss.61
and 61A and, parenthetically, the various specific anti-avoidance provisions in the IRO. These
are not mutually exclusive. Accordingly, when advising clients in tax planning, it is important to
bear in mind both the effect of statutory anti-avoidance provisions and the potential risk of the
Ramsay principle operating to deny a tax advantage.

Key Learning Point

The Ramsay principle is a principle that applies to the interpretation of revenue statutes. It
departs from the assumption that tax laws were written to apply to real-world transactions
and not to artificial, uncommercial arrangements; accordingly, purely artificial steps with
no commercial purpose in a transaction may be disregarded when applying a taxing
statute.

10.2.5 Penalty on Tax Avoidance

Tax avoidance is not a criminal offence; it is legal, although discouraged as a matter of
government and tax policy. As a technical matter, therefore, there is no penalty associated
with a tax avoidance transaction as such. That being said, ss.80 and 82A provide for a discrete
administrative penalty regime for filing an incorrect tax return. The IRD’s published penalty
policy in tax avoidance cases is found in DIPN No. 15 and in summary is as follows: whether a
certain tax avoidance scheme may be regarded as a tax evasion arrangement and be penalised
as such depends on the availability of evidence to prove that the tax avoidance scheme was
a sham set up for the purposes of tax evasion. No single factor may conclusively lead to such
a conclusion. The wrongdoer would be penalised if there is sufficient admissible evidence to
prove that the taxpayer and/or his or her tax adviser has committed an offence under s.80(2) or
s.82 of the ordinance. The provisions in ss.61/61A and ss.80(2)/82A are not mutually exclusive.
As such, penalty actions can be invoked under s.80(2) or s.82A against the taxpayer concerned
regardless of whether s.61 or s.61A has been applied to bring the profits/income in question
into the tax net.

What that in essence means is that the IRD reserves the right to levy an administrative
penalty in cases where it may not have sufficient evidence to secure a conviction for tax evasion
under s.82, which requires the prosecution to prove beyond reasonable doubt a dishonest tax
evasion motive on the part of the taxpayer. The evidential burden in that regard is very high.
Conversely, penalties under ss.80 and 82 are on a strict liability basis: all that is sufficient is that
an incorrect return be furnished without reasonable excuse. The probative standard in that

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regard is evidently much lower. Thus, one can infer that when the IRD is satisfied that there was
some wilful wrongdoing on the part of the taxpayer that did not amount to dishonesty or, if it
did amount to dishonesty, there is not sufficient evidence to warrant prosecution under s.82,
it may nevertheless seek to penalise the taxpayer under ss.80 or 82A on the basis that the tax
avoidance transaction in question involved the furnishing of incorrect returns or information to
the IRD, contrary to one of those sections.

Note that penalties can be objected to and appealed as though they were assessments
under ss.64 and 68 of the IRO.

An officer of a company is not personally liable for penalties levied on the company under
ss.80 and 82. The penalties in question are levied on the company as a separate legal person
and are therefore incapable of being applied to its agents or advisers (Koo Ming Kown & Anor v
CIR (2018) HKCFI 2593).

Key Learning Point

The IRD reserves the right to penalise taxpayers who enter in tax avoidance arrangements
caught under statutory anti-avoidance provisions or the Ramsay principle. Such penalties
are technically not for tax evasion, which requires that dishonesty be shown, but for filing
incorrect returns.

10.2.6 Tax Implications and Development of Tax Avoidance Cases

Judicial approaches to tax avoidance have changed considerably over the last century. Whereas
older case law would suggest that it is wholly legitimate for taxpayers to seek to minimise
their tax liability within the bounds of the statute, there is a marked tendency in the common
law world to depart from that proposition and seek to apply both statutory anti-avoidance
provisions and common law canons of statutory interpretation to deny tax benefits that
would otherwise arise from aggressive tax avoidance schemes. It is nonetheless important
to distinguish between artificial or aggressive tax avoidance, which is generally proscribed
throughout the common law world as unacceptable or at least open to judicial challenge on the
basis of anti-avoidance provisions and tax mitigation, which should not in the ordinary course
be subject to challenge. The boundary between these two is blurred.

In New Zealand Commissioner of Inland Revenue v Challenge Corporation Ltd (1986) STC 548,
the Privy Council opined that tax mitigation occurs where taxpayers obtain a tax advantage by
reducing their income or by incurring expenditure in circumstances in which the taxing statute
affords a reduction in tax liability. Conversely, tax avoidance takes place where taxpayers
reduce their liability to tax without involving them in the loss or expenditure which entitles
them to that reduction. Taxpayers engaged in tax avoidance do not therefore reduce their
income or suffer an economic loss or incur expenditure but nevertheless obtain a reduction
in their liability to tax as though they had. It would therefore appear that tax avoidance will
in general be identified where taxpayers claim a tax benefit without having experienced
the economic consequences that would normally give rise to that tax benefit. Thus, where
expenditure was incurred for objective commercial purposes but with a subjective tax
mitigation motive, it was allowable as a deduction on the terms of the taxing statute: this was

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not avoidance, but mitigation (Ensign Tankers (Leasing) Ltd v Stokes (1992) 1 AC 655). Put another
way, the hallmark of tax avoidance is that taxpayers reduce their liability to tax without
incurring the economic consequences that the legislature intended to be suffered by any
taxpayer qualifying for such a reduction in his or her tax liability. Conversely, the hallmark of tax
mitigation is that taxpayers take advantage of a fiscally attractive option afforded to them by
the tax legislation and generally suffers the intended economic consequences (CIR v Willoughby
(1997) STC 995).

A consensus appears to be emerging that revenue statutes are concerned with the
characterisation of transactions which have a commercial unity rather than the individual steps
into which such transactions may be divided. This approach does not deny the existence or
legality of the individual steps but may deprive them of significance for the purposes of the
characterisation required by the statute (Carreras Group Ltd v Jamaican Stamp commissioner
(2004) STC 1377). You will recall that in Ramsay and Arrowtown the court held that taxing
statutes are intended to apply to real-world commercial transactions. Where, however, steps
with no commercial purpose are interposed between the genuinely commercial steps effecting
the transaction, the court is entitled to disregard such steps for the purposes of applying the
taxing statute. While the outcome of a sophisticated tax planning structure is thereby rendered
uncertain, because taxpayers and their advisers are not necessarily in a position whether a
court will find as a matter of fact and law that any given step has no commercial basis, such
uncertainty, the Privy Council affirmed in Carreras, is inherent to aggressive tax planning.

Key Learning Point

Judicial opinion and revenue practice have become increasingly hostile to tax avoidance.
That climate is apparent in the recent OECD initiatives like base erosion and profit
shifting (BEPS) and the introduction of the common reporting standard (CRS) and
automatic exchange of information (AEOI) regime that seek to discourage and undermine
the effectiveness of tax avoidance structures.

Apply and Analyse 1
Ancient Production Ltd (Ancient) had been carrying on a garment manufacturing business
in Yuen Long, Hong Kong, since 1951. Ancient owned a factory in Yuen Long. In 2018,
the management of Ancient resolved to relocate its factory to Vietnam. Following the
relocation of the factory, the factory would be demolished and the land (the Land) would
be transferred to a newly set-up wholly owned subsidiary company, namely, Bravo
Property Development Ltd (Bravo). Bravo would enter into a joint venture agreement
with an unrelated property development company, Superb Property Ltd (Superb) to
develop residential units and commercial plaza on the Land. Based on a valuation made
by a professional valuation company, the market value of the Land as at 1 July 2018 was
HK$2,000 million. Ancient would assign the Land to Bravo at a consideration of HK$1,500
and share of 50% profits from sale of the residential units developed on the Land. It is in
general unusual for parties dealing at arm’s length to agree to such terms. It was expected
that the total consideration might end up at HK$3,000 million, which it was envisaged
would exceed the market value of the Land by a clear margin.

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Apply and Analyse 1 (continued)

Analyse the potential risk of the preceding arrangement between Ancient and Bravo

Analysis

The relevant provisions in the IRO and case law that we need to consider are:

1. Ss.16 and 17 of the IRO: S.16(1) allows deductions of any outgoings and expenses
to the extent they were incurred in the production of chargeable profits. S.17(1)(b)
prohibits deductions of any expenses that were not expended for the purpose of
producing chargeable profits.

2. S.61A of the IRO: S.61A provides that if it can be concluded that a transaction
was entered into or carried out for the sole or dominant purpose of enabling the
relevant person, either alone or in conjunction with others, to obtain a tax benefit,
the person shall be assessed as if the transaction or any part thereof had not been
entered into or carried out, or in such other manner as appropriate to counteract
the tax benefit.

3. In CIR v Tai Hing Cotton Mill (Development) Limited (2008) HKRC 90-198, where a
holding company had transferred a land lot to its wholly owned subsidiary at a
consideration exceeding the market value, by applying ss.16, 17 and 61A, the CFA
held the transfer value should be reduced to the market value. Specifically, the
CFA held that if the effect of a transaction was that ’the liability to tax is less than it
would have been on some other appropriate hypothesis’, the taxpayer concerned
would be regarded as having obtained a tax benefit. The fact pattern of the Tai Hing
case is similar to the present case.

Comments on the present case:

a. The land cost included a sharing of 50% profits realised by Bravo from the sale of
residential units which were redeveloped on the Land. The total consideration of
HK$3,000 million is far exceeding the market value. The IRD may consider that the
payments which exceeded the market value were not expenses incurred in the
production of the profits from the redevelopment project but an appropriation of
the profits. Such excessive consideration of HK$1,000 million should be disallowed
pursuant to ss.16(1) and 17(1)(b).

b. Alternatively, the Commissioner may invoke s.61A and take the view that the sole
or dominant purpose of the transaction, being the purchase of the Land from
Ancient in accordance of the agreed terms, was to confer a tax benefit on Bravo
by enabling it to deduct a land cost more than it could have done if the sale had
been at market value. By invoking, the commissioner can reduce the purchase
price down to market value of HK$2,000 million. The following features of the
transaction may support the Commissioner to invoke s.61A:

(i) Bravo is a wholly owned subsidiary of Ancient. In the Tai Hing case, a holding
company and its wholly owned subsidiary was held as ’the same enterprise
under the same direction in economic terms’ and plainly not dealing at
arm’s length.

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Apply and Analyse 1 (continued)

(ii) The considerations for the Land consisted of an element for the appropriation
of the profit derived from the redevelopment project. It was unusual for
companies to have entered into such an agreement if they were dealing at
arm’s length.

(iii) At the time the transaction was entered into, the management of Ancient and
Bravo had already expected that the total considerations paid by Bravo for the
Land would exceed the market value. Unless there was other valid commercial
reason for doing so, it was commercially unrealistic to set up such a high
assignment price.

(iv) The preceding circumstances are strong indicators that the purpose of the
transaction is to boost up the transfer price to be paid by Bravo and hence
increase the deduction of Bravo, but the corresponding amount received by
Ancient is capital in nature and non-taxable.

Knowledge Check Questions

Question 1
Identify which of the following statements most accurately describes the general
anti-avoidance provision in s.61A.
A A provision that provides for a convention of statutory interpretation enabling the IRD to
set aside certain transactions in the event that they are uncommercial or are otherwise
tax-driven
B A provision that provides for a general principle of statutory interpretation that applies
in circumstances where the taxpayer has sought to exploit a given taxing provision in a
manner inconsistent with its legislative intent
C A provision that operates to disapply a tax benefit that would, but for the operation of
that provision, have been successfully obtained by a taxpayer where, having regard for
the relevant circumstances, it would be concluded that the transaction was driven by the
desire to secure that benefit
D A provision that operates to deny a tax benefit where, having regard for all the relevant
circumstances of a given transaction, it would be concluded that it was artificial or a sham

Question 2
Identify which of the following is not an example of a specific anti-avoidance provision.
A S.61B
B S.9A
C Ss.50AAK and 50AAF
D S.61

Question 3
Summarise, in a few sentences, the Ramsay principle.

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1 0 . 3
ADVANCE RULING SYSTEM

The advance ruling regime was introduced in 1998 by s.88A of the IRO. It provides that a
person may apply to the IRD in accordance with Schedule 10, part 1, for a ruling on how
any provision of the IRO, other than those addressing the imposition and remission of
penalties, the correctness of a return or other information supplied by a person, and some
administrative matters, applies to the applicant or to the arrangement described in the
application. According to DIPN No. 31 (Revised), the scope of the advance ruling service is
wide. The matters for which ruling is sought include territorial source principle, preferential
regime, general anti-avoidance provision, etc. Questions regarding the application of DTAs to
which Hong Kong is party are not covered by the advance ruling process; however, you should
be aware that the Commissioner may make an advance pricing agreement (APA) with a
person relating to how that person’s income or loss is to be computed under s.50AAF (arm’s
length principle for provision between associated persons) or s.50AAK (separate enterprises
principle for attributing income or loss of non-Hong Kong resident person) for a fixed period
of time. In essence, this extends the advance ruling regime to the context of transfer pricing.
Thus, where a multinational enterprise is concerned that the allocation of profits between
either two associated parties or between a head office and PE are may be at risk of a transfer
pricing adjustment by the IRD on the basis that the allocation is not on an arm’s length
basis (i.e. a basis that one would expect to find between two independent parties, acting
commercially, in the same or similar transaction), they may apply for an APA to obtain legal
certainty. Details about the APA are set out in DIPN No. 48.

The appendix to DIPN No. 31 (Revised) sets out the preferred format for an advance ruling
application, which must contain submissions of both fact and law regarding the arrangement
or transaction, together with a proposed draft ruling. The applicant must pay HK$45,000
for questions of law regarding the source of profits under s.14, and HK$15,000 for all other
questions. Once the IRD receives a valid and complete application, it institutes the advance
ruling process and will endeavour to respond within six weeks of the date of receipt of the
application. However, an applicant could wait for longer time for a ruling, depending on
the complexity of the matter and the volume and level of detail of any requests for further
information.

The Commissioner is not obliged to make a ruling. Under Schedule 10: Part I, s.3, the
Commissioner is not permitted to make a ruling if:

• He considers that the arrangement in relation to which the ruling is sought is not
seriously contemplated by the applicant;

• Determines the application is frivolous or vexatious;

• He is undertaking an audit on how any provision of the IRO applies to the applicant, or
to an arrangement similar to the arrangement which is the subject of the application,
during any period for which the proposed ruling would apply were the ruling
to be made;

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• He considers that the applicant has not provided sufficient information in relation to
the application; or

• He considers that it would be unreasonable to make a ruling in view of the resources

available to him.

A ruling made by the Commissioner, whether advantageous to the taxpayer or not, is final.
Once a ruling has been issued, no further correspondence will be entertained and it will not be
subject to objection or appeal within the schema of the advance ruling regime (though see the
following on the taxpayer’s options in the event of an unfavourable ruling). The ruling made by
the Commissioner will state:

• The identity of the taxpayer, the provisions of the IRO and the arrangement to which
the ruling applies;

• The period for which the ruling applies; and

• Any material assumptions about future events or other matters made by the
Commissioner.

The advance ruling will be subject both to any assumptions made by the Commissioner
and to the material accuracy of the factual matrix provided by the applicant taxpayer to the
Commissioner.

In the case of a favourable ruling, when an applicant indicates on his tax return that
he wishes to rely on an advance ruling, the said ruling is binding on both the IRD and the
applicant. The advance ruling regime therefore enables an applicant to ask the IRD to make
a determination on a given question of law under the IRO. It is, in principle, a service offered
by the IRD to the taxpayer to promote transparency and mitigate the tax risk associated with
commercial transactions. At first sight, there are evident practical benefits to the system. It
gives the taxpayer the opportunity to gauge the IRD’s response to structures and arrangements
with contentious or ambiguous tax implications in Hong Kong. In turn, that enables a taxpayer
to obtain clarity and certainty on the fiscal consequences of a transaction, thereby mitigating
the risk of litigation, which may be extremely expensive in Hong Kong. In principle, the process
should also foster a transparent and mutually beneficial dialogue between the IRD and the
taxpayer, thereby buttressing the stated fiscal imperative of the Hong Kong government to
maintain a ‘low and simple tax’ system.

That said, once made, an advance ruling is in effect final. This creates practical problems
if the ruling is an unfavourable ruling – that is, its result is adverse to the taxpayer’s position.
The advance ruling regime has no appeal mechanism built into it. In practice, what that
means is that a taxpayer aggrieved with an advance ruling has the choice of not carrying out
the proposed arrangement, or has his remedy in objecting to and appealing an assessment
made by the Commissioner pursuant to the advance ruling. That said, because the ruling
is binding on the Commissioner, the outcome of an objection is a foregone conclusion and
the taxpayer thus needs to be ready to take matters either to the Board of Review or to a
higher court. Theoretically, it may be possible to institute judicial review proceedings against
an unfavourable ruling on the basis that it is unreasonable and a ruling that no reasonable

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Commissioner properly instructed in fact and law would have made; given the expense and
complexity associated with such proceedings, however, it would in general be preferable to
bring a substantive appeal.

Advance rulings made by the Commissioner that have an international dimension – that
is, relating to the taxation of an undertaking that operates both in Hong Kong and outside
Hong Kong – may be exchanged with the tax authority of such other jurisdiction(s). The kinds
of rulings that will be exchanged by Hong Kong are listed in DIPN No. 31, appendix 9. They
include rulings relating to preferential regimes (i.e. tax incentives), cross-border unilateral
APAs, cross-border rulings giving a unilateral downward adjustment to the applicant’s taxable
profits, rulings on PEs and related party conduit rulings. This is consistent with Hong Kong’s
commitment to the OECD’s BEPS project. The general rule is that the IRD will exchange rulings
with the jurisdiction(s) whose taxing rights may be affected by the Hong Kong ruling. In that
regard, the exchange of tax rulings enables tax authorities to better understand the tax
planning strategies of undertakings and so to detect aggressive tax avoidance structures.

Advance rulings play a crucial role in tax planning, especially if the client is non-litigious.
They can provide legal certainty in the context of transactions that are complex, potentially
aggressive, or otherwise involve parties that are highly risk averse and who would like to
maintain comity with the IRD. In essence, advance rulings can assist tax advisers in managing
the risk of the IRD challenging a given structure or transaction. A list of published advance
rulings, albeit in summary and anonymised format, may be accessed at https://www.ird.gov.hk/
eng/ppr/arc.htm, broken down by subject matter.

Key Learning Point

Advance rulings can be an important risk management tool for tax advisers. At a cost of
time and professional fees, they can potentially provide legal certainty in matters that
would otherwise be doubtful or complex.

Illustrative Example 3
Condor Legion Ltd (Condor) would like to introduce in Hong Kong the same employee
incentive share scheme its parent company has introduced in Germany. It is, however,
uncertain of the tax implications of introducing a foreign law share scheme to Hong
Kong. It therefore instructs its accountants, Chin, Pan & See (CPS), to advise. Upon
consideration, CPS conclude that there is some doubt as to the year of assessment
in which participating employees will be taxed with respect to shares granted under
the scheme. Because the share scheme would involve a large number of participating
employees, many of whom are not sophisticated and who may therefore be averse to
falling into a dispute with the IRD, CPS advises Condor to apply for an advance ruling. The
advantages of an advance ruling are legal certainty: assuming the ruling is favourable,
Condor will be able to communicate to its employees how they should file their salaries’
tax returns. Commercially and from a human resources management perspective that is
desirable, it warrants the HK$15,000 application fee and attendant professional costs.

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Knowledge Check Question

Question 4
Identify which of the following best describes an advance ruling.
A An advance ruling is a service offered by the IRD to the taxpayer whereby the
Commissioner expresses his opinion on a specified matter of tax law under the IRO, and
subsequently binds him-or herself to that opinion.
B An advance ruling is a form of revenue clearance whereby the taxpayer applies to the
IRD for it to recognise the tax treatment of a given transaction as submitted in the
advance ruling application.
C An advance ruling is a dispute resolution mechanism that enables the IRD and the
taxpayer to settle any disagreements over revenue law matters outside the scope of the
board or the higher courts.
D An advance ruling is a statutorily mandated process of revenue clearance whereby the
taxpayer is required to make certain submissions of fact and law to the IRD in response
to queries raised by the Commissioner on the tax affairs of the applicant.

1 0 . 4
HONG KONG TAX PLANNING
OPPORTUNITIES

Hong Kong has historically been regarded as a tax planning friendly jurisdiction because of its
relatively low headline rates of tax, narrow charging basis – there is no general income tax and
no capital gains tax – and relatively straightforward tax administration requirements. Recent
developments in anti-avoidance doctrine and the IRD’s increasingly aggressive approach to
structures that are considered as having been entered into for the avoidance of tax either in
Hong Kong or abroad, means that prudence and technical precision are required to conduct
successful tax planning. The expansion of the Hong Kong’s DTA network also presents both
opportunities and challenges for tax structuring. Opportunities can be found in the lower rates
of withholding tax on payments to and from Hong Kong, and on the greater legal certainty
guaranteed by a DTA. Conversely, an increasingly hostile approach both in Hong Kong
and internationally to tax avoidance strategies requires practitioners to be able to think of
innovative solutions to address such regulatory challenges.

10.4.1 Tax Planning on Provision of Services by Individuals

Income and emoluments from employment that are either in the form of cash or convertible
into cash are chargeable to salaries tax. Conversely, certain sums and benefits in kind are either
tax neutral or taxed on an advantaged basis. Similarly, payments made in consideration for the
abrogation of contractual rights upon the termination of an employment, or for post-employment
restrictive covenants are not in the ordinary course chargeable to salaries tax unless they were
stipulated in the contract of employment, since under those circumstances the payment in

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question could properly be said to flow from the employment contract (Poon Cho-Ming v CIR (2019)
HKCA 303).

Although capital gains are not taxable, s.9(1) deems perquisites received by employees
from their employment, including capital receipts, to be chargeable to salaries tax. Shares
granted to an employee in connection with his employment will therefore be chargeable to
tax upon receipt on any element of bounty that he obtains: that is, the difference between the
market value of the shares and the amount (if any) the employee paid to acquire them. After
the payment of such upfront salaries tax, dividends and gains with respect to the shares in
question are exempt from salaries tax.

Separately, there arises the question of in what form an individual should render his
services. In other words, is it more tax efficient for him to be employed or self-employed,
rendering services as an independent contractor? You will recall in Section 10.2.2.3 of this
chapter that there are extensive anti-avoidance provisions in s.9A to prevent individuals
claiming to render services via personal services companies while they are, in reality, employed
by the person to whom those services are provided (See Chapter 4, Section 4.4.1.1, on deemed
income from employment). In the ordinary course s.9A will prevent aggressive tax planning
via personal services companies where the objective of such an arrangement is to disguise a
relationship of employment.

Assuming, however, that individuals have a bona fide choice between providing services
either as employees or independent contractors, there are a number of factors that they
should bear in mind:

As employees:

• Salaries tax is charged at progressive rates: if a person’s income is relatively modest,

it may be comparatively advantageous for him to be treated as employees and so pay
salaries tax, though in practice, personal assessment would enable a person chargeable
to profits tax to access the progressive salaries tax rates.

• Compulsory enrollment in an MPF/recognised occupational retirement scheme will

entail certain mandatory deductions at source – currently limited to HK$18,000 per
annum, albeit such mandatory withholding is deductible from the perspective of
the employee.

• Employment contracts (i.e. contracts of service) are generally less flexible from the
perspective of the employee than contracts for services.

• Deductions for expenses are strictly limited to expenditure wholly, exclusively and
necessarily incurred in the production of income chargeable to salaries tax (s.12),
which is a far more restrictive provision than the general provision for the deductibility
of expenditure or outgoings incurred in the production of taxable profits for profits
tax (s.16).

• A major advantage for employees is that many benefits in kind are not taxable to the
extent that they are not convertible into money (ss.9(1)(a)(iv) and 9(2A)(a)).

• Note, in particular, the housing allowance provisions that enable housing to

be provided to employees to be treated as a deemed 10% (or 8% in the case of
accommodation of not more than two rooms or 4% in the case of accommodation of

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not more than one room) of that employee’s taxable income from employment, which,
in view of current property prices in Hong Kong, will often be, relatively speaking, to the
advantage of the employee (s.9(2)).

• Employed people enjoy a broader range of concessionary deductions for non-business

expenditure relating to dependant family and home loan interest (Part 4A of the IRO).

• Certain terminal payments upon termination of employment will not be taxable

provided that they are not a reward for past, present or future services in employment
(Poon Cho-Ming).

As self-employed people:

• The range of deductions available is far more extensive in an assessment to profits

tax (s.16).

• They may avail themselves of the two-tiered rate for the first HK$2 million of assessable
profits, chargeable at 7.5% for unincorporated business or 8.25% for incorporated
business (s.14(2)).

• If services are provided via a company, dividends distributed by that company are
exempt from tax in Hong Kong.

• A sole trader does not need to register for any pension scheme and is therefore not
required to make mandatory contributions.

• A sole trader generally has greater flexibility in structuring his remuneration package
and negotiating the consideration payable for his services.

• They may access progressive salaries tax rates if filing under personal assessment.

Illustrative Example 4
Jason Lim is employed by Skinner & Co as an investigative consultant. He has agreed
with his employer that he will be paid HK$2 million per year. If he takes the whole
remuneration as cash, the full amount will be chargeable to salaries tax. Consider,
however, the following alternative scenarios:

• Mr. Lim does not have a residential property at his disposal, so he will in any event
need to rent. Assume that he finds a rental property at HK$480,000 per annum.
Instead of being paid HK$2 million (all taxable), with which he would then pay
his rent, he may agree with Skinner & Co to be paid HK$1.52 million by way of
salary, but his employer will provide him with lodgings. Ss.9(1)(b) and 9(2) together
provide that the taxable rental value of the apartment is deemed to be 10% of his
income from employment as computed under s.9(1): thus, HK$152,000. In this
scenario, Mr. Lim still obtains HK$2 million of benefits, but is charged to salaries tax
as though his income were HK$1.672 million, which would make for a considerable
tax saving.

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Illustrative Example 4 (continued)

• Assume that Mr. Lim is successful in his position, and becomes entitled to a
bonus of HK$500,000. If that bonus were paid in cash, the full amount would
be chargeable to salaries tax. If, in lieu of a cash bonus, Mr. Lim had agreed
with Skinner & Co that he would be granted shares in an associated company,
Duane Barry Ltd, whose value is linked to the performance of the Skinner & Co
undertaking, he would, upon the issue of the shares, have been taxable only on the
difference between their open market value and the amount he actually paid to
subscribe for them. Any subsequent gain and any dividends declared with respect
thereto, however, will not be chargeable to salaries tax, enabling Mr. Lim to enjoy
these tax free.

• Skinner & Co agrees with Mr. Lim that it will bear the economic cost of supplying
Mr. Lim with health insurance. If Skinner & Co allows Mr. Lim to seek insurance on
the market, and reimburses him for that expenditure by way of a cash payment,
that amount will be chargeable to salaries tax. If, however, Skinner & Co were to
independently contract for insurance, and enter into a bilateral arrangement with
the insurer whereby it is liable for the premium and not Mr. Lim, the benefit arising
from the insurance would not be chargeable to salaries tax under ss.9(1)(a)(iv) and
9(2A): although Mr. Lim receives a net benefit, it is not in connection with a holiday
journey and is not convertible into money.

10.4.2 Determining Organisational Structure for Tax Planning

One of the principal advantages of Hong Kong’s tax regime is that dividends are in general
not taxable. That means that corporations are very efficient tax planning vehicles. That
being said, Hong Kong does not have an extensive variety of business vehicles from which
to choose as a matter of domestic law: partnerships, companies limited by shares and sole
proprietorships are the most common business vehicles available. Trusts may in certain
cases be used in commercial structuring, though in Hong Kong they are most commonly
used in the specific contexts of estate and succession planning. A trust is not a separate legal
person and therefore not itself taxable under the ordinance; however, a trustee is expressly
defined as a taxable person in s.2 and it is the trustee who will therefore be liable for tax
administration and tax payment requirements with respect to any chargeable profits arising
to the trust.

In tax planning, the specific tax attributes of each entity within an organisational structure
must be taken into account. This includes compliance and regulatory costs: for example,
a company incorporated in Hong Kong must prepare audited financial statements on an
annual basis, and file a tax return, even if no tax is payable, and file an annual return with
the Companies Registry. Similar requirements to register under the Business Registration
Ordinance (Cap.310) and file tax returns will apply to permanent establishments (PE) in the
name of the head office company.

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The first question, therefore, to ascertain is the commercial role to be played by each entity.
Operating companies carry on substantive activities and will therefore in general most likely be
liable to tax. They should be in a position to transfer dividends up a chain of companies to the
ultimate beneficial owners. To the extent that they carry on activities in multiple jurisdictions,
care should be taken to familiarise oneself with the relevant PE and profit allocation rules in
those jurisdictions.

Property or asset holding companies may derive passive income: they should be resident
in jurisdictions with DTAs that guarantee the best possible withholding tax (WHT) rates with
respect to the income stream the property in question is expected to yield. In turn, that
may only be determined by reference to the jurisdiction of the source of the passive income
in question.

Conduit companies in essence play no commercial role save as a channel for dividends
and other sources of income. Generally, they are established in tax-neutral jurisdictions, such
as the Cayman Islands or the British Virgin Islands. Income can be channelled through such
companies without the risk of any tax leakage arising. As a practical matter, such companies
are also useful because the limitation of liability of the shareholders places additional distance
between the ultimate individual beneficial owners of the undertaking and the companies
carrying on the undertaking’s business.

Careful coordination with overseas tax advisers is important. What makes sense from
a Hong Kong perspective may give rise to complications in other jurisdictions where the
undertaking operates, or where its ultimate beneficial owners are resident. Notably, many
jurisdictions, such as the United Kingdom and Australia, have so-called controlled foreign
companies (CFC) rules, which provide that where a resident individual participates in an
offshore company that receives passive income that is chargeable at a lower rate of tax relative
to the jurisdiction of residence (or not tax at all), such income is imputed to the resident
individual, irrespective of whether it has actually received it or otherwise disposed of it. CFC
rules are therefore anti-avoidance provisions with the aim of preventing resident individuals
from benefiting indirectly from structuring their financial affairs through offshore companies.
Hong Kong does not have CFC rules; however, given the low headline rates of corporate
taxation in Hong Kong, it is relatively easy for a Hong Kong company to be involved in the
operation of the CFC rules of another jurisdiction.

10.4.3 Tax Implications of Incorporating a Subsidiary or Forming a Branch

Establishing a company means complying with corporate law and, most likely, tax filing
requirements. Because a company is by definition formed to carry out commercial
functions, the general assumption is that it will be a tax subject. Accordingly, every company
incorporated in Hong Kong is automatically registered under the Business Registration
Ordinance (Cap.310), which operates as Hong Kong’s de facto tax registration law. Similarly,
establishing a branch – and therefore, by definition, a PE in Hong Kong will likewise require
registration under Cap.310. A branch or a PE is not a separate legal person: both are the
same, legally speaking, as the entity that constitutes the head office. For example, the Hong
Kong branch of a bank incorporated in France is part of the French incorporated entity, albeit

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that it operates in Hong Kong. A branch or a PE is, however, in practice treated as a separate
taxable person. Having a PE in Hong Kong, by its very nature, amounts to carrying on a trade
or business in Hong Kong for the purposes of s.14 (s.50AAK). S.50AAK is, however, silent on
the matter of the source of profits that are allocated to a PE. It must therefore independently
be determined whether profits allocated to a Hong Kong PE are chargeable on the terms of
s.14 and, for those purposes, the conventional profits tax analysis should apply. Merely being
issued with a tax return by the IRD does not mean that a given company is chargeable to tax in
Hong Kong. It does, however, entail an administrative obligation to file the tax return together
with audited financial statements. That process can be onerous in and of itself, and incurs
significant time and professional costs.

Incorporating a subsidiary company will require an understanding of the specific

commercial functions allocated to that company and its relationship with its parent(s). The
issues here are twofold: first, the taxation of the subsidiary in its jurisdiction of residence
and any jurisdiction where it may have constituted a PE. In this case, the analysis is primarily
a profits or income tax analysis, to be determined by reference to the specific business to
be exercised by the subsidiary. The second issue of importance is the remittance of profits.
Dividends and other income that may under the right circumstances amount to a de facto
allocation of profit (such as intra-group loans) should be payable to the holding company
on a tax-efficient basis. An understanding of the domestic and treaty WHT rates is therefore
essential. A subsidiary carrying on its substantive business in a jurisdiction that levies WHT on
dividends, for example, should in principle be incorporated under a parent company that is
tax resident in a jurisdiction that has a favourable treaty with the jurisdiction of residence of
the subsidiary when it comes to dividends WHT rates (or, indeed, interest WHT rates, as the
case may be).

Hong Kong is a convenient holding company jurisdiction because it does not tax dividends
and does not in general tax interest sourced outside of Hong Kong received by any person
other than a financial institution. It must nonetheless be borne in mind that the transfer in
shares in a company incorporated in Hong Kong is chargeable with ad valorem stamp duty
at the aggregate rate of 0.2% on the higher of the transfer consideration or the value of the
shares (ss.4 and 19 and Heads 2(1) and 2(3) of the Stamp Duty Ordinance, First Schedule).

10.4.4 Group of Companies Tax Strategies

There are relatively few specific fiscal advantages in Hong Kong for corporate groups compared
to other jurisdictions. Whereas Hong Kong does not in general tax dividends, such that profits
may readily be channelled from one company to another in a group structure, the ordinance
focuses on the taxation of companies on a solus basis. That means that each company is
regarded as a discrete taxable person. Contrast jurisdictions such as the United Kingdom and
Singapore that have group loss relief provisions. Those provisions enable unrelieved losses
carried forward by one company in a group to be set off against the taxable profits of another
company in the same group. There are no equivalent provisions in Hong Kong: s.19C(4) clearly
states that the utilisation of unrelieved losses carried forward is confined to the company
bearing the losses, with no possibility of transfer.

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That being said, with the introduction of a court-free company amalgamations regime in
the Companies Ordinance (Cap.622), it is in practice possible to transfer losses from one group
company to another by merging them together. Assuming that both companies meet the
corporate law requirements for amalgamation – that is: (i) both are incorporated in Hong Kong
and (ii) one is the 100% subsidiary of the other or they are both 100% subsidiaries of a third
company – the losses of the amalgamating company should be transferred to the amalgamated
company. Note, however, that the IRD imposes certain stringent conditions on the transfer of
losses. Reference should be made to the IRD’s guidance on their website:
https://www.ird.gov.hk/eng/tax/bus_cfa.htm.

The amalgamating company is treated for profits tax purpose on the day immediately
before the amalgamation as having:

• Ceased to carry on its trade, profession or business (see ss.15C–15D); and

• Realised its trading stock in the open market (see s.15AB).

The amalgamated company is treated for profits tax purpose on the date of amalgamation
as having:

• Continued to carry on the trade, profession or business of the amalgamating company

by way of succession;

• Qualified for annual allowances in respect of commercial/industrial buildings or

structures by way of its entitlement to the relevant interests subject to balancing
charges on disposal not exceeding the aggregate of the allowances made to it and the
amalgamating company;

• Qualified for annual allowances in respect of machinery or plant by reference to

reducing values still unallowed subject to balancing charges on disposal not exceeding
the aggregate of allowances made to it and the amalgamating company;

• Qualified for any allowances/deductions under ss.16B, 16E, 16EA, 16F, 16G and 16I
that the amalgamating company would have been allowed but for the amalgamation,
subject to the assessment of proceeds as trading receipts on sale;

• Been entitled to deductions that the amalgamating company would have been allowed
but for the amalgamation; and

• Earned the amount that would have been income or trading receipt of the
amalgamating company but for the amalgamation.

Tax losses brought forward in the amalgamated company can be used to set off against
profits derived from the trade or business succeeded from the amalgamating company if:

• The amalgamated company has adequate financial resources (excluding intra-group

loans) to purchase the trade or business of the amalgamating company other than
through amalgamation (financial resources test);

• The amalgamated company was carrying on a trade or business until the amalgamation
(trade continuation test); and

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• Such losses were incurred after the amalgamating company and the amalgamated
company had become wholly owned subsidiaries of the same group (post entry test).

If not all the conditions are met, the IRD is of the view that tax losses can only be used to set
off against the profits derived by the amalgamated company from its own trade or business.

The meaning of the word ‘same’ in the phrase ‘same trade or business’ imports identity
and not similarity (Rolls-Royce Motors Ltd v Bamford (1976) STC 162). In applying the same trade
test, it is necessary to compare the trade or business actually carried on by the amalgamating
company in the years of assessment in which it was making the tax losses in question and the
trade or business carried on by the amalgamated company the profits derived therefrom are to
be set off by such tax losses.

It should be noted that the IRD’s published policy on the carrying forward of losses of
companies in an amalgamation scenario has no apparent basis in the IRO and has been
criticised by tax practitioners and academics.

Company grouping can lead to important stamp duty savings when it comes to the
intra-group transfer of Hong Kong immovable property and Hong Kong stock. S.45 of the SDO
provides that the transfer of such assets from one company to a 90% associate is exempt from
ad valorem stamp duty, provided that the transferor and transferee remain 90% associates
for at least two years following the transfer. In this context, association within the terms of
s.45 means that either one company is a 90% subsidiary of the other (which may be traced
through multiple interposed corporate layers) or both companies are 90% subsidiaries of a
third company (which may again be traced through layers of interposed bodies corporate).
Please refer to Chapter 7 for details on the s.45 group relief.
All intra-group transactions and arrangements are in practice caught by the transfer
pricing rules in Part 8AA of the ordinance. That means that there is now an expectation that
intra-group arrangements and transactions be effected on an arm’s length basis. The net
effect of the introduction of detailed transfer pricing rules has been that whereas structuring
intra-group arrangements in Hong Kong was historically straightforward, it now presents many
of the same transfer pricing complications that are found in other jurisdictions. Note that
transfer pricing rules apply to apparently routine intra-group transactions such as a parent
company providing a contractual guarantee for a subsidiary, an intra-group loan, and the
secondment of employees from one group company to another.

Corporate tax planning in Hong Kong usually benefits from two general approaches:
(i) procuring that profits or income, as the case may be, is sourced outside of Hong Kong; and
(ii) realising capital gains in lieu of revenue gains. Where either or both strategy is successful,
no profits tax should be payable domestically, thereby avoiding Hong Kong tax leakage.
Although it is increasingly difficult to do so following the implementation of BEPS PE anti-
avoidance measures globally, it was historically viable to structure the affairs of a Hong Kong
company offshore without, in turn, giving rise to a PE in that other jurisdiction, but book
the profits in Hong Kong. Under those circumstances, the profits were not taxable in any
jurisdiction. That strategy is best illustrated by way of an example.

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Illustrative Example 5
Mosconi S.p.a. (Mosconi) is a company incorporated and resident in Italy. It trades in
sporting goods sourced from Chinese suppliers. For those purposes, Mosconi established
a Hong Kong subsidiary, Lugaresi Ltd (Lugaresi). Lugaresi is responsible for sourcing
manufactured goods directly from Chinese suppliers in Dongguan. It then resells these at
a markup of 40% to Mosconi, which in turn packages the products and markets them in
western Europe, selling them directly to retail stores at a further markup of 60%.

The profits comprised in the 40% markup charged to Mosconi are booked in the
accounts of Lugaresi. Lugaresi, however, otherwise has no substantive presence in Hong
Kong, save for a Hong Kong bank account. All contracts for sale and purchase are effected
in jurisdictions outside of Hong Kong where the occasional effectuation of contracts does
not in itself trigger a liability to domestic tax. No goods are stored in or transit through
Hong Kong. Lugaresi, however, does not have an Italian PE. It would follow that on the
terms of the Hong Kong–Italy DTA, it is, as a Hong Kong resident company, completely
sheltered from Italian taxation. Hong Kong thus has exclusive taxing rights under Article
7(1) of the DTA. But it cannot exercise those taxing rights because Lugaresi, not carrying
on a trade or business in Hong Kong (and, even if it did, not deriving any Hong Kong
source profits therefrom) is not chargeable to profits tax. Mosconi has therefore achieved
considerable tax efficiency for the group, because the 40% markup charged by Lugaresi
has escaped taxation entirely.

It would therefore follow that Hong Kong was, at least prior to the introduction of
legislation aimed at implementing BEPS, a highly favourable jurisdiction for structuring cross-
border commercial operations. Anti-avoidance rules and the enactment of a detailed transfer
pricing regime, however, have made aggressive tax structuring more complicated.

10.4.5 Tax Implications of Asset Deal and Share Deal under Merger

and Acquisition Transaction
A merger and acquisitions (M&A) transaction is commonly used to refer to the acquisition of a
company. What constitutes a ‘company’ for M&A purposes must first be determined. In certain
cases, the M&A is a share purchase: the buyer acquires shares in a company, the target, from a
vendor. Under those circumstances, the only assets that one must consider for fiscal purposes
in Hong Kong are the shares themselves, and not the underlying assets of the target company,
which will not change hands by virtue of the transaction. An alternative to a share sale is a
business sale. A business sale takes place where the undertaking of the target company is
purchased by the buyer. In a business sale, the target and the vendor are in effect the same
because the buyer buys the business assets of the target directly.

10.4.5.1 Common Tax Issues to Buyer and Seller

A prudent buyer will perform extensive due diligence prior to an M&A transaction. That means
checking the corporate, tax, employment, regulatory, and all other commercially relevant
documents of the target company and, where relevant, the vendor to form a view as to the risk
profile of the proposed acquisition.

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In a share sale, the fiscal, corporate law and regulatory characteristics of the target are
relevant. The buyer will want to make sure that the target does not bear any liabilities that
have not been disclosed or of which the buyer is not aware. In particular, any legal or fiscal
liabilities or regulatory defaults on the part of the target will remain with the target following
the completion of the transaction. For that reason, matters such as disputes with the IRD (or
other foreign revenues) are often covered in M&A agreements, allocating the risk of such tax
disputes to the seller (via indemnification of the target) for a given period of time, usually up to
or around completion, and thereafter exclusively to the target.

Illustrative Example 6
Vulture Ltd (Vulture) is a private equity firm specialising in acquiring distressed targets;
accordingly, due diligence is vital to its operations. It is interested in acquiring 100% of
the share capital in Carrion Ltd (Carrion), a company trading in lighting fixtures that has
fallen on difficult economic times. In reviewing Carrion’s financial statements, Vulture’s
professional advisers identify a provision of HK$15 million for tax claimed by the IRD
under an additional assessment. That discovery enables Vulture to raise the matter
with Carrion’s vendor, JoyLuck Holdings Ltd. From this discussion, Vulture discover that
Carrion is engaged in an ongoing tax dispute with the IRD. The IRD accepted to hold over
HK$7.5 million of tax claimed unconditionally. That means, however, that if Carrion were
unsuccessful in its tax dispute with the IRD, Vulture would need to price in HK$7.5 million
of additional tax plus interest. That, in turn, could have a substantial impact on the
commercial attractiveness of the acquisition.

From the perspective of the buyer:

• Ad valorem stamp duty is payable on the transfer of shares in a company incorporated

in Hong Kong or otherwise listed on the Hong Kong Stock Exchange at the rate of 0.1%,
or 0.2% if the buyer agrees to bear the seller’s stamp duty on the higher of the value of
the shares transferred or the transfer consideration.

• No capital allowance or concessionary deductions are available with respect to the

purchase: the asset acquired is an equity interest in another company.

• The target company will all other things being equal not be regarded as having either
ceased or commenced its business.

From the perspective of the seller:

• Ad valorem stamp duty is payable on the transfer of shares in a company incorporated

in Hong Kong or otherwise listed on the Hong Kong Stock Exchange at the rate of 0.1%,
or 0.2% if the seller agrees to bear the buyer’s stamp duty on the higher of the value of
the shares transferred or the transfer consideration.

• Profits tax may be chargeable if the shares are held as trading stock, which in the
ordinary course is highly unlikely (Lee Yee Shing v CIR (2008) 11 HKCFAR 6).

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• No balancing charges or allowances will apply, as the subject matter of the disposal is
shares and not the underlying assets of the company.

• No employment law issues will arise with respect to the termination of employment
contracts because the employment contracts of employees would follow the company.

• No deemed disposal of trading stock upon cessation of business (s.15C).

Business sales give rise to a greater number of issues. From the buyer’s perspective, the
acquisition of assets, including potentially both capital assets and trading stock can give rise
to manifold fiscal considerations. First, the buyer must understand the tax characteristics of
each type of asset. If, for example, the buyer acquires assets eligible for capital allowances, it
must ascertain the allowable cost, which, if they are acquired part-way through their usable life,
would logically need to be computed by reference to historic depreciation. Similarly, certain
intangible assets like goodwill and intellectual property rights may be difficult to value for tax
purposes. Note that although Hong Kong does not offer capital allowances for intangibles (i.e.
amortisation) in its domestic tax code, many other jurisdictions do. The transfer of Hong Kong
immovable property, including industrial and commercial buildings, will give rise to a charge to
ad valorem stamp duty, and will incur ongoing liability to property rates levied under the Rating
Ordinance (Cap.116).

The buyer should also consider the operation of the Transfer of Businesses (Protection of
Creditors) Ordinance (Cap.49) (TBO). This is an exception to the general rule that debts follow
the person and not the business. Under s.3 of the TBO, a transferee of a business undertaking
(as distinct from a buyer of shares in a company) will be liable for the liabilities for the
transferor, including tax liabilities to the IRD for tax due and unpaid and any penalties accruing
thereon, unless notice of transfer is given and published in Hong Kong in accordance with s.5
of the TBO.

From the seller’s perspective, a crucial issue will be the effect of disposing of: (i) trading
stock and (ii) capital assets. As regards trading stock, assuming the transfer is for consideration,
the stock will be treated as realised for tax purposes, potentially giving rise to an immediate
charge to profits tax in the year of assessment in which the M&A transaction took place.
Gains arising from the sale of capital assets will be exempt from profits tax under s.14(1), but
note that balancing charges may arise if capital allowances with respect to those assets had
previously been claimed under Part 6 of the IRO by the seller.

In summary:

Cash: generally not relevant for tax purposes, unless deposits held as trading stock
(e.g. in a forex trade) in which case its sale will be treated as a trading disposal chargeable
to profits tax in the hands of the vendor, with corresponding deductions being available to
the buyer.

Trading stock: the sale and purchase of trading stock will in the ordinary course be
treated as a trading disposal taxable under s.14, with a corresponding deduction available to
the buyer.

Trade debts: generally tax neutral, unless released and charged under s.15(2).

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Plant and machinery: may give rise to balancing charges or allowances under s.39D for
vendor. Corresponding allowances should be available for the buyer.

Industrial and commercial buildings: may give rise to balancing charges or allowances
under s.35 for the vendor. If the building is unused at the time of purchase, allowances
may be available to the buyer (s.35B). Allowances for the residue of the expenditure will
likewise be available for a purchaser of a used building (ss.33A(2) and 34(2)): in other words,
the expenditure unused for capital allowances purposes by the builder and vendor may be
transferred to a subsequent purchaser, and available for deduction to the extent the building in
question is occupied and used for the purposes of a trade or business.

Shares: if the shares are Hong Kong stock (see Chapter 7) then they will be subject to ad
valorem stamp duty at the aggregate rate of 0.2% on the higher of the transfer consideration
or the value of the shares. If the shares are unlisted, they are unlikely to be treated as trading
stock and so chargeable to profits tax (s.14(1) and Lee Yee Shing), though listed shares are liquid
and may therefore more readily qualify as trading stock. If the buyer likewise holds shares as
trading stock, corresponding deductions should be available for their acquisition.

Immovable property: if situated in Hong Kong, ad valorem stamp duty and, possibly, special
stamp duty and buyer’s stamp duty (see Chapter 7) will be payable on the sale and purchase.
Profits tax, too, may also arise to the extent the immovable property is held as trading stock.
If the buyer also holds the immovable property as trading stock, corresponding deductions
should be available for its acquisition.

Intangibles: For patents or specified intellectual property rights, disposal may be taxable
if deductions have previously been claimed by the vendor (ss.16E and 16EB) and, by the
same token, allowances may be available for the purchaser (ss.16E and 16EA). The disposal
of goodwill will almost certainly be treated as a capital disposal and so exempt from tax, but
likewise no deductions or allowances should be available to the buyer.

Because business sales present a number of potential tax complications both in Hong
Kong and abroad, market practice in Hong Kong tends to favour share sales for M&A purposes.
In summary:

• Advantages of a share sale:

°° No direct disposal of underlying assets, so no charge to profits tax or risk of

balancing charges.

°° Does not in general entail the cessation of the target company’s trade for
tax purposes.

°° Stamp duty on shares is charged at a much lower rate than stamp duty on
immovable property located in Hong Kong; hence, a share sale is advantageous for
both buyer and seller when acquiring enveloped Hong Kong immovable property.

°° No TBO risk.

°° Relative to an asset sale it is less likely that it will involve the cessation of a trade
or business, with the subsequent deemed disposal rules relating to trading
stock (s.15C).

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• Advantages of an asset sale:

°° Buyer can directly secure deductions for trading stock, patent rights, and specified
intellectual property rights and allowances for plant and machinery and buildings.

°° Due diligence may be limited to the assets specifically being acquired.

°° Unrelieved losses carried forward of the acquiring company may be set off against
the profits of the acquired business.

Apply and Analyse 2 – Share Transfer Versus Assets Transfer

Ace Ltd was incorporated in Hong Kong and wholly owned by Mr. Abraham, who was
discussing with Mr. Brand on how to sell the business of Ace Ltd to Bee Ltd. Bee Ltd is
wholly owned by Mr. Brand. In 2005, Ace Ltd was set up by Mr. Abraham, who incurred
total set-up costs of HK$4 million (including share capital paid up, legal expenses, etc.).

The transfer would be made either by way of transferring shares of Ace Ltd to Bee Ltd
or transferring individual assets to Bee Ltd. Regardless of the way of transfer, the total
consideration would be the same, that of HK$244.8 million. If the sale is to be made by way
of assets transfer, Ace Ltd would cease all its business upon completion of the sale. Bee Ltd
would continue to carry on the same business as Ace Ltd now was carrying on. All profits
from the business are derived from Hong Kong and assessable to profits tax.

Details of the assets held by Ace Ltd as of 1 February 2020 and the respective transfer
values are shown as follows:

Cost/tax written Details Transfer

down value/balance value
of unallowed (HK$)
expenditure (HK$)
Office 60,000,000 • Construction completed in 180,000,000
building (in 2009/10, with construction cost
Hong Kong)
of HK$100 million

• Commercial building allowance

at 4% per year had been
allowed for 10 years from
2009/10 to 2018/19

• The tax written value b/f from

2018/19 was HK$60 million
(=HK$100 million ×
(1 – (4% × 10)))
Staff 50,000,000 Acquired on 1 March 2019 (i.e. 60,000,000
quarters (in 2018/19) at cost of HK$50 million
Hong Kong) from the property developer, no tax
allowances have been claimed
Equipment 320,000 HK$320,000 is the tax written down 200,000
value of 20% pool assets

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Apply and Analyse 2 (continued)

Cost/tax written Details Transfer

down value/balance value
of unallowed (HK$)
expenditure (HK$)
Trademark 800,000 Acquired in 2018/19 at a cost of 1,200,000
HK$1 million (protection period
will end on 31 March 2028), 20%
deduction on acquisition cost had
been allowed under s.16EA. Hence
the amount of unallowed expenditure
is HK$800,000 (= HK$1 million ×
(1 − 20%))
Stock 2,500,000 Stock valued at the lower of cost or 2,600,000
net realisable value is HK$2.5 million;
market value is HK$3 million
Trade debts 800,000 Trade debts receivable before 800,000
receivable written off of doubtful debts, if any, is
HK$800,000
244,800,000

Both Ace Ltd and Bee Ltd carry on business in Hong Kong and close account on
31 March every year.

Assuming the transfers are executed on 1 February 2020, the tax implications are
analysed as follows:

Option A – Shares transfer

Stamp Duty: (HK$244.8 million × 0.2%) + HK$5 = HK$489,605

Profits tax:

Ace Ltd was set up by Mr. Abraham in 2005 and has been held by him as a long-term
investment for over 10 years, the disposal gain of HK$244.8 million − HK$4 million =
HK$240.8 million should be capital in nature and non-taxable.

Option B – Assets transfer

(i) Sale of the office building

Stamp duty:

Ad valorem duty (AVD): HK$180 million × 8.5%* = HK$15.3 million

*For non-residential property, Part 2 of Scale 1 rates apply

Special Stamp Duty (SSD) and Buyer’s Stamp Duty (BSD) are not payable as the
office building is not a residential property.

Though, theoretically, the AVD is jointly and severally liable by both the
seller and buyer, in practice the buyer (i.e. Bee Ltd) would be responsible for the
payment of AVD.

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Apply and Analyse 2 (continued)

Profits tax implications to Ace Ltd:

Balancing adjustment for the year 2019/20

HK$
Residue of expenditure before sale 60,000,000
Sale proceeds 180,000,000
Excess of sale proceeds over residue of 120,000,000
expenditure
Balancing charge (limited to allowances given) 40,000,000

The building had been owned and used by Ace Ltd for 10 years. The gain on
disposal of HK$80 million (HK$180 million − HK$100 million) should be capital in
nature and non-taxable.

Profits Tax implications to Bee Ltd:

Commercial building allowance for 2019/20

Bee Ltd should be entitled to commercial building allowance if the building is

continued to be used by it for carrying on business in Hong Kong for production of
assessable profits.

Computation of commercial building allowance for Bee Ltd for the

year 2019/20

HK$
Residue before sale 60,000,000
Add:
Balancing charge 40,000,000
Residue after sale 100,000,000
Annual allowance (see the following) 6,250,000
Qualifying expenditure c/f 93,750,000

Year of first use 2009/10

Year of sale 2019/20
25th year after year of first use 2034/35
Number of years from the year of sale to 16 years
25th year after the year of first use

Annual allowance per year: HK$100 million ÷ 16 = HK$6.25 million

Bee Ltd would be entitled to the annual allowance of HK$6.25 million per year
until 2034/35 if it has used the building for the purpose of production of assessable
profits for the relevant year and had not sold the building at the relevant year end.

(ii) Sale of the staff quarters

Stamp Duty:

AVD: HK$60 million × 15% = HK$9 million

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Apply and Analyse 2 (continued)

SSD: HK$60 million × 15% = HK$9 million

(Holding period from 1 March 2019 to 1 February 2020, i.e. 11 months)

BSD: HK$60 million × 15% = HK$9 million

Bee Ltd is not a permanent resident in Hong Kong and hence BSD is chargeable
on sale of the staff quarters.

Though strictly, the AVD and SSD is jointly and severally liable by both the seller
and buyer, in practice the buyer (i.e. Bee Ltd) would be responsible for payment of
the AVD and SSD. Bee Ltd will be liable to BSD.

Profits tax implications to Ace Ltd:

As the staff quarters have been owned by Ace Ltd for just 11 months, it is very
likely that the IRD would regard the gain on sale of HK$10 million (HK$60 million
− HK$50 million) as trading in nature and taxable. The profits tax liability would be
HK$10 million × 16.5% = HK$1.65 million.

Profits tax implications to Bee Ltd:

If Bee Ltd uses the property as its staff quarters, it will be entitled to
commercial building allowance at 4% on the construction cost of the property.

Further information should be obtained from Ace Ltd and or the relevant
property developer about the cost of construction. If Bee Ltd holds the property for
trading purpose, no commercial building allowance would be available.

(iii) Transfer of equipment

Tax written down value: HK$320,000; Sale consideration: HK$200,000

Profits tax implications:

Ace Ltd

A balancing allowance of HK$120,000 (HK$320,000 − HK$200,000) would be

deductible to Ace Ltd (assuming the sale consideration is not higher than the cost
of acquisition of the equipment).

Bee Ltd

Bee Ltd would be entitled to depreciation allowance for the equipment – initial
allowance of HK$120,000 (HK$200,000 × 60%); annual allowance of HK$16,000
((HK$200,000 − HK$120,000) × 20%).

(iv) Transfer of trademark

Unallowed expenditure: HK$800,000; sale consideration: HK$1.2 million

Profits tax implications:

Ace Ltd

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Apply and Analyse 2 (continued)

Balancing adjustment should be made as follows:

HK$
Unallowed expenditure 800,000
Sale proceeds 1,200,000
Excess of sale proceeds over unallowed 400,000
expenditure
Taxable amount (limited to deduction 200,000
allowed before)

Bee Ltd

Deduction should be available under s16EA as follows:

HK$
Cost of acquisition 1,200,000
Deduction at 20% for 2019/20 240,000
Unallowed expenditure 960,000

Bee Ltd would be entitled to deduction of HK$240,000 for each of the years
from 2019/20 to 2023/24.

(v) Transfer of stock

 ost: HK2.5 million; sale consideration: HK$2.6 million; market value of

C
HK$3 million

Profits tax implication:

Ace Ltd
As Bee Ltd would continue to carry on Ace Ltd’s business in Hong Kong and the
acquisition cost would be claimed for deduction in computing Bee Ltd’s assessable
profits, s.15C applies. Under s.15C, the sale consideration (i.e. HK$2.6 million) could
be accepted for the purpose of ascertaining the profits tax liability of Ace Ltd, even
it is below the market value.

Bee Ltd
As previously mentioned, Bee Ltd would be entitled to claim deduction of
HK$2.6 million for profits tax purpose.

(vi) Transfer of trade debts receivables

Amount receivable: HK$800,000 (before written off of doubtful debts, if any)

Sale consideration: HK$800,000

Profits tax implications:

Ace Ltd

There should be no implication.

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Apply and Analyse 2 (continued)

Bee Ltd

If any of the debts become uncollectible after the transfer, Bee Ltd would not
be able to claim deduction thereof under s.16(1)(d) because Bee Ltd has never
included such debts as trading receipts in ascertaining its assessable profits. It
should review if there is any doubtful debt and ask Ace Ltd to write off such debt
in its account and hence claim deduction thereof before the transfer. If there is
write-off of doubtful debts, the sale consideration might need to be adjusted after
further discussion by both sides.

10.4.5.2 Using a Tax Indemnity Clause to Address Tax Uncertainties Under Merger

and Acquisition Transaction
Tax indemnities are not, technically, indemnities. A tax indemnity clause is an agreement
that allocates risk between the buyer and the seller. Most frequently, tax indemnities are
time-bound. Prior to a given date, the seller covenants with the buyer that it will pay any
outstanding tax liability relating to the target and, following that date, the buyer (or the target
as the case may be) will be wholly responsible for the target’s tax liabilities. The commercial
role of a tax indemnity is to provide the seller with comfort that the buyer will not seek to
institute proceedings against it under the sale and purchase agreement for recovery of tax
owed by the target arising after a given point in time. Unforeseen or imminent tax liabilities
may be considerable and therefore need to be priced into the transfer consideration: shares
in a company nominally worth HK$10 million, but with HK$1 million of imminent or incipient
tax liability is, as a commercial matter, worth HK$9 million or, potentially, less if one were, for
example, to price in reputational or litigation concerns.

There are two important first principles to bear in mind when drafting tax indemnities. The
first is the definition of tax: usually this is covered in the definitional section of the agreement,
and it may be quite intricate. In particular, it should be drafted with sufficient breadth to cover
all taxes and similar imposts, including stamp duty, excise duty, indirect tax such as GST/VAT,
and penalties attaching to the late or non-payment of tax, or for filing incorrect returns. The
second issue is the timing issue: it is important to understand the basis for the allocation of
the responsibility to pay tax under an indemnity clause. There may be a material difference
between the time the liability to tax first emerges and, for example, when the revenue authority
in question makes a claim by issuing an assessment.

10.4.6 The Implications of BEPS, FATCA and CRS

The OECD began its existence as an international organisation dedicated to the economic
reconstruction of Western Europe after the Second World War. In time, however, it assumed
a very active role in setting out the principles and approaches that would govern international
taxation. The OECD is not a regulator: it has no executive or administrative power. It is,
however, highly influential in setting the agenda for the development of the norms and
structures of international taxation. Hong Kong is not a member of the OECD; however, it is
deeply influenced by OECD approaches to international taxation.

Base Erosion and Profit Shifting (BEPS) is a set of actions that the OECD considers
participating jurisdictions should undertake in order to comply with international standards

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of international taxation when it comes both to the construction and application of DTAs and
the adaptation of domestic tax laws to the prevailing global standards. ‘Base erosion’ is a
general term that refers to the use of tax planning structures to reduce the net tax revenue of
a given jurisdiction by decreasing the income, profits or gains taxable in the said jurisdiction.
‘Profit shifting’ can be understood as a specific form of base erosion and refers to the use of
aggressive tax planning structures to allocate profits to (usually low-tax) jurisdictions in which
the profits in question were not in substance generated. The BEPS project aims to prevent base
erosion and profit shifting by requiring participating jurisdictions to make certain amendments
to both the DTAs to which they are party – this is achieved through signing a single Multilateral
Convention – and to reform their domestic laws and practices.

The impact of BEPS in Hong Kong has been pronounced. For example, granting a non-
resident a tax benefit or incentive not available to a resident is considered a ‘harmful tax
practice’ because it operates to erode the base of other jurisdictions that do not offer the same
incentive. Accordingly, Hong Kong has been compelled to redraft its offshore funds regime to
offer the same profits tax exemption, subject to certain conditions, to all qualifying investment
funds (see Chapter 3, Section 3.10.6.3 for details). BEPS has also entailed Hong Kong adopting
a fully-fledged transfer pricing regime, which is now written into Part 8AA of the IRO. Transfer
pricing enables profits to be allocated between and within jurisdictions on an arm’s length
basis – that is, on commercial terms, one would expect to find between two parties acting
independently with respect to the same or substantially the same transaction. That, in turn, is
consistent with the stated BEPS principle of aligning value creation with taxation.

While BEPS has had an impact on the substantive application of tax law both domestically
and internationally, the common reporting standard/automatic exchange of information
(CRS)/(AEOI) regime is exclusively concerned with the exchange of financial information
between participating jurisdictions. CRS rules are written into Part 8A of the IRO. The central
administrative provision for the implementation of CRS is s.50C, which requires financial
institutions to make annual returns to the IRD with respect to reportable accounts. To
summarise, CRS operates as follows: financial institutions take on reporting requirements
with respect to their financial accounts. Although in common parlance a financial institution
is generally understood as a bank, within the CRS regime any person holding money or other
assets on behalf of another by way of business can be classed as a financial institution and
therefore be subject to a reporting requirement. Financial institutions under the CRS regime
must exercise due diligence – that is, they must investigate the affairs of the persons on whose
behalf they hold assets – to identify reportable accounts. A reportable account is an account
held by a reportable person, which is a person resident in a jurisdiction that is participating in
the CRS system. The information contained in a CRS return is relatively basic: it includes the
value of the account, the identity of the account holder or ultimate beneficial owner of the
account, and the jurisdiction of tax residence of such persons. The purpose of CRS is to enable
tax authorities to understand the degree to which their tax residents hold assets abroad, and
so to ensure that their domestic tax declarations are consistent with the CRS returns made with
respect to them in other participating jurisdictions. At its most essential, the CRS regime is an
anti-tax evasion regime, since it is was devised to enable the detection of individual taxpayers
who fail to report their overseas assets (or assets to which they are beneficially entitled
overseas) in their domestic tax declarations.

Because financial accounts are often held by intermediaries, such as companies or trustees,
the CRS rules require the financial institutions to look behind such intermediaries and identify

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the individual (i.e. natural person) beneficial owners and/or controllers of the account. The one
general exception to this rule is when the account is held by another financial institution or by
an active non-financial entity – that is, broadly speaking, a person carrying on a substantive
trade or business other than the passive holding of assets.

CRS is a passive information exchange mechanism. Once reporting financial institutions

have filed a CRS return with the IRD, the IRD will in turn upload the information they have
received on a global CRS portal, enabling the tax authorities of participating jurisdictions to
identify returns made by Hong Kong financial institutions with respect to their residents.
Similarly, the IRD will be able to access the online CRS portal to identify assets held by
Hong Kong tax residents abroad. Because, however, Hong Kong is a low-tax and territorial
jurisdiction, there can be little doubt that in practice CRS will be of greatest benefit to high-tax
jurisdictions that charge tax on a worldwide basis on residents.

The US equivalent of the CRS regime – the United States does not participate in CRS
– is Financial Accounts Tax Compliance Act (FATCA), which stands for the piece of US
legislation that first enacted the relevant information exchange rules: the Foreign Accounts Tax
Compliance Act. FATCA is operationally similar to CRS, but applies only to US persons – that is,
broadly speaking, US citizens or individuals who have the right of abode in the United States.
Hong Kong participates in the FATCA via its adherence to the Intergovernmental Agreement
with the United States (IGA). Generally speaking, many of the concepts found in the CRS regime
are replicated in the FATCA regime. On the terms of the IGA, financial institutions must register
with the US Inland Revenue Service, and make annual filings with respect to US persons –
broadly speaking, individuals who are US citizens.

FACTA and CRS are information exchange mechanisms. They do not directly affect the
liability of any person to tax. They do, however, have a profound indirect effect on tax planning.
First, taxpayers are less likely to engage in aggressive tax planning if they are aware that
their financial data are shared across jurisdictions. Tax enforcement and the application of
anti-avoidance provisions are in practice often reliant on revenue detection. The systematic
exchange of information increases the probability of detection and therefore the litigation risks
associated with tax planning. Further, the desire to avoid having one’s financial information
exchanged with other jurisdictions, which may either be legitimate (i.e. the jurisdiction receiving
the information has a history of property expropriation or the persecution of certain groups) or
illegitimate (i.e. because the subject of the information exchange knows that he has not been
compliant with the tax laws of the jurisdiction receiving the information) has given rise to a sub-
set of tax planning which is CRS/FATCA planning. As with tax avoidance, such schemes seek to
avoid the application of CRS/FATCA reporting to certain financial accounts.

BEPS has a more direct effect on tax planning because it was introduced specifically
with the objective of rendering ineffective many prominent tax planning strategies. Such
strategies traditionally focused on moving profits from the place where they were in substance
generated to low-tax jurisdictions. BEPS will, among other things, render profit shifting across
jurisdictions more difficult and, in some cases, potentially unlawful. BEPS also aims to address
the challenges of the digital economy and may be moving towards requiring jurisdictions to
adopt essentially analogous tax laws. The so-called Pillar 1 of BEPS seeks to address the issue
of PE avoidance by way of remote or dematerialised transactions: large internet retailers
such as Amazon or Taobao can avoid having a PE in the jurisdictions in which they realise
their profits simply by not having any fixed physical presence there, such that they avoid

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tax entirely on their sales. Pillar 2 of BEPS goes further and suggests that a basic, worldwide
minimum tax should be applied and that the computation of the taxable base of profits
should be harmonised across jurisdictions. If these projects come to fruition, they will have a
profound impact on the development of tax legislation in Hong Kong, and the direction of this
city’s economy.

Key Learning Point

CRS/AEOI and FACTA are international mechanisms for the exchange of tax information.
They require financial institutions to file periodic returns with respect to tax residents in
certain jurisdictions. BEPS reflects an international consensus that profits ought to be
taxed in the jurisdiction where they are in substance generated.

Illustrative Example 7
Billion Profit Abundant Jade Bank (BPAJD) is a Chinese bank that wishes to establish
a presence in Hong Kong. It duly registers under the Banking Ordinance (Cap.155),
and opens its first branch in Sha Tin. BPAJD is a financial institution. Accordingly, the
CRS regime applies to it. It will be required to exercise due diligence on all depositors
and identify their jurisdiction of tax residence. For those of them who are resident in
reporting jurisdictions other than Hong Kong, BPAJD will be required to file an annual
CRS return to the IRD. That return will, among other things, specify the amount each such
account holder has in their account. The IRD will then exchange that information with the
jurisdictions of tax residence of the relevant account holders.

Knowledge Check Questions

Question 5
Summarise two approaches to salaries tax planning.

Question 6
Summarise, with reasons, the tax planning considerations you would make if you were
asked to advise a company on the incorporation of a subsidiary in Hong Kong.

Question 7
Summarise the relative pros and cons of an asset sale as opposed to a share sale and
explain the reasons for them.

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1 0 . 5
DOUBLE TAXATION AGREEMENTS
OVERVIEW

Double taxation agreements/arrangements (DTAs) are instruments of public international law,

that is, they bind the jurisdictions that are party to them. They also create rights and obligations
for taxpayers as a matter of domestic law because each DTA to which Hong Kong is party is
transposed into Hong Kong law by the enactment of a specific order by the Chief Executive
(s.49(1)). Taxpayers may therefore enforce their rights under a DTA specifically against the IRD,
without needing to resort to international litigation or arbitration. As you will already have
learned, Hong Kong has the constitutional right to negotiate DTAs with other jurisdictions,
notwithstanding that it is not a sovereign state (Articles 106 and 116 of the Basic Law). A DTA
operates to allocate taxing rights: the operation of a DTA determines which jurisdiction is
entitled to tax a given gain or income stream in a cross-border transaction or arrangement.
DTAs are of vital importance to international trade because they contribute to legal certainty
and enable sophisticated cross-border tax planning. Generally, DTAs are intended to avoid
double taxation – that is, the taxation of a given income stream or gain more than once.
Avoiding double taxation may be achieved either by allocating taxing rights exclusively to a
given jurisdiction or by allocating taxing rights to the jurisdiction of residence of the taxpayer
subject to a credit for tax paid in the jurisdiction of source of the income or gain in question.
We consider those mechanisms in greater detail in Section 10.5.5.

DTAs are ideal tax planning tools because they enable a tax adviser to identify the most
advantageous jurisdictions in which to establish a business or corporate presence in order
to take exploit particularly generous terms of that treaty. The international consensus is that
planning a structure purely on the basis of accessing the benefit of a given DTA and not,
for example, because the parties to the transaction wish to establish a bona fide business
presence in one or more of the said jurisdictions, amounts to artificial tax avoidance. The terms
most often used to define this type of tax avoidance are ‘treaty shopping’ or ‘treaty abuse’. As a
consequence, many DTAs now have specific and general anti-avoidance provisions that aim to
discourage and prevent tax avoidance in the context of DTAs. We shall consider these in greater
detail in the following section.

Key Learning Point

DTAs are the basic building blocks of international tax structuring. A DTA answers the
essential question of which jurisdiction is entitled to tax a given income stream or gain.

10.5.1 Double Taxation Agreements Scope and Terminology

A DTA is a bilateral arrangement: it only applies between the two contracting jurisdictions
and not otherwise. Hong Kong is party to approximately 40 DTAs as at the date of writing of
this chapter. As regards the jurisdictions with which Hong Kong has a DTA, the terms of the
DTA take precedence over the terms of the IRO (ss.49(1A) and 49(1C)). Because a DTA creates

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obligations as a matter of public international law for the government of Hong Kong, the
default approach in applying DTAs is that domestic legislation must be construed in the way
that best gives effect to the application of the DTA and if the two provisions are irreconcilable,
then the DTA prevails. Interpreting DTAs is very different to interpreting domestic taxing
statutes (RCC v Anson (2015) UKSC 44). Because a DTA is governed by public international law,
the same canons of statutory instruction as are employed in Hong Kong – for example, the
Interpretations and General Clauses Ordinance (Cap.1) or the common law approach to reading
enactments – do not necessarily apply. The Vienna Convention on the Law of Treaties (1969)
codifies customary international law when it comes to the interpretation of treaties and is
regarded as the preferred basis for interpreting DTAs.

Also of vital importance is the OECD’s Commentary on the Model Double Taxation
Convention. The Model Convention is the ‘prototype’ or ‘default’ DTA, from which, in
substance, each DTA currently in force is drawn. The content of all DTAs in general conforms
to the structure and drafting of the Model Convention. Accordingly, the Commentary on the
Model Convention is of vital importance. Although it is not binding, it sets out in detail the
OECD’s analysis of each individual article of the Model Convention and, accordingly, assists
practitioners in predicting how the DTA will actually be interpreted by the taxing authorities of
contracting jurisdictions.

Because Hong Kong is not a sovereign state, the terminology utilised to DTAs to which Hong
Kong is party is ‘agreement’ or ‘arrangement’; however, globally DTAs are generally known as
double tax treaties (DTTs). Thus, you should bear in mind the following vital terms:

1. ‘Treaty resident’ means resident in a given jurisdiction under the terms of a DTA, and
not as a matter of the domestic law of one or both contracting jurisdictions.

2. ‘Treaty benefit’ means to obtain a tax benefit from the operation of a DTA – for
example, a lower rate of withholding tax than would be paid by a resident of a
jurisdiction with which the jurisdiction of source does not have a DTA.

3. ‘Competent authority’ means the public body in a given jurisdiction charged with
implementing its tax laws. In Hong Kong, the competent authority is the IRD.

The substantive tax-allocating provisions of a DTA apply only to the taxes enumerated in
the ‘Taxes Covered’ article (usually Article 2), from the effective date specified in the ‘Entry into
Force’ article (usually Article 29). A DTA does not apply otherwise; in particular, DTAs do not
generally allocate taxing rights as regards goods and services tax/valued added tax, excise duty,
inheritance tax/estate duty, stamp duty, and property rates or government rent. Such taxes are
outside the scope of most DTAs in general, and evert DTA to which Hong Kong is party.

DTAs refer to ‘enterprises’ which are to be understood in the commercial sense as business
undertakings, not necessarily limited to a specific legal person.

10.5.2 Jurisdictions with which Hong Kong Has Entered into a Double

Taxation Agreement
As of 1 June 2020, Hong Kong has signed 43 comprehensive DTAs with jurisdictions, including
Austria, Belarus, Belgium, Brunei, Cambodia, Canada, Czech Republic, Estonia, Finland,
France, Guernsey, Hungary, India, Indonesia, Ireland, Italy, Japan, Jersey, Korea, Kuwait,
Latvia, Liechtenstein, Luxembourg, Macau SAR, China (Mainland), Malaysia, Malta, Mexico,

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Netherlands, New Zealand, Pakistan, Portugal, Qatar, Romania, Russia, Saudi Arabia, South
Africa, Spain, Switzerland, Thailand, United Arab Emirates, United Kingdom and Vietnam.

10.5.3 Key Articles in the Double Taxation Agreement

To apply a DTA to a given scenario, reference must be made to certain essential concepts,
which are summarised in the following.

10.5.3.1 Residence
As a prior point, Article 1 of each DTA provides that only a person as defined in the DTA
may enjoy a benefit under the relevant agreement. A person must be resident either in one
contracting jurisdiction or other of a given DTA for the provisions of that DTA to have any
application.

Treaty residence means residence in a contracting jurisdiction on the terms of the DTA. The
article containing the definition of residence is usually Article 4. As regards the DTAs to which
Hong Kong is party, residence in Hong Kong is usually established by reference to different
factors depending on whether the person is an individual or a body corporate. Individuals
are usually resident in Hong Kong to the extent that they either spend more than 180 days
in any given year of assessment physically in Hong Kong – you will recall that the midnight
rule applies, which is each midnight spent in Hong Kong is counted as a day – or 300 days in
two consecutive years of assessment or who is otherwise ordinarily resident in Hong Kong.
Ordinarily resident in this context means that Hong Kong is the habitual place of residence,
putting aside temporary absences for transitory reasons, of that individual. Conversely, a
body corporate is treated as resident in Hong Kong if it is either incorporated in Hong Kong,
or normally managed and controlled in Hong Kong. Normal management and control in this
context has a very similar meaning to ‘central management and control’, which is the standard
common law test to determine the jurisdiction of tax residence of a company (De Beers
Consolidated Mines Limited v Howe (Surveyor of Taxes) (1906) 5 TC 198). A company is regarded
as normally managed or controlled in the jurisdiction in which decisions at the board level are
in substance taken. This is distinct from the conduct of the everyday commercial business of
the company, or its control at the shareholder level. Persons other than individuals or bodies
corporate, such as partnerships and, where recognised as persons by the relevant DTA, trusts,
are treated as being resident in the jurisdiction under which laws they were organised.

Hong Kong’s approach to determining treaty residence is, by global standards, unorthodox.
Most jurisdictions that are DTA partners with Hong Kong define treaty residence as being
taxable under their domestic laws by reason of a person’s residence, domicile, place of control
etc. The divergent approaches between Hong Kong and other jurisdictions in establishing treaty
residence are likely a function of Hong Kong’s distinctive territorial tax regime.

As a practical matter, and as a result of the influence of the BEPS project on Hong Kong’s
domestic assessing practice, the IRD has been known to decline to issue a certificate of resident
status (CoR) to companies that have insufficient economic substance in Hong Kong. A CoR
is certification issued by the IRD that a person is resident in Hong Kong for the purposes of
a given DTA. The IRD considers that if it has reason to believe that a person should not be
entitled to benefits under a DTA (and in that regard, the influence of BEPS will mean that
the use of DTAs for tax avoidance purposes would preclude their application) it may request
further information from the person before deciding whether a CoR can be issued. In cases

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where it is not clear to the treaty partners whether a person would be entitled to such benefits,
the IRD may need to exchange information to help them come to an informed decision as to
whether such benefits can be granted.

Any ‘person’ so defined in Article 1 of the relevant DTA may apply for a CoR. Thus, in Hong
Kong, the IRD envisages the following applicants:

• An individual who ordinarily resides in Hong Kong.

• An individual who stays in Hong Kong for more than 180 days during a year of
assessment or for more than 300 days in two consecutive years of assessment one of
which is the relevant year of assessment.

• A company/partnership/trust/body of persons incorporated or constituted in

Hong Kong.

• A company/partnership/trust/body of persons incorporated or constituted outside

Hong Kong but managed or controlled in Hong Kong.

The practical relevance of a CoR is that it is often required by the revenue authorities of
jurisdictions with which Hong Kong has a DTA as a condition precedent for authorising the
payment of dividends, royalties, interest, capital gains etc. at the treaty rate rather than the
domestic rate. In this context, economic substance means a real business presence in Hong
Kong such as having a physical office with permanent staff in Hong Kong. It is therefore now
much more difficult to conduct effective tax structuring in Hong Kong through ‘brass plate’
companies that only have a notional presence in the jurisdiction.

10.5.3.2 Permanent Establishment
A permanent establishment (PE) is a taxable presence of a non-resident person in a given
jurisdiction. The treaty definition of a PE is a fixed place of business through which the
business of an enterprise is wholly or partly carried on. There are two important concepts to
consider from that brief definition: first there must be a place of business. A PE can only arise
when there is some place of business at the disposal of the non-resident person, which will
in the ordinary course be commercial premises, but in extreme cases may include personal
residences or hotel rooms to the extent such premises are utilised in the course of the ­
non-resident person’s business and are in effect at its disposal. The second fundamental
criterion for a PE to arise is a degree of fixity: to be clear, ‘permanent’ does not mean eternal
or unchanging, but requires some degree of permanence that is more than merely transitory.
The general assumption in many DTAs is that a presence in a given jurisdiction for more than
six months meets the criterion of fixity for the purpose of constituting a PE. Reference should
always be made to Article 5 of the relevant DTA, since the rules for determining whether a PE
has arisen may vary from one DTA to the other.

A PE is not usually a separate legal person at law: the PE is part and parcel of the legal
personality of the non-resident head office and does not, therefore, in the ordinary course
include subsidiary, even if that subsidiary is wholly owned.

A PE by definition includes the following:

a. a place of management;

b. a branch;

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c. an office;

d. a factory;

e. a workshop; and

f. a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

In many DTAs, the following are also treated as PEs:

1. A building site utilised for more than six (or 12) months;

2. Consultancy services rendered for more than 183 days; and

3. The presence of agents who habitually conclude or habitually play the principal role
leading to the conclusion of contracts for and on behalf of the head office, though note
that an enterprise is not deemed to have a PE merely because it carries on business in
a given jurisdiction through a broker, general commission agent or any other agent of
an independent status, provided that such persons are acting in the ordinary course of
their business.

Note that the conceptual notion of a PE is ever-expanding. It is increasingly queried whether

virtual or electronic presences may amount to a PE. In the OECD context, debate has shifted
to dealing with the challenges of the digital economy. For the time being, the IRD has not given
any indication that it would treat a remote or virtual presence of a non-resident person, albeit
economically significant in Hong Kong, as constituting a Hong Kong PE or, parenthetically, carrying
on a trade or business in Hong Kong within the meaning of s.14. Certain jurisdictions, however,
like Israel and India, are moving beyond the purely physical concept of a PE, and considering that
effective connection with a jurisdiction via electronic means – such as the online retailer model of
operations – may in and of itself constitute a PE. The reasoning behind this development is that
where a non-resident person exerts an economic impact on another jurisdiction – for example,
by having an extensive local client base, then there is no principled reason for that non-resident
person to escape domestic taxation, where a non-resident person with a physical presence
carrying on the same or similar activities would undoubtedly thereby constitute a PE.

Conversely, the following do not give rise to a PE notwithstanding that they may be fixed
places of business:

a. the use of facilities solely for the purpose of storage, display or delivery of goods or
merchandise belonging to the enterprise;

b. the maintenance of a stock of goods or merchandise belonging to the enterprise solely

for the purpose of storage, display or delivery;

c. the maintenance of a stock of goods or merchandise belonging to the enterprise solely

for the purpose of processing by another enterprise;

d. the maintenance of a fixed place of business solely for the purpose of purchasing goods
or merchandise or of collecting information, for the enterprise;

e. the maintenance of a fixed place of business solely for the purpose of carrying on, for
the enterprise, any other activity of a preparatory or auxiliary character;

f. the maintenance of a fixed place of business solely for any combination of activities
mentioned in subparagraphs (a) to (e), provided that the overall activity of the fixed
place of business resulting from this combination is of a preparatory or auxiliary
character.

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A PE is for the purposes of the allocation of profits and tax computation treated as a
separate taxable person. That means that where a PE is constituted in Hong Kong, it must take
care to prepare accounts that are specific to the PE and enable its liability to Hong Kong tax, if
any, to be determined with sufficient clarity (see also rule 5 of the Inland Revenue Rules).

Note that s.50AAC(5) and Schedule 17G of the IRO contains domestic PE legislation, which
applies in the case of a non-resident person resident in a jurisdiction with which Hong Kong
does not have a DTA.

10.5.3.3 Business Profits
The allocation of taxing rights to business profits is usually covered in Article 7 of a DTA. The
general rule is that a person is taxable with respect to business profits only in the jurisdiction of
treaty residence unless it has a PE in the other jurisdiction; in that case, so many of the profits
as are attributable to the PE may be taxed (but do not necessarily need to be so taxed) in the
jurisdiction in which the PE is established. Here, the arm’s length principle applies for profit
attribution. Thus, the drafting shorthand for that approach is that the profits to be attributed
to a PE are the profits which it might be expected to make if it were a distinct and separate
enterprise engaged in the same or similar activities under the same or similar conditions and
dealing wholly independently with the enterprise of which it is a PE.

The IRD’s published policy on the attribution of profits to a Hong Kong PE is set out in DIPN
No. 60, which in general reflects orthodox OECD practice in that regard. The starting point in
any attribution exercise is the financial statements or accounts of the PE, which should be a
fair reflection of the real economic functions performed, the assets used and risks undertaken
by the PE. The rule for attribution of profits is the separate enterprises principle. Profits are
attributed to the PE in the amount that it would have made if it were a distinct and separate
enterprise engaged in the same or similar activities under the same or similar conditions
dealing wholly independently with the non-Hong Kong resident person. This includes the
assumption that the PE would have such equity and loan capital attributed to it as it would
reasonably be expected to have if it were a separate entity.

In determining the profits of a PE, deductions on account of expenses which are incurred
for the purposes of the PE’s business, including executive and general administrative expenses
so incurred, are allowable. That means that the computation of PE profits in Hong Kong
follows the standard rules of computation in the IRO, subject to the override of the arm’s
length attribution of profits requirement expressly set forth in the relevant DTA. The separate
enterprise principle is relevant here, as the expenditure must have been incurred specifically
by the PE in order to produce the profits the PE reports as taxable in Hong Kong. Deductible
expenditure under s.16 therefore must likewise be attributed on a PE/head office basis, as
must unrelieved losses. An important proviso to the computational code in the business profits
article is that profits are to be attributed to a PE by reason of the mere purchase by that PE of
goods or merchandise for the enterprise. That proviso has interesting parallels with s.14 of the
IRO and the jurisprudence on the locality of profits in Hong Kong, since it is well established
at tax law that the mere purchase of goods (i.e. by way of a purchasing office) is not a profit-
generating operation.

An important proviso to the general deductibility rules is that interest payable under a loan
between a head office and a PE is not in general deductible unless banking operations carried
on by a financial institution are involved.

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Finally, DIPN No. 60 further stipulates an overarching reasonableness check. This means
that bearing in mind the cardinal ‘separate entity’ and ‘arm’s length’ principles, are the profits
attributed to the PE in Hong Kong in all respects reasonable. The attribution of profits will
necessarily depend on the specific configuration of operations carried on by the head office
and the PE in the context of the enterprise’s undertaking. That means that no given formula
will be applicable in any event. Referring back to the foundational principles of international
taxation is, therefore, critical to ensuring that each case is at least conceptually treated on the
same footing.

Where no DTA applies, the same principles as are found in Article 7 of the Model
Convention are in effect replicated in S.50AAK to attribute profits to the Hong Kong PE of a
non-resident person.

Illustrative Example 8
Rottweiler Films GmbH (RFB) is a Swiss film production company. In June 2019, it
dispatched three employees in Hong Kong to conduct preliminary surveys on the
suitability of Hong Kong as a filming location for a film. The crew arrived, and operating
out of an office under a short lease performed some local research, and returned to
Switzerland in December 2019. There is a DTA between Switzerland and Hong Kong;
accordingly, one must refer to Article 5 of that DTA to determine whether a PE has been
established in Hong Kong. Because the activities appear on their face to be preparatory
and ancillary, arguably no PE was constituted at that stage on the terms of Article 5(4)
of the DTA. The presence has a degree of fixity – that is, RFB had an office – but the
activities in question did not meet the PE threshold.

In February 2020, the board of RFB decided to establish an office in Hong Kong, and
green-lit the establishment of a filming and production facility. For those purposes, an
office in Quarry Bay was leased for a period of three years by RFB. It would now appear
that RFB has constituted a PE. That is because there is a place of business through which
the profit-making business of RFB is carried on in Hong Kong. The making and production
of films is an essential part of what RFB does to realise its profits. It would follow that if it
were to commence to do so in Hong Kong, its presence in the jurisdiction should amount
to a PE. Accordingly, RFB will be required in Hong Kong to register under the Business
Registration Ordinance (Cap.310) and to file a tax return. It will further be required to
allocate profits to its Hong Kong PE on the basis of the arm’s length rules in Article 7
of the DTA.

10.5.3.4 Dividends, Interest, Royalties and Capital Gains

Dividends, interest and royalties are regarded as passive income. They arise usually from the
mere fact of possessing some assets, such as shares, a credit, or an intellectual property right,
though they may also separately arise in the course of a particular trade or business. In many
jurisdictions, passive income is subject to withholding tax (WHT) when paid to a non-resident
payee. WHT is tax that is charged at source, in the hands of the payor. The payor, therefore,
is required by the laws of its jurisdiction of residence to withhold a proportion of the gross
payment due to the non-resident payee on account of tax. The policy reason for WHT is to

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ensure that tax can be levied on non-resident persons where enforcement of the jurisdiction’s
tax laws would otherwise be administratively and practically complicated by the taxpayer being
outside of the jurisdiction of the taxing authority. Hong Kong currently levies a WHT on royalties
paid to non-resident payees under ss.15(1)(a)–(bb), charged at 16.5% or 4.95% depending on
the circumstances pursuant to s.21A (see Chapter 8 for details).

WHT is charged on dividends, interest, and royalties in a number of jurisdictions with

which Hong Kong has a DTA. The advantage of a DTA under those circumstances is that a
payment to a Hong Kong resident payee from a payor in a DTA partner jurisdiction will usually
be subjected to lower rate of WHT relative to the domestic rate. The stipulated treaty rate of
WHT is usually found in Article 10 (dividends), Article 11 (interest) and Article 12 (royalties).
Each such article, however, contains an important specific anti-avoidance provision: the
reduced rate of WHT only applies where the recipient of the payment is the beneficial owner
of the income in question. ‘Beneficial ownership’ in this context should not be confused with
beneficial ownership at common law. The OECD Model Commentary suggests that beneficial
owner in the context of a DTA means a person having effective control over the income, albeit
that person may not necessarily be beneficially entitled to it. For example, a trustee will in the
ordinary course be regarded as a beneficial owner of the income for the purposes of a DTA
because it has the power to dispose of the income on the terms of the trust; conversely, a mere
nominee or custodian often would not. In particular, where there is a contractual agreement
or other binding arrangement in place whereby the recipient of the income is required to pay
that income over to a party resident in another jurisdiction, the benefit of the reduced rate of
WHT will in general be denied to the recipient on the basis that it is not the beneficial owner of
the income.

Gains from the sale of a capital asset are expressly exempt from profits tax under s.14(1);
however many jurisdictions do tax capital gains. The capital gains article (usually Article 13)
allocates taxing rights depending on the character of the capital asset. Immovable property is
almost always taxable in the jurisdiction in which the property is physically situated, though
the state of residence of the disponer may also claim taxing rights with respect to the gain,
subject to a credit for any tax paid in the jurisdiction of situs of the asset. A similar treatment is
extended to real estate companies – that is, companies that derive at least 50% of their value
directly or indirectly form immovable property situated in a given jurisdiction, though there are
carve-outs for shares traded on recognised stock exchanges. Gains from disposal of shares in
private companies other than real estate companies are often taxable only in the jurisdiction of
residence of the disponer. This creates interesting structuring opportunities from a Hong Kong
tax perspective, for which see Section 10.5.4.1.

Key Learning Point

WHT is a tax levied at source. The payor of the taxable income withholds a part of the gross
sum on account of tax, which it pays over to the revenue authority holding taxing rights to
that sum, and the payee receives the sum net of WHT.

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10.5.3.5 Income from Employment
Article 15 establishes the general rule that employees are taxable only in the jurisdiction in
which he is treaty resident unless he exercises that employment in the whole or in part in the
other treaty jurisdiction. If he does, so much of his income from employment as is attributable
to services rendered in the other jurisdiction will be taxable in that other jurisdiction.
Essentially, treaty provisions mirror Hong Kong’s time in/time out approach to salaries taxation
in the context of non-Hong Kong employment contracts.

Paragraph 2 provides an important proviso to that general rule. Where an employee who
is resident in one jurisdiction spends not more than 183 days in any given 12-month period in
the other jurisdiction, and his remuneration is paid by an employer who is not resident in the
other jurisdiction or by a PE of the employer in that other jurisdiction, he is taxable only in the
jurisdiction of his residence.

Hong Kong’s domestic salaries tax provisions are expressly subject to the operation of any
DTA in force. For example, the general rule in s.8(1A)(c) that exempts from taxation income
from an employment exercised abroad which was taxable in that jurisdiction is now expressly
disapplied where a DTA is in force and provides for a tax credit for foreign tax paid (s.8(1C)).
The purpose of that exclusion is to prevent an employee from claiming both an exemption
and a credit.

When it comes to cross-border employment tax planning you should refer first to the
provisions of any applicable DTA and then to the IRO to determine the best strategy to
advise clients.

10.5.3.6 Director’s Fees
Director’s fees and similar payments are treated as distinct from income from employment.
The general rule is permissive taxation in the jurisdiction where the company of which the
person is a director is resident: director’s fees and other similar payments derived by a resident
of one party in his capacity as a member of the board of directors of a company which is a
resident of the other contracting party may be taxed in that other party. In other words, where
a person is tax resident in the United Kingdom, which generally taxes its residents on their
worldwide income, but is a director of a company managed and controlled in Hong Kong, then
the remuneration that he receives from the office of director will be taxable in Hong Kong
(under s.8(1)(a) of the IRO as income from an office of profit sourced in Hong Kong), but may
also be taxable in the United Kingdom, subject to a credit for tax paid in Hong Kong.

10.5.3.7 Mutual Agreement Procedures

Most DTAs have a mutual agreement procedures (MAP) article (usually Article 25) for the
resolution of disputes with respect to the proper interpretation and application of the DTA.

A MAP is a process by which a dispute relating to some matter in a given DTA is resolved by
mutual agreement between the competent authorities (generally, the revenue departments)
of the contracting jurisdictions. In certain DTAs, MAPs are mandatory in certain cases of
disagreement as between the taxing authorities themselves. Where, however, taxpayers
consider that the actions of one or both of contracting jurisdictions result or will result for
them in taxation not in accordance with the provisions of the DTA, it may, irrespective of the
remedies provided by the domestic laws of each contracting jurisdiction, present its case
to the competent authority of the jurisdiction of which it is a resident requesting that the

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relevant authority seek mutual agreement with the relevant authority of the other contracting
jurisdiction. The case must be presented within three years from the first notification of the
action resulting in taxation not in accordance with the provisions of the DTA in question.

When the application for MAP is duly made, the competent authority to which it was made
is required to endeavour, if the objection appears to it to be justified and if it is not itself able to
arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent
authority of the other contracting jurisdiction, with a view to the avoidance of taxation that is
not in accordance with the provisions of the DTA in question. Any agreement reached must
be implemented notwithstanding any time limits in the domestic laws of the contracting
jurisdictions. Any issues that remain outstanding or undecided following the conclusion of the
MAP procedure may be put to arbitration for final determination, though arbitration is not
permitted where the matter in question has already been decided by a court or administrative
tribunal of either contracting party having jurisdiction.

A MAP is a non-contentious dispute resolution mechanism, which should in principle assist

both taxpayers and the IRD in resolving complex matters of international tax law, though, in
practice, much depends on the levels of sophistication and administrative transparency of
the competent authority of the other contracting jurisdiction. As will be apparent from the
jurisdictions with which Hong Kong has signed a DTA, such measures may well be variable.

S.50AAB transposes the MAP regime into domestic Hong Kong law, and specifies that the
IRD may request that the taxpayer pay any costs and reasonable expense incurred by the
IRD in relation to the MAP and/or any future arbitration. In practice, that may well act as a
disincentive for taxpayers asserting their rights under the MAP article of a DTA.

Key Learning Point

MAPs are dispute resolution mechanisms to resolve controversies relating to the
application of a DTA. MAP solutions are typically bilateral, involving the revenue authorities
of the two relevant jurisdictions arriving at a negotiated solution.

10.5.3.8 Exchange of Information
Taxpayer information held by the IRD is generally confidential. S.4 provides that it is a criminal
offence for an employee of the IRD to disclose that information to any other person except in
the performance of their duties under the IRO. S.49(5) creates an express exception to this rule
for information exchanged under the relevant provisions of a DTA. The legislative basis for the
exchange of information is as follows:

• S.49(1A) clarifies that if an arrangement made with a territory outside Hong Kong allows
exchange of information, it shall have effect in relation to tax of that territory.

• S.51(4AA) enables the assessor to exercise the same power under s.51(4) to collect
information concerning tax of a territory outside Hong Kong for the purpose of
exchange of information.

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• S.51B(1AA) enables a magistrate to exercise the same power under s.51B to issue
search warrants for information concerning tax of a territory outside Hong Kong for the
purpose of exchange of information.

• S.80(2D) provides that a person commits an offence if he, without reasonable excuse,
gives any incorrect information in relation to any matter that affects his or another
person’s liability to tax of a territory outside Hong Kong for the purpose of exchange of
information.

• The word ‘tax’ in s.58(1)(c) of the Personal Data (Privacy) Ordinance (Cap.486) includes
any tax of a territory outside Hong Kong for the purpose of exchange of information.
Note that tax information for the purposes of information exchange includes taxes –
such as inheritance taxes or value added or capital gains taxes that are not charged in
Hong Kong but which nonetheless fall within the taxes covered by a given DTA.

Exchange of information provisions in DTAs enable competent authorities to exchange

fiscal information with one another. This system is governed by the relevant exchange of
information article in the DTA (usually, the relevant article is Article 26). Hong Kong’s exchange
of information policy is that information will only be exchanged upon request, and Hong Kong
has not yet agreed to exchange information on an automatic or spontaneous basis (apart from
CRS and FATCA). Information, including bank information, will only be supplied upon specific
and bona fide requests received from the competent authority of a treaty partner in justifiable
cases. A request for information must be grounded in some bona fide investigation of the
taxpayer’s affairs. It must be ‘foreseeably relevant’ to a genuine tax investigation or inquiry.
Exchange of information articles expressly prohibit requests for exchange of information on
a ‘fishing expedition’ basis – that is, where information is requested generally, without even
a prima facie ground for investigation. When a legitimate exchange of information request is
received, the contracting jurisdiction will be required under the terms of the DTA to use the
powers at its disposal to extract the information from the local taxpayer and to exchange
this with the authority of the other jurisdiction making such request. Nevertheless, DTAs in
general stipulate that the competent authority will not be required to go above and beyond
its information gathering or other powers as a matter of domestic law. In practice, it is rare
for competent authorities to refuse exchange of information requests. That would in many
cases be regarded as a breach of international comity. It is not open for the government of
one jurisdiction to look behind the laws and practices of a government of another jurisdiction
and on that basis assess the legitimacy of a request for exchange of information (AXY & Ors v
Comptroller of Income Tax (2017) SGHC 42).

The information gathering power of the IRD is not restricted to information in the
possession of a person but also information under the person’s control. The term ‘possession’
does not mean physical possession only. It should also bear the meaning of legal possession
(i.e. possession that is recognised and protected as such by law). If a person is the owner of the
information that at the material time is kept by other party, say the record books held by their
auditors or lawyers, the person is still in possession of such information, and he or she has to
provide such information to the IRD.

The IRD has summarised its policy on the exchange of information under DTAs in
DIPN No. 47.

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Illustrative Example 9
If the government of France sent an information exchange request to the government
of Hong Kong with respect to a French resident under investigation in France for
tax evasion, the Hong Kong government would likely not query whether the French
government had a tenable basis at French law to investigate the French resident
taxpayer, but would not be required to do any more than could ordinarily be done at
Hong Kong law to investigate the tax affairs of a Hong Kong resident person. It could not,
for example, subject any person to arbitrary arrest in violation of the Basic Law on the
basis of an exchange of information request from a foreign government.

10.5.4 Double Taxation Agreements and the Inland Revenue Ordinance

DTAs are an important development for common law revenue codes like Hong Kong.
Historically, the consensus in common law jurisdictions was that the judicial and taxing
authorities of one jurisdiction did not assist another jurisdiction in collecting that jurisdiction’s
tax (India v Taylor (1955) AC 491). This was known as the ‘government of India principle’ and
is based in the acknowledgement that historically the right to tax was a paradigmatically
sovereign right, in which it was undesirable for other jurisdictions to interfere. The proliferation
of DTAs and the introduction of BEPS, however, have entailed a change in which tax
cooperation between jurisdictions is perceived. The current Model Convention, for example,
includes Article 27, which would enable jurisdictions to render assistance to one another in the
collection of taxes.

The relationship between DTAs and the IRO is potentially complex. Hong Kong is a common
law jurisdiction; accordingly, public international treaties are not automatically transposed into
domestic legislation. DTAs must be separately enacted as domestic legislation. Once enacted,
however, they take effect as domestic law. You will recall that s.49(1A) provides that DTAs duly
enacted in Hong Kong have effect in relation to tax charged under the IRO. In order to enable
Hong Kong to comply with its public international law obligations, s.49(1C) stipulates that in the
event of conflict between the IRO and the terms of a DTA in force, the terms of the DTA shall
prevail as regards the following matters:

• affording relief from tax charged under the IRO;

• taxing income, profits or gains of DTA territory resident persons arising in, or derived
from, sources in Hong Kong;

• taxing chargeable gains accruing to DTA territory resident persons on the disposal of
assets in Hong Kong;

• determining income, profits or gains to be attributed to DTA territory resident persons;

• determining income, profits or gains to be attributed to PE in Hong Kong of DTA

territory resident persons; or

• determining income, profits or gains to be attributed to Hong Kong resident persons

who have special relationships with DTA territory resident persons.

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10.5.4.1 Definition of Royalties
Royalties are defined in Article 12(2) of the Model Convention as: ‘payments of any kind
received as consideration for the use of, or the right to use, any copyright of literary, artistic or
scientific work including cinematograph films, any patent, trade mark, design or model, plan,
secret formula or process, or for information concerning industrial, commercial or scientific
experience’. Compare, for reference, the charging provisions for royalties for the use or the
right to use certain intellectual property rights in Hong Kong in ss.15(1)(a)–(ba). Generally,
these overlap and, in practice, the IRD acknowledges that a charge to profits tax under ss.15(1)
(a)–(ba) will be treated as a royalty for the purposes of any DTA to which Hong Kong is party.
S.21A provides that the standard WHT rate for royalties in Hong Kong is either 16.5% or 4.95%:
the higher rate applies when the sum is derived from an associate of the payee and a person
carrying on a trade, profession or business in Hong Kong has at any time wholly or partly owned
the rights in question, and the lower rate applies in all other cases. Thus, where a royalty is paid
by a Hong Kong payor to a payee resident in a jurisdiction with which Hong Kong has a DTA, and
the payee is the beneficial owner of the royalty, the treaty rate of WHT will apply, and not the
domestic rate (if different) provided in s.21A.

Illustrative Example 10
Corrigan Ltd, a company incorporated and resident in the United Kingdom, licences
intellectual property rights to a banking algorithm to DragonBank Ltd, a company
incorporated and resident in Hong Kong, in consideration for an annual licence fee
of HK$1 million. The licence is for the right to use an algorithm, which was the result
of proprietary research undertaken by Corrigan. It would follow that it falls within the
definition of a royalty in Article 12(2) of the Model Convention and, specifically, Article
12(3) of the United Kingdom–HK DTA. Assuming that Corrigan is the beneficial owner of
the royalty – that is, it is not a mere conduit which is contractually required to pass the
amount of the payment on to a third party – the maximum rate of WHT chargeable by
Hong Kong will be 3% instead of 4.95% or 16.5% as stipulated in s.21A. The provisions of
a DTA take precedence over provisions of domestic taxation; accordingly, in this case, the
treaty rate of WHT applies.

10.5.4.2 What Constitutes Capital Gains

Capital gains are gains derived from the sale or other disposal of a capital asset. It is often
stated that Hong Kong does not charge a tax on capital gains. That is not strictly speaking
correct: s.14(1) exempts from profits tax gains from the sale of capital assets. Gains arising
otherwise than from the sale of a capital asset are in principle taxable if they fall within the
scope of the charging provision. Article 13 of the Model Convention applies to ‘capital gains’. In
practice, however, it is understood to apply to all gains derived from the sale of capital assets
as distinct from business profits attributable to a PE in Article 7. It would follow that where, for
example, a person resident in a DTA jurisdiction disposes of Hong Kong immovable property
(as defined in Article 6 of the convention) and realises a gain therefrom, taxing rights to such
gains will be allocated in accordance with Article 13(1): that is, Hong Kong will be able to tax the
gains in question. That is irrespective of the fact that under Hong Kong revenue law, such gains,

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assuming they are chargeable to tax because they arose to a person carrying on in Hong Kong
the trade, profession or business of being a property developer, would be chargeable to profits
tax and not to capital gains tax as such. The same logic would apply to gains arising from the
alienation of shares under Article 13(4). DIPN No. 44 contains further guidance in this matter
specifically as regards the Hong Kong–China DTA. The IRD should however apply the same
approach to all DTAs to which Hong Kong is party.

10.5.5 Tax Credits Computations and Application

There are two approaches to avoiding double taxation: the exemption method (Article 23A
of the Model Convention) and the credit method (Article 23B of the Model Convention). The
exemption method is straightforward: only one jurisdiction party to the DTA has taxing rights
on a given income stream or gain. The credit method applies where both the jurisdiction
of residence of the taxpayer and the jurisdiction of source of the income stream or gain in
question have taxing rights. Under those circumstances, the objective of the credit method is to
prevent the taxpayer from paying more, in aggregate, by way of tax than they would have, had
the income or gain been taxable exclusively in their jurisdiction of residence. A tax credit means
that taxpayers will be given credit for tax paid in the jurisdiction of source of the income stream
or gain with respect to such income or gain in their jurisdiction of residence, again on the basis
that both jurisdictions have taxing rights to the relevant sums.

The relevant provision governing tax credits in the IRO is s.50, which applies to tax credits
under DTAs to which Hong Kong is party. Crucially, only a person who is a Hong Kong resident
in the relevant year of assessment can avail itself of a tax credit under s.50 to reduce his or her
liability to tax in Hong Kong. A Hong Kong resident is defined in s.48A, which refers back to the
‘Residence’ article in the relevant DTA under which the credit is claimed.

Tax credits are often incorrectly called deductions. They are not, however, deductions
in the sense of s.16 of the IRO. S.50(2) provides that the amount of tax and not the amount
of assessable income is to be reduced by the amount of the available tax credit. There are,
however, limits to the extent to which the quantum of Hong Kong tax payable may be reduced
by the amount of the credit. S.50(3) stipulates a so-called tax credit limit. Broadly speaking,
that limit is the amount of tax that would have been charged in a hypothetical scenario where
by the income or gain subject to foreign tax had been computed in accordance with the
provisions of the IRO and taxed at rate ascertained by dividing the tax actually chargeable
(before allowance of credit under any DTA) on the total income of the person entitled to the
income by the amount of his total income. The purpose of that limit is to prevent a tax credit
from disproportionately impacting a taxpayer’s liability to Hong Kong tax. S.50(4) provides
that total credit cannot exceed the total Hong Kong tax payable by him or her for that year of
assessment: in other words, a tax credit cannot be utilised to give rise to a loss that may then
be carried forward for set off against future profits.

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Illustrative Example 11
Tax credit for a corporation – Profits tax

For the year of assessment 2018/19, Gee Company Ltd (GCL) had derived HK$1 million
assessable profits from Hong Kong, in which HK$100,000 was also assessable to corporate
income tax in mainland China. GCL is subject to profits tax at 16.5% in Hong Kong, and
income tax at 25% in mainland China.

The calculation of tax credit for the Mainland income tax and total tax payable for GCL
(before tax reduction) is as follows:

Hong Kong Mainland China Total

Gross assessable income (HK$) 1,000,000 100,000 1,000,000
Tax rate 16.5% 25%
Tax payable (HK$) 165,000 25,000
Total tax payable before tax 190,000
credit (HK$)
Less: Tax credit (HK$),
the lower of
Tax paid in mainland China 25,000
or
Tax credit limit 16,500b (16,500) Nil (16,500)
(100,000 × 16.5%)
Total tax payable after tax 148,500 25,000 173,500
credit (HK$)
a
 Assuming the two-tiered profits tax rates regime does not apply.
b
 If the profits tax payable is computed at a flat rate, the simplified formula can b.e applied as below:

Credit limit for tax paid in mainland China Income from mainnland China
(Profits tax payable in Hong Kong ÷ Total assessable income)

HK$100,000 (165, 000 1, 000, 000) HK$16,500.

Alternatively, the tax credit limit and profits tax payable can be calculated in
accordance with ss.50(3) and 50(5) as follows:

Step 1:

Calculation of tax credit limit and amount not allowed as a tax credit

HK$ HK$
Income tax paid in mainland China 25,000
After-tax income from mainland China grossed up at effective 89,820
Hong Kong tax rate:
HK$75,000 × 100% ÷ (100% − 16.5%)
Less:
After-tax income from mainland China (75,000)
Tax credit limit (14,820)
Amount not allowed as a tax credit 10,180

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Illustrative Example 11 (continued)

Step 2:

Calculation of profits tax payable after tax credit

HK$
Total assessable income 1,000,000
Less: Amount not allowed as a tax credit (10,180)
989,820
Profits tax payable before tax credit at 16.5% 163,320
Less: Tax credit (14,820)
Profits tax payable after tax credit 148,500

Illustrative Example 12
Tax credit for an individual – salaries tax

For the year of assessment 2018/19, Mr. A had derived salaries income of HK$820,000,
which is wholly assessable to Hong Kong salaries tax. Out of the total income of
HK$820,000, HK$400,000 was also subject to individual income tax (IIT) in mainland China
and IIT of HK$53,080 was paid. For the year 2018/19, he had incurred deductible expenses
of HK$20,000 and made MPF contribution of HK$18,000.

Step 1:

Calculation of effective tax rate in Hong Kong before tax credit

HK$
Total Hong Kong assessable income 820,000
Less: Deductible expenses (20,000)
Net assessable income 800,000
Less: MPF contribution (18,000)
782,000
Less: Basic allowance (132,000)
Net Chargeable Income 650,000

Salaries tax at 15%: HK$782,000 × 15% = HK$117,300

Salaries tax at progressive rates: (650,000 − 200,000) x17% + HK$16,000
= HK$92,500
Salaries tax payable before tax credit 92,500
Effective tax rate 11.56%
= (Salaries tax payable ÷ Net assessable income) × 100%
= (92,500 ÷ 800,000) × 100%

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Illustrative Example 12 (continued)

Step 2:

Calculation of tax credit limit and amount not allowed as a tax credit under
ss.50(3) and 50(5)

HK$
Assessable income from mainland China 400,000
Less: IIT paid (A) (53,080)
Income after IIT (B) 346,920
Gross-up at the effective tax rate in Hong Kong of 11.56% (C) a
392,265
= 346,920 × 100% ÷ (100% − 11.56%)
Tax credit limit for IIT (D) = (C) − (B) 45,345
Amount of IIT not allowed as a tax credit (E) = (A) − (D)
a
7,735
a
 (C) = Assessable income from mainland China – (E)

= HK$400,000 − HK$7,735 = HK$392,265

Step 3:

Calculation of salaries tax payable (before tax reduction) for the year of assessment 2018/19

HK$
Total assessable income (including income taxable in mainland China of 820,000
HK$400,000)
Less: Amount not allowed as tax credit (see Step 2 above) (7,735)
812,265
Less: Deductible expenses (20,000)
792,265
Less: MPF contribution (18,000)
774,265
Less: Basic allowance (132,000)
Net Chargeable Income 642,265
Salaries tax payable at progressive rates 91,185
(HK$642,265 − HK$200,000) × 17% + HK$16,000
Less: Tax credit for IIT paid in mainland China (See Step 2 above) (45,345)
Salaries tax payable after tax credit for IIT 45,840

Apply and Analyse 3
Healthy (HK) Ltd (Health HK) was a Hong Kong-based company, which manufactured and
distributed medicinal products in Hong Kong. Healthy HK acquired rights to use certain
patents developed by overseas companies in manufacturing products for its own sale.
Occasionally, Healthy HK also acquired the right for using some patents in all of Asia and
sublicenced the right to other companies outside Hong Kong. There was one patent for
producing medicines for early-stage lung cancers, namely, TARGET, which was owned
by a UK company, namely, Recovery Ltd (Recovery). Healthy HK acquired the right to use

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Apply and Analyse 3 (continued)

TARGET in the Mainland and Hong Kong. Healthy HK used TARGET in Hong Kong and
sublicenced the right to use TARGET to Robust Ltd (Robust), which manufactured and sold
medicinal products in the Mainland. All licencing contracts and sublicencing contracts in
relation to TARGET were negotiated, concluded and enforceable in Hong Kong.

For the year ended 31 December 2018, the following income and expenses were
derived and incurred by Healthy HK in respect of sub-licencing TARGET to Robust.

Income, expenses and taxes HK$

Royalty income from sublicencing TARGET to Robust 5,000,000
Royalty expense to Recovery – for sub-licencing right to Robust 4,000,000
China withholding income tax on royalty income received from Robust 350,000
(7% on gross receipts of HK$5 million)
China withholding value added tax on royalty income received from 300,000
Robust (6% on gross receipts of HK$5 million)

Analysis

Under DIPN No. 21 and DIPN No. 49, the source of a royalty income other than those
deemed chargeable under ss.15(1)(a), (b) or (ba) is the ‘place of acquisition and granting of
the licence or right of use’ (re: TVBI case).

On the basis of DIPN No. 21 and DIPN No. 49, the source of the royalty income from
Robust would be determined by looking at the place where the licencing contract and sub-
licencing contract of Healthy HK were effected. In the case, both contracts were effected in
Hong Kong, that is, Healthy HK had acquired the right and granted the right in Hong Kong.
Hence, the royalty income from Robust would be regarded as sourced from Hong Kong.

As the royalty income derived from Robust of HK$5 million is assessable, the
corresponding royalty fee paid of HK$4 million would be deductible.

Healthy HK had incurred value added tax (VAT) in the Mainland of HK$300,000
(HK$5 million × 6%) in the production of the royalty income from Robust and such VAT
should be deductible. Healthy HK had also paid income tax in the Mainland of HK$350,000
(HK$5 million × 7%). As the royalty fee would also be taxable in Hong Kong, income tax paid
in the Mainland would be creditable, subject to the credit limit of Hong Kong tax payable.

The net Hong Kong tax payable of Healthy HK after allowance of tax credit is calculated
as follows:

HK$ HK$
Assessable profits (royalty) HK$(lion5 million − 4 million − 300,000) 700,000
Tax payable before allowance of tax credit at 16.5% a
115,500
Less: tax credit
Income tax paid in China 350,000
The tax credit limit b
115,500
(115,500)
Hong Kong tax payable after allowance of tax credit 0
a
 Assuming the two-tiered profits tax rates regime is not applicable.

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Apply and Analyse 3 (continued)

b
The formula of the credit limit is based on ss.50(3) and 50(5). As the tax payable by
Healthy HK is computed at a flat rate, the following simplified formula can be used to
compute the credit limit:

Taxcredit limit for tax paid in the Mainland Taxable income from the Mainland
Tax payable in Hong Kong Total assessa able profits

HK$
Taxable income from the Mainland 700,000
Tax payable in Hong Kong before allowance of tax credit 115,500
Total assessable profits 700,000

700, 000 115, 500 700, 000 115, 500

Alternatively, the tax credit can be calculated in accordance with s.50(5), where tax
paid in the Mainland that is not allowed as a tax credit, that is, HK$280,838 (HK$350,000 −
HK$69,162), can be allowed as a deduction as shown in the detailed computation below:

HK$ HK$
Mainland tax paid 350,000
Net income from the Mainland after tax (grossed up at effective
Hong Kong tax rate)
HK$350,000 × (100% ÷ (100% − 16.5%)) 419,192
Less: Net income from the Mainland after deduction of tax (350,000)
(700,000 − 350,000)
Less: Tax credit limit for tax paid in the Mainland (69,162)
Tax paid in the Mainland not allowed as a tax credit 280,838

HK$ HK$
Hong Kong tax payable before tax credit 69,162
HK$(700,000 − 280,838) × 16.5%
Less: Tax credit limit for tax paid in the Mainland (69,162)
Hong Kong tax payable after allowance of tax credit 0

10.5.6 Arrangement between the Mainland of China and the Hong

Kong Special Administrative Region for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income
In practice, this is one of the most important DTAs, in view of Hong Kong’s reliance on the
Chinese economy and is the subject of the IRD’s most extensive published guidance on the
application of DTAs: DIPN No. 44. Although historically regarded as highly advantageous from

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Hong Kong’s perspective, in the sense that Hong Kong resident persons had access to very
favourable rates of WHT under the DTA for income sourced in China, the revision of a number
of tax treaties to which China is party with third-party jurisdictions means that the Hong Kong
– mainland China DTA is no longer as markedly favourable as it was in the past. That, in turn,
means that it is no longer necessary for tax residents in third-party jurisdictions to invest
into China via Hong Kong strictly for tax or DTA reasons. Evidently, however, there are other
commercial reasons (such as rule of law, certainty of property rights, efficient administration
etc.) for which operating in the Mainland via Hong Kong may be desirable relative to operating
directly in the Mainland.

The most relevant articles in the Hong Kong – mainland China DTA are as follows:

• Article 4: For entities that are tax residents of both mainland China and Hong Kong, tax
residency status is determined by the effective management under the existing DTA
between mainland China and Hong Kong. The Fifth Protocol establishes a procedure
by which the IRD and China’s State Taxation Administration (STA) can reach a mutual
agreement regarding a taxpayer’s tax residency. In reaching such an agreement,
the IRD and STA consider a taxpayer’s place of effective management and place of
incorporation. A taxpayer is not entitled to an exemption under the DTA unless the IRD
and STA give their mutual consent.

• Article 5: The general rule that a PE is a permanent place of business through which
the business of an enterprise is wholly or partly carried on applies. Note that under
the Second Protocol the so-called ‘183 days’ rule will apply. In other words, if within
any 12-month period the cumulative number of days during which services have
been provided by an enterprise of one party in the other party exceeds 183 days,
that enterprise will be regarded as having a PE in that other party. Under the Fifth
Protocol, representative offices, that are common in the Mainland, are in general not
treated as PEs provided that their activities do not directly generate profits and the
functions of the representative office are only of a supportive (i.e. preparatory and/or
auxiliary) nature.

The following activities are also deemed to be PEs:

1. A building site utilised for more than six months;

2. Consultancy services rendered for more than 183 days within any 12-month
period; and

3. The presence of agents who habitually conclude or habitually play the principal
role leading to the conclusion of contracts for and on behalf of the head office,
though note that an enterprise is not deemed to have a PE merely because it
carries on business in a given jurisdiction through a broker, general commission
agent or any other agent of an independent status, provided that such persons
are acting in the ordinary course of their business.

• Article 6: ‘Income from immovable property’ means the income derived from the use
of immovable property without transfer of ownership. Income derived from alienation
of immovable property will be dealt with in accordance with the provisions of Article
13 (Capital Gains). The question of whether a property is immovable property is to
be determined according to the laws of the party in which the property in question is
situated. Paragraph 2 of Article 6 provides that certain assets and rights must always be
regarded as immovable property. These assets and rights include property accessory

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to immovable property, livestock and equipment used in agriculture and forestry, and
rights to which the provisions of general laws in respect of real estate apply. However,
ships and aircraft shall never be regarded as immovable property.

• Article 7: Profits arising in each party should be computed in accordance with the
prevailing tax computation rules therein. In computing the profits of a PE, it will be
considered as a distinct and separate enterprise. Deductions will be allowed (wherever
incurred) that are incurred for the purposes of producing the relevant profits, including
executive and general administrative expenses so incurred (including a reasonable
share of the administrative expenses of the head office). Relevant expenses that can
be clearly attributed to that PE are deductible. Otherwise, an allocation of the relevant
expenses should be made. The allocation can be based on the proportion of the
business turnover or gross profit of the PE to that of the enterprise.

°° Paragraph 3 of Article 7 specifically sets out three categories of amounts that will
not be deductible in ascertaining the profits of a PE, whether they are paid to the
head office of the enterprise or any of its other offices (other than reimbursement
of actual expenses): (1) by way of royalties, remuneration, fees or any other
similar payments in return for the use of patents or other rights; or (2) by way of
commission for specific services performed or for management; or (3) by way of
interest on moneys lent to the PE, except in the case of a banking enterprise, that is,
relevant interest is deductible in such a case.

°° Paragraph 5 of Article 7 stipulates that no profits will be attributed to a PE by reason

of the mere purchase by that PE of goods or merchandise; purchasing activities do
not directly generate profits in the overall business activities.

• Article 10:

°° The treaty rate of WHT is 10% or 5%. Hong Kong does not levy a domestic WHT
on dividends. The lower rate of WHT is available for Chinese source dividends
where the payee is a body corporate which owns at least 25% of the capital of the
company paying the dividend. The lower rate of WHT is therefore not available to
individual payees.

°° In order to access the treaty rate of WHT, the recipient of the dividend must be its
beneficial owner. Beneficial ownership in this sense must be distinguished from
beneficial ownership at common law. Generally, any person other than a mere conduit
will be treated as the beneficial owner of the dividend. In this context, a mere conduit
is a person who is under some contractual or other obligation to pass the dividend on
to a third party. Most trustees will therefore be, paradoxically, beneficial owners for
DTA purposes because they control the management and distribution of trust income.
A bare nominee will not, in the ordinary course, however, be a beneficial owner. Note
that the beneficial ownership requirement also applies to other passive incomes
(e.g. interest, royalties).

• Article 11:

°° The treaty rate of WHT is 7%. There is no WHT on interest in Hong Kong.

°° Paragraph 3 provides that interest received by government entities is

exempt from WHT.

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°° Paragraph 7 applies transfer pricing rules: the treaty rate of WHT applies only to
arm’s length interest, and interest in excess of that amount will not be eligible for
the treaty rate of WHT.

• Article 12:

°° The treaty rate of WHT is 7%. Nevertheless, royalties arising in Hong Kong and
paid to a resident in the Mainland will be taxed at 4.95% (gross royalty × 30% ×
16.5% (s.21A)) or 2.475% (where the two-tier profits tax rate applies to the first
HK$2 million of assessable profits) for a corporation, where the relevant conditions
in s.21A are fulfilled.

°° The WHT rate charged by the Mainland on royalties arising in the Mainland and paid
to a resident in Hong Kong is 7%, or 5% where the royalties are paid to an aircraft
and ship leasing business (Article 2 of the Fourth Protocol).

°° The IRD considers that the definition of ‘royalties’ as provided for in paragraph 3
of Article 12 is wide enough to cover the provisions of paragraphs (a), (b), (ba), and
(d) of s.15(1) and thus not only includes royalties for the use of patents, intellectual
property rights, and literary and cinematic works, but also sums received by or
accrued to a person by way of hire, rental or similar charges for the use or the right
to use movable property generally in Hong Kong.

°° Paragraph 6 applies transfer pricing rules: the treaty rate of WHT applies only to
arm’s length royalties, and royalties in excess of that amount will not be eligible for
the treaty rate of WHT.

• Article 13:

°° There are different rules for shares, immovable property, and shares in companies
rich in immovable property. Paragraph 1 provides that gains from immovable
property are non-exclusively taxable in the jurisdiction where the immovable
property is situated. Paragraph 4 provides that gains arising from the disposal
of shares in companies the assets of which are comprised, directly or indirectly,
mainly of immovable property are non-exclusively taxable in the jurisdiction in
which the immovable property in question is situated. Paragraph 5 provides that
the sale of substantial shareholding (at least 25%) in a company resident in one
jurisdiction (not including those mentioned in paragraph 4, that is, companies rich
in immovable property) is non-exclusively taxable in that jurisdiction.

°° For the purposes of the allocation of taxing rights under the DTA, certain gains
arising from the disposal of shares that are chargeable to profits tax in Hong Kong
are treated as ‘capital gains’, notwithstanding that Hong Kong does not levy a
capital gains tax. As regards shares for the purposes of Paragraph 5 of Article 13,
Hong Kong interprets the word ‘shares’ as referring to shares sold at the time of
alienation, rather than the total shares in a company held or once held by the
alienator. In other words, it is only when shares alienated are not less than 25%
of the entire shareholding of a company may gains derived from the alienation
be taxed in the jurisdiction of which the company is resident. The Fifth Protocol
clarifies that the IRD has the right to tax relevant gains from alienation, whether
they arise from shares in a company or from comparable interests in a partnership
or trust. Conversely, China interprets ‘25%’ as referring to 25% or more of the
shares in a company once held by the alienator. That is, if shares representing 25%

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or more of the entire shareholding of a Chinese company were once held by a Hong
Kong resident, gains derived by the Hong Kong resident from the alienation of all or
part of its shareholding may be taxed in the Mainland. Under the Second Protocol,
a compromise was reached whereby gains derived by a resident of one party from
the alienation of shares, other than the shares referred to in paragraph 4 (with
reference to the First and Second protocols to the DTA), or other rights in the capital
of a company which is a resident of the other party may be taxed in that other
party if, at any time within the 12 months before the alienation, the recipient of the
gains had a participation, directly or indirectly, of not less than 25% of the capital of
the company.

• Article 14: the provisions governing income from employment are rather similar to
those found in the OECD Model Convention. Given, however, how common it is for
Hong Kong companies operating in the Mainland to second staff to the Mainland to
supervise projects or engage in client relationship management functions, this article
is of great practical importance. Employees resident in Hong Kong may avoid the much
higher rates of Chinese IIT to the extent that:

°° They do not stay in China for more than 183 days in any given 12-month period;

°° Their salary is paid by or on behalf of an employer who is resident in Hong Kong

and not in China; and

°° Their salary is not borne (in terms of costs) by the Chinese PE of their employer.

• Article 18: The Fifth Protocol establishes Article 18(A), which applies to employees of
officially recognised educational or research institutions in Hong Kong. Should Hong
Kong residents in such professions remain in mainland China as visiting teachers
or researchers at an eligible institution, they can receive a three-year income tax
exemption in China from the STA, provided that such remuneration is taxable in Hong
Kong. After the exemption period, the STA can determine that such remuneration is
taxable in mainland China.

• Article 21: Double taxation is eliminated by means of a credit: if the same income is
taxable in both jurisdictions under the DTA, then a credit is allowed in the jurisdiction
of residence for any tax paid in the jurisdiction of source. That means that tax paid in
Hong Kong is allowable as a credit against tax payable with respect to the same income
in China. Conversely, tax payable in China will, subject to the provisions of the tax laws
of Hong Kong relating to the allowance of a deduction and a credit for tax paid in any
territory outside Hong Kong, be allowable as a credit in computing the amount of Hong
Kong tax payable. Please refer to Section 10.5.5 for details.

• Article 24: Under the Fourth Protocol, in addition to taxes to which the DTA applies,
the information to be exchanged shall cover the following other taxes enforced and
imposed in the Mainland of China:

°° value added tax;

°° consumption tax;

°° business tax (this has already been abolished);

°° land appreciation tax; and

°° real estate tax.

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The WHT rates under the Hong Kong – mainland China DTA are as follows:

Dividends Interest Royalties

Hong Kong 0% 0% 4.95%/2.475%a
China 5%/10% 7% 5%/7%

a
Where the conditions in s.21A are fulfilled. Otherwise, WHT rate of 7% will apply.

Illustrative Example 13
Joy Luck Co Ltd (JLC) is a company incorporated in Hong Kong that historically carried
on the business of manufacturing toys. With spiralling personnel and rental costs in
Hong Kong, it decided to relocate its manufacturing activities to other countries in East
Asia, while keeping all its product development, general and corporate management,
and client relationship functions in Hong Kong. In May 2016, JLC decided to open a
representative office in Wuhan with a view to establishing a fixed presence in China
and gaining intelligence on the Chinese market. By June 2017, that presence had
been upgraded to a purchasing office acquiring simple components and inputs to be
assembled in JLC’s factory in Laos. As a result of political turbulence and regulatory
constraints in Laos, JLC decided to relocate its manufacturing activity to China in August
2017. For those purposes, JLC leased a manufacturing plant and sent a number of Hong
Kong resident managers to supervise the operations of the factory and ensure quality
control. Formally, those managers were employed by the JLC head office in Hong Kong.

JLC owned a number of registered designs and patents, which played an important role
in assisting in producing competitive products, and in marketing these effectively by way
of brand recognition. In January 2018, it licenced some of the older registered designs and
trademarks to a Chinese toy manufacturer, Billion Jade Double Profit (BJDP) on the basis
that BJDP operated on a completely different budget toy market and was therefore not a
serious competitor. In July 2018, BJDP became so successful that JLC bought a 35% stake in
it. In January 2019, BJDP declared a dividend of RMB100 million to JLC.

JLC employed two experienced managers, Mr. S.T. Wong and Mr. H.L. Fook, who
are Hong Kong permanent residents and have lived all of their lives in Hong Kong. They
both had longstanding experience in overseeing the manufacture and marketing of
toys. Accordingly, JLC sent them from August 2017 onwards to manage the operations
of its Chinese plant. Mr. Wong and Mr. Fook were very well paid, but had significant
family expenses to consider. They both expressed a desire not to be chargeable to tax
in China because the tax rate was much higher and tax compliance obligations much
more onerous.

If you were asked to assess this structure from a tax planning perspective, you should
consider the following matters:

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Illustrative Example 13 (continued)

1. When did JLC constitute a PE in China?

You should refer first to Article 5 of the DTA between Hong Kong and the Mainland
for a definition of a PE. A representative office and a buying office should not
in principle qualify as PEs. That is because they do not directly generate profits.
They may be indispensable parts of JLC’s undertaking, but they are, relative to
its profit-making operations (the manufacture and sale of toys) for the time
being preparatory and auxiliary. When, however, JLC resolved to establish a
manufacturing plant in China it doubtless constituted a Chinese PE (Article 5(2)(4)).

The implications of constituting a PE are that profits will need to be allocated to

the PE on an arm’s length basis, and such profits will be chargeable to tax in China
(Article 7(1)). To the extent such profits are also taxable in Hong Kong under s.14(1)
– for example, on the basis of a 50 : 50 apportionment of manufacturing profits in
a contract processing scenario – any tax paid in China would be credited against
JLC’s liability to Hong Kong profits tax subject to limit on the credit (Article 21(2)
and s.50).

2. What are the tax consequences of the royalty?

Although JLC has a Chinese PE, the royalty is not paid with respect to the business
operations of the PE and, accordingly, should in principle only be taxable in Hong
Kong; however, Article 12(2) authorises China to levy a WHT on the royalty at
source, subject to a maximum treaty rate of 7%. Note that the rate at which the
royalty is charged must be an arm’s length rate, especially because JLC participates
in the capital of BJDP as a 35% shareholder and it would follow that there is a
special relationship between them requiring the application of transfer pricing
provisions (Article 12(6)).

Note that the royalty may also be taxable in Hong Kong if, for example, it were
deductible in ascertaining the profits of any person to Hong Kong tax (s.15(1)(ba))
or otherwise simply the profit of a trade, profession or business carried on in Hong
Kong and sourced in Hong Kong (CIR v HK-TVBI (1992) 2 AC 397). If so, then a credit
will be available for the WHT levied in China subject to limit on the credit (Article
21(2) and s.50).

3. What are the tax consequences of the dividend?

Dividends are generally not taxable in Hong Kong; however, the dividend may be
paid subject to Chinese WHT (Article 10(2)). The rate of that WHT cannot, however,
exceed 5% because it is specified in the facts that JLC owns 35% of BJDP’s share
capital, which is in excess of the 25% threshold for the lower treaty rate of WHT
(Article 10(2)(1)).

4. How to assist Mr. Wong and Mr. Fook in avoiding Chinese tax on their income from
employment?

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Illustrative Example 13 (continued)

Article 14(1) provides that Mr. Wong and Mr. Fook, being Hong Kong residents, are only
taxable in Hong Kong unless they exercise their employment in China, in which case so
much of their income as is attributable to their employment exercised in China is taxable in
China. You are instructed that Mr. Wong and Mr. Fook wish to avoid Chinese tax entirely. In
order to secure that outcome, they will need to rely on the exclusive taxation provision in
Article 14(2), which applies if and only if:

• Mr. Wong and Mr. Fook ensure that they are not present in China for more than
183 days in any 12-month period. They should be advised to keep travel records
and ensure that their schedules are properly maintained for those purposes.

• It can be inferred that JLC is not resident in China: it is incorporated in Hong

Kong and apparently normally managed and controlled in Hong Kong (Articles
4(2)(iii) and 4(3)); thus, their income from employment is not borne by a person
resident in China.

• It must be ensured that their salary is not paid by or borne as an expense of JLC’s
Chinese PE, but that it is entirely borne by the head office.

10.5.7 Tax Advantages of Using a Hong Kong Incorporated Company to

Facilitate China’s Inbound and Outbound Investments
Hong Kong is a convenient holding and intermediary company jurisdiction. In particular, it
levies no WHT on either dividends or interest. It is, therefore, convenient to channel dividends
through a Hong Kong company, or otherwise roll up the proceeds of dividends declared from
operating businesses in China tax free in Hong Kong. The tax regime in Hong Kong is territorial
and capital receipts are not, in general, taxed. That means that flows of capital and investment
are readily channelled through Hong Kong on a tax-free basis: there is no tax leakage at
the Hong Kong level unless the company carries on its trade or business in Hong Kong, and
receives Hong Kong source profits from that particular trade or business. That is also true of
many classic offshore jurisdictions like the Cayman Islands or the British Virgin Islands; Hong
Kong’s principal advantage over such jurisdictions, however, is that it has a solid and expanding
DTA network.
As we have previously seen, the advantages of a DTA are certainty on the allocation of taxing
rights between jurisdictions (i.e. which jurisdiction is entitled to tax which income or gain in a cross-
border scenario) and lower rates of WHT. Because Hong Kong has an advantageous DTA with
China, dividends paid out of Chinese subsidiaries to a Hong Kong holding company – assuming, of
course, such payments are compliant with China’s very stringent capital controls legislation – are
eligible to be paid at a lower rate of WHT relative to the payment of the same dividend to, say, a
Cayman Islands company because the Cayman Islands does not have a DTA with China.

Similar advantages arise in outbound investment scenarios – that is, investment from China
to overseas destinations. Using a Hong Kong intermediary company enables the investor to
access Hong Kong’s DTA network. More importantly, it enables dividends and other payments
from overseas to be received tax free in situations where such payments would likely be
taxable if received directly by a Chinese resident parent company.

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Knowledge Check Questions

Question 8
Identify which of the following should not constitute a PE in Hong Kong under the IRO.
A A hotel room in central Hong Kong which is used by dependent agents of a German
resident company to negotiate and conclude contracts with Hong Kong customers on
the company’s behalf
B A leased office in Ap Lei Chau that acts as a showroom for the motor cars manufactured
by a Swedish automaker
C A branch of a Finnish bank established in Mongkok
D An aquaculture fishery in Sai Kung established by a Singaporean food manufacturer

Question 9
Identify which of the following definitions best describes the principal purpose of a DTA.
A An arrangement between two countries to decide the basis on which to tax cross-border
transactions
B A public international law agreement to resolve disputes between the contracting states
in taxation matters
C An international treaty to encourage international investment by decreasing rates of
WHT between the jurisdiction of source of the income or gain and the jurisdiction of
residence of a taxpayer, and to avoid double taxation
D An agreement of public international law between contracting jurisdictions to allocate
taxing rights between the jurisdiction of residence of a person and the jurisdiction of
source of income or gains

Question 10
Identify which of the following statements on the international exchange of tax information
is most accurate.
A CRS/AEOI requires non-Hong Kong resident account holders to file annual returns to the
IRD with respect to the amounts in their Hong Kong accounts.
B The exchange of information provisions in the various DTAs to which Hong Kong is party
enable a foreign revenue to request that the IRD obtain such information as is required
by the tax laws of the requesting jurisdiction, and exchange it.
C CRS/AEOI requires financial institution to conduct due diligence on account holders to
obtain, among other things, their jurisdiction of tax residence.
D When an exchange of information request is made under a DTA to which Hong Kong is
party, the IRD is required to ascertain the legal basis on which the competent authority
of the treaty partner jurisdiction has made the request.

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Knowledge Check Questions (continued)

Question 11
Identify which of the following is not a potential advantage available to the taxpayer
under a DTA.
A Reduced rates of WHT if paid to a beneficial owner resident in the other contract
jurisdiction.
B Certainty on the allocation of taxing rights between contracting jurisdictions.
C Certainty that the provisions of the DTA will in general override provisions of
domestic law.
D Certainty on the characterisation of income or gains arising to a resident in one
contracting jurisdiction from a source in the other.

Question 12
Identify which of the following best defines the concept of a tax credit under a DTA.
A A deduction available to the taxpayer for the amount of tax paid in another jurisdiction
with respect to the same income or gain
B A reduction in the amount of tax payable by a taxpayer resident in one jurisdiction
computed by reference to tax paid in the other with respect to the same income or gain
C A reduction in the amount of tax payable by a taxpayer in his or her jurisdiction of
residence computed by reference to WHT levied in the jurisdiction of source
D A deduction available to the taxpayer for the amount of tax paid in another jurisdiction
limited to a reduction in the assessable amount of the income or gain assessed to tax in
that other jurisdiction

1 0 . 6
TAX COMPLIANCE AND TAX
ADVISORY SERVICES

Professional accountants are often instructed to improve the tax efficiency for their clients. A
good adviser is able to secure tax efficiency for his client through strategies and approaches
that have a risk profile with which the client is comfortable, and which adhere to professional,
ethical, and legal requirements and guidance. This section covers those requirements and
provides applicable guidance for professional accountants working in tax practice.

10.6.1 Professional and Ethical Considerations in Tax Compliance

Engagements and Tax Planning Regarding Particular Business
Transactions
Ethical and professional guidance for professional accountants working in tax practice is
codified in the HKICPA Code of Ethics (COE) in s.600: Ethics in Tax Practice. The underlying
requirement in the tax practice is to observe the five fundamental principles that are

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enumerated in s.110 of the COE. The COE states that a professional tax accountant should
put the client’s interest forward to the extent that services can be rendered with professional
competence, without impairment to the standards of integrity and objectivity, and with
compliance with the law.

The COE provides applicable guidance to professional accountants working in tax practice
in ss.600.3–600.9. The following paragraphs correspond to those sections.

• Tax professionals should ensure that clients are aware of the limitations of tax advice
and services so that clients do not interpret tax advice as an assertion of fact, but rather
an expression of opinion. Clients should understand that a tax professional’s advice is
not beyond challenge and a tax professional should be prepared to reasonably support
any position that may be in doubt.

• Further, it is important for clients to understand that the client, not the tax professional,
is responsible for the content of a return. However, the tax professional should take any
necessary steps to ensure the return is prepared properly based on the information
received from the client.

• Additionally, all tax advice or opinions of material consequence given to a client should
be recordeded and filed.

• Tax professionals who have reason to believe that a return contains false or misleading
information, contains information furnished recklessly or without any real knowledge
of whether they are true or false, or omits or obscures information that would mislead
the tax authority (IRD) should resign, notify the IRD of the resignation, and consider
notifying the IRD and the external auditors of the issue that prompted the resignation.

• It is generally acceptable for tax professionals to prepare returns using estimates if it

is not practical to obtain exact information and the tax professional is satisfied that the
estimates are reasonable. It is important to disclaim the use of estimates or otherwise
avoid the implication of greater accuracy than exists.

• Additionally, while it is generally acceptable for tax processionals to rely on information

provided by the client if the information appears reasonable, tax professionals should
request supporting evidence, documentation, or data where appropriate.

The COE provides guidance on the steps a tax professional should take in the event a
tax professional becomes aware of a material error or omission in a client tax return of a
prior year. First the professional should advise the client of the issue and recommend the
client file an appropriate disclosure to the IRD. If the client does not correct the error, the
tax professional should inform that they cannot act on behalf of the client in connection
with the problematic return and consider whether they can work in any capacity with the
client. If it is determined that the professional can continue to work with the client, all
reasonable steps should be taken to ensure that the error is not repeated in subsequent
returns. If the professional decides to cease working for the client because of the issue, the
client should be notified before the authorities are notified, if necessary. The professional
should determine whether disclosure of the matter to the external auditor or the IRD is
appropriate.

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Chapter F of the COE also provides guidelines on anti-money laundering and counter-
terrorist financing matters for professional accountants. When an accounting professional in
Hong Kong prepares for or carries out for a client a transaction or a trust or company service
as prescribed in the Anti-money Laundering and Counter-terrorist Financing Ordinance
(Cap.615), he should conduct customer due diligence and keep records in accordance with the
requirements. In particular, he must conduct customer due diligence when:

• An usual or suspicious transaction takes place;

• A transaction not consistent with the accounting professional’s knowledge of the

customer or the customer’s business or risk profile, etc., takes place; or

• A material change occurs in the way in which the customer’s account is operated.

If the accounting professional fails to comply with the customer due diligence
requirements in respect of a client, he must terminate the business relationship.

If in doubt as to whether a given approach is ethical or consistent with your

professional obligations, you should always consult the COE published by the HKICPA.

Illustrative Example 14
Consider a situation in which Pat Lee, a professional accountant working as a tax adviser
to a local manufacturing company. Pat is working on the prior year’s tax return for
the company and is assigned to complete certain sections related to the company’s
expenses. According to the policy and procedures of his accounting firm and guidance
contained within s.600 of the COE, Pat requests and reviews the recent historical returns
as well as documentation supporting a sample of material expenses. While Pat relies
on the information provided by the client to a certain extent, Pat corroborates the
information using the prior years’ returns and independent verification techniques, such
as bank confirmations. Upon review, Pat becomes aware that the prior year return as
well as the current year return include a material overstatement of expenses.

Pat notifies the client of the errors and advises for prompt disclosure to the IRD; the
notification is delivered in writing and a copy is filed. Pat is prepared to inform the client
that no further work will be performed in connection with any returns containing material
misstatements and that Pat’s firm will consider discontinuing its relationship with the
company if the errors are not corrected. Pat knows that if the errors are not corrected his
firm will cease working with the company, notify the company immediately, then notify
the external auditors and the IRD. Pat has learned in his firm’s training programme that
public trust is essential to his firm’s success and that it cannot afford to be associated with
any controversial returns giving the appearance of impropriety. Fortunately, the client
recognises the misstatements as errors and takes the necessary steps to correct the issue
and disclose the issue to the IRD.

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10.6.2 Legal Considerations in Tax Compliance Engagements and

Tax Planning Regarding Particular Business Transactions
Tax avoidance is not illegal and will not result in criminal sanctions being imposed on either
the adviser or their client. Aggressive tax avoidance is, however, risky. That is because it may
be challenged under both statutory anti-avoidance provisions and/or under the Ramsay
principle. Courts are increasingly hostile to aggressive tax avoidance, and the IRD’s assessing
practice does not exclude levying penalties in the event of a failed tax avoidance scheme (i.e.
where the Board of Review or higher court confirms the additional assessment raised by the
Commissioner). It is important as a matter of professional ethics and best practices that tax
mitigation and avoidance strategies fit the risk profile of the client. Certain clients may be very
risk tolerant and encourage their advisers to formulate bold and sophisticated tax avoidance
schemes. Others, especially large institutions or government-linked entities, may be averse to
negative publicity and not wish to be seen to be avoiding paying their ‘fair share’. They may
even prefer to pay tax in dispute, or arrive at a negotiated settlement, instead of litigating. For
those reasons, it is critical to know your client’s priorities.

Tax planning must be strictly compliant with the law. That means that knowingly false
declarations, or the knowing falsification or modification of documents, or misattribution on
the source or character of income and gains, among other things, are strictly outside the limit
of legitimate tax planning and the ethical framework of the accountancy profession. Such
conduct may give rise to criminal liability both for the client and for the professional advisers
who knowingly abetted it. S.82 of the IRO makes clear that wilfully making false declarations
to the IRD or filing incorrect returns with intent to enable another person to avoid tax is
sanctioned on the same basis as the tax evader himself. Professional advisers may therefore
bear direct criminal liability in such circumstances.

That said, s.82 is a criminal offence that requires both a specific act (actus reus) and a
specific state of mind when committing that act (mens rea). In summary, s.82 requires that
there be an act to evade tax or to assist another person to evade tax and that the act must
be done knowingly and dishonestly. For example, in R v Ng Wing-keung (1996) 4 HKTC 264, the
Court of Appeal held that for a defendant to be convicted for an offence contrary to s.82(1)
(c) or (g) it was not enough for the prosecution to show that the taxpayer knew the contents
of the tax returns that he or she signed; he or she must have signed the tax return with the
dishonest intent to evade tax. Note that the normal criminal burden of proof of ‘beyond
reasonable doubt’, to be proven by the prosecution applies. (Note that tax evasion could also
be prosecuted as cheating the public revenue contrary to common law and tax evasion under
s.101E of the Criminal Procedure Ordinance.)

As to what constitutes tax evasion, a useful summary from the Australian case of Denver
Chemical Manufacturing Co v FCT (1949) 4 AITR 216 states that it means more than avoidance
and also more than a mere withholding of information or the mere furnishing of misleading
information. It is probably safe to say that some blameworthy act or omission on the part of
taxpayers or those for whom they are responsible is contemplated. An intention to withhold
information lest the Commissioner should consider the taxpayer liable to a greater extent than
the taxpayer is prepared to concede is conduct that if the result is to avoid tax would justify
finding evasion. The term is defined broadly in DIPN No. 11 and includes: (a) deliberate non-
lodgement of a return; (b) deliberate understatement of income or over-claiming of deductions;
(c) understatement of income or over-claiming of deductions owing to ignorance of taxation
obligations (even if without any conscious intention to undermine compliance or to understate

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assessable income); and (d) overly aggressive tax planning. The use of a transfer pricing or
re-invoicing scheme may be considered an offence of tax evasion, particularly if the success of
the scheme is entirely dependent upon the Commissioner never finding out the true facts.

You should be aware that the IRD and the Department of Justice take a ‘zero tolerance’
approach to tax evasion, including assistance rendered by a professional adviser to a taxpayer
with a view to assisting him or her in avoiding tax. Most convictions under s.82 result in
custodial sentences.

Note that correspondence between accountants and their clients are not legally privileged.
That means that what an accountant writes to his or her client on a given point of tax planning
may be called upon as evidence and disclosed in court. Conversely, the same does not apply
in general to correspondence between a lawyer, whether a solicitor or barrister, and his or her
client, which is privileged and may therefore be kept outside of proceedings before the board
or a higher court.

Illustrative Example 15
Rottweiler Films GmbH (RFB), a Swiss film production company, is presented with
an aggressive tax avoidance structure by its accountants, Chin, Pan & See (CPS). CPS
suggests that RFB book the sale of rights to films shot and produced in Hong Kong, Blue
Lantern, as a capital disposal so as to avoid profits tax on the transaction. There is case
law to suggest that profits from that transaction would be regarded as a trading disposal,
since RFB’s trade is the making and commercialisation of films. The question is a moot
point of law and both sides are arguable.

Cornelius Chin, the managing partner of CPS, writes to the board of RFB and informs
them objectively of the risks of the IRD challenging the arrangement, and potentially
levying penalties under s.82A for filing an incorrect return. Mr. Chin believes CPS’s analysis
to be the better view, but warns that there is a risk that the matter may have to be
litigated, since the amount of tax at stake is very large. Upon consideration, the board of
RFB takes a conservative view: it does not wish to be embroiled in tax litigation in Hong
Kong. Accordingly, the board instructs CPS either to find a less contentious approach to
tax savings, or simply to pay profits tax on any gains deriving from the sale of rights to
Blue Lantern.

Knowledge Check Questions

Question 13
Identify the steps that a tax professional should take if there is reason to believe that a
return of his or her client contains false or misleading information.

Question 14
State the measures that the IRD can take against aggressive tax avoidance.

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SUMMARY

• Tax planning involves analyses, strategies, approaches and solutions designed to enable
taxpayers to pay less tax than they otherwise would absent the tax planning arrangement.

• There is an informal sliding scale of tax planning strategies: tax evasion is criminal and is
tax planning that takes places outside of the ambit of legality, usually involving fraud or
dishonesty; tax avoidance is legal, but uses statutory or other provisions in ways in which,
broadly speaking, they were not intended to be used to gain a tax advantage; tax mitigation is
’legitimate’ tax avoidance, that takes place within both the letter and the spirit of the law.

• Tax planning is politically controversial: public opinion has shifted against aggressive tax
planning strategies by both individuals and bodies corporate. That means that tax advisers
need to be aware not only of tax planning opportunities but the technical and reputational
risks of tax planning structures.

• Historically, case law suggested that a person was free to plan its tax affairs as it saw fit
provided that the tax planning strategies adopted fell within the letter of the law.

• The IRO, however, has extensive anti-avoidance provisions intended to deter and in
appropriate cases disapply tax avoidance. There are two types of anti-avoidance provisions:
general anti-avoidance provisions like s.61 and 61A target all transactions of a certain type,
irrespective of which tax they are designed to avoid and how the avoidance is envisaged
to take place. Specific anti-avoidance provisions, by contrast, target tax avoidance in
specific contexts. For examples, s.61B targets the transfer of losses; s.9A the use of
companies for salaries tax planning purposes, and ss.50AAF and 50AAK address non-arm’s
length arrangements between associated companies or a head office and its permanent
establishment.

• In addition to statutory anti-avoidance provisions, the Ramsay principle may be used to

challenge tax avoidance transactions. The Ramsay principle is not a tax avoidance provision: it
is a principle of statutory interpretation that provides that because tax statutes are drafted to
reflect real-world transactions, where a transaction has steps that are plainly uncommercial or
have no business justification, the taxing statute should apply to the transaction as a whole as
though those steps had not been undertaken.

• The key question, therefore, is whether the tax law, read purposively, was intended to apply to
a given transaction, viewed realistically (Arrowtown).

• If detected by the IRD, tax planning arrangements may be challenged on anti-avoidance

grounds or on the basis of the application of the Ramsay principle. The IRD may also seek
to levy penalties on the taxpayer under ss.80 or 82A for filing an incorrect tax return or for
otherwise not meeting tax filing and documentation requirements.

• One way to obtain greater legal certainty on the application of a given structure is to apply for
an advance ruling under s.88A of the IRO. This is a service offered by the IRD. A favourable
ruling can provide legal certainty that the Commissioner will treat a given transaction or

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arrangement as stated in the ruling. There is, however, no guarantee of a favourable ruling
and the process can be expensive and/or time consuming from the perspective of the client.

• CRS/FATCA are regimes for the automatic exchange of tax and financial information held by
financial institutions. Financial institutions are, generally speaking, banks and other persons
who hold assets for and on behalf of others. Such financial institutions must make periodic
returns on the assets they hold for designated non-resident persons. This exchange of
information is intended to assist revenue authorities globally (in the case of CRS) or in the
United States of America (in the case of FATCA) to deter and prevent tax evasion.

• Hong Kong presents many good tax planning opportunities because it has a territorial system
of taxation and a wide DTA network. It is relatively advantageous for multinational enterprises
to set up headquarters or branches in Hong Kong and receive passive income from abroad
because such income may not be taxable in Hong Kong depending on the circumstances, and
is subject to favourable treaty withholding tax rates in the jurisdiction of source.

• DTAs allocate taxing rights between jurisdictions. In summary, that means that a DTA can be
used to ascertain which jurisdiction will be able to tax which income stream or capital gain.

• A crucial concept to understand in the context of DTAs is the permanent establishment (PE).
A PE is a place where the business of a non-resident enterprise is wholly or partially carried
on in. In practice, a PE is treated as a separate taxable subject. Profits must be allocated to the
PE on an arm’s length basis to determine the extent to which the enterprise is taxable in the
jurisdiction where it has the PE.

• Hong Kong has domestic PE legislation; however, where an enterprise resident in a jurisdiction
with which Hong Kong has a DTA has a presence in Hong Kong, the relevant test to determine
whether it has a Hong Kong PE will be as set out in the DTA itself.

• Where tax is paid in one jurisdiction party to the DTA, a tax credit is in general allowed against
taxation levied on the same income or gain in the other jurisdiction. This is the single most
important provision to prevent double taxation.

• Most DTAs contain exchange of information provisions. These enable tax authorities
to exchange tax information despite domestic confidentiality provisions. The scope of
information exchanged under such exchange of information provisions is generally broader
and more detailed than that exchanged under CRS/FATCA.

• DTAs however also have anti-avoidance provisions. Certain DTAs may limit benefits under the
DTA if the principal purpose or one of the principal purposes of a taxpayer having established
a presence in a treaty jurisdiction was to take advantage of the treaty, as opposed to any
genuine commercial reason. Most DTAs require that in order for the reduced treaty rate of
withholding tax to apply the payee should be the beneficial owner of the income in question.

• Many DTAs have so-called mutual agreement procedures (MAP) that require the contracting
jurisdictions to agree on a matter of interpretation of the DTA in question as between
themselves.

• Of all DTAs that Hong Kong has entered into, the one between Hong Kong and the Mainland
is perhaps the most relevant to individuals and companies that are Hong Kong residents.
It provides tax planning opportunities, in particular for China’s inbound and outbound
investments. The IRD has issued DIPN No. 44 (Revised) to illustrate its position and practice in
relation to the DTA with the Mainland.

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• Tax planning is always a question of risk acceptance. Not all clients need or want aggressive
tax planning structures even if these can be implemented. Some clients are especially
litigation averse or have reputational or public perception concerns and may therefore prefer
not to take part in aggressive tax planning.

• You should always ensure that you comply with proper ethical and professional standards
when advising on tax planning strategies.

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M I ND M A P

OVERVIEW OF TAX PLANNING HONG KONG TAX PLANNING

OPPORTUNITIES
A set of strategies, approaches and
solutions utilised by tax practitioners Tax Planning on Provision of Services by
to advise clients to mitigate or eliminate Individuals
tax liability Determining Organisational Structure for
ANTI-AVOIDANCE PROVISIONS UNDER Tax Planning
THE IRO Tax Implications of incorporating a
Subsidiary or Forming a Branch
General Anti-avoidance Provisions
(ss.61 and 61A of the IRO) Group of Companies Tax Strategies
Specific Anti-avoidance Provisions Tax Implications of an Asset Deal and
• Utilisation of Loss to Avoid Tax (s.61B) Those of a Share Deal Under M&A
• Service company ‘Type I’ arrangements The Implications of BEPS, FATCA and CRS
• Service company ‘Type II’ arrangements DOUBLE TAXATION AGREEMENTS
• Other specific anti-avoidance provisions HONG KONG TAX OVERVIEW
in the IRO PLANNING IDEAS
Ramsay principle – purely artificial steps AND STRATEGIES Double Taxation Agreements Scope and
with no commercial purpose in a Terminology
transaction may be disregarded when Jurisdictions with which Hong Kong has
applying a taxing statute Entered into a DTA
Penalty on tax avoidance (DIPN No. 15) Key Articles in the DTA
Tax Implications and Development of Tax • Residence
Avoidance Cases – generally hostile to • Permanent Establishment (PE)
tax avoidance • Business Profits
• Dividends, Interest, Royalties and
ADVANCE RULING SYSTEM Capital Gains
• Income from Employment
Advance ruling regime (S.88A of the IRO)
• Director’s Fees
• Scope
• Mutual Agreement Procedures (’MAPs’)
• Costs
• Exchange of Information
• Benefits
• Options in case of unfavourable ruling DTA and the IRO
Tax Credits Computations and Application
Arrangement between the Mainland of
China and the Hong Kong Special
Administration Region for the Avoidance
of Double Taxation and the Prevention of
Fiscal Evasion with Respect to Taxes on
Income
Tax Advantages of Using a Hong Kong
Incorporated Company to Facilitate China’s
Inbound and Outbound Investments
TAX COMPLIANCE AND TAX ADVISORY
SERVICES
Professional and Ethical Considerations
Legal Considerations

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. An uncommercial transaction may not be equivalent to ‘sole or
dominant purpose’ is for taxation.
Answer B is incorrect. S.61A technically is not directly applied for interpretation of the
legislative intent of another provision of the IRO.
Answer C is correct. S.61A can be invoked where the sole or dominant purpose of any
arrangement is for obtaining a tax benefit. By applying this section, the CIR or DCIR can
either disregard the arrangement or take whatever way to counteract the tax benefit.
Answer D is incorrect. S.61 rather than s.61A should be invoked to a transaction that is
‘artificial and a sham’.

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Question 2
Answer A is incorrect. S.61B specifically relates to the utilisation of losses; hence it is a
specific, rather than general, provision.
Answer B is incorrect. S.9A is concerned specifically with salaries tax avoidance via PSCs;
hence it is specific and not general in scope.
Answer C is incorrect. Ss.50AAK and 50AAF are both operative transfer pricing provisions;
hence, they are also specific in that they apply only in their restricted contexts of,
respectively, allocation of profits between a head office and its permanent establishment
and allocation of profits between associated enterprises.
Answer D is correct. It is a general anti-avoidance provision.

Question 3
The Ramsay principle is a principle of statutory interpretation. It provides that in applying
a taxing statute one must apply the relevant provision, read purposively (i.e. with a view
to what the Legislature intended it to do) to the transaction or arrangement, viewed
realistically (that is, discounting any step which does not have any verifiable commercial or
business purpose).

Question 4
Answer A is correct. An advance ruling is an optional service offered by the IRD whereby
the applicant may, upon payment of a fee and having made the appropriate submission of
fact and law, request the Commissioner’s opinion on certain matters of tax law in the IRO.
Answer B is incorrect. An advance ruling is not a clearance of a given transaction.
Answer C is incorrect. An advance ruling is not for resolving a dispute after a transaction is
done. An advance ruling is made before a transaction is carried out.
Answer D is incorrect. An advance ruling is not mandatory, but optional. It is also not a
process of revenue clearance.

Question 5
(a) To use rent-free accommodation/reimbursement of rental payment to replace
salaries in cash

(b) To use stock options

(c) To provide tax-free fringe benefit, such as the employer to take up the sole and
primary liability on making payments to a third party for provision of benefit to the
employee, instead of reimbursement of employee’s own expenses. For example,
the employer enters into a contract with an insurance company to provide
medical insurance benefit to the employee. Note, to secure the non-taxability
of the benefit, there should not be any guarantee for the employer to make the
payment of insurance premium, and the benefit cannot be convertible into cash in
whatever manner.

Question 6
(a) Tax implications and commercial implications for different forms of business
vehicles: sole-proprietorship, partnership, limited companies and trust

(b) The use of holding companies and conduit companies located in Hong Kong or
other tax neutral jurisdictions

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Question 7
A number of potential tax complications can arise during a business sale. Hong Kong,
market practice tends to favour share sales for M&A purposes, but asset sales offer a few
distinct advantages. In an asset sale the buyer can directly secure deductions for trading
stock, patent rights, and specified intellectual property rights and allowances for plant and
machinery and buildings. Another advantage is that unrelieved losses carried forward of
acquiring company may be set off against the profits of the acquired business. Finally, due
diligence may be limited to the assets specifically being acquired.

Question 8
Answer A is incorrect. A PE is constituted by virtue of agents habitually concluding
contracts on behalf of their principal.
Answer B is correct. A showroom or other facility used exclusively for exhibiting products is
expressly excluded from being a PE.
Answer C is incorrect. A branch is by definition a PE.
Answer D is incorrect. A physical production facility is plainly a PE.

Question 9
Answer A is incorrect. The scope of a DTA is much broader than just cross-border
transactions.
Answer B is incorrect. The resolution of disputes is ancillary to the principal goal of
allocating taxing rights. This is a purpose, but it is not the principal purpose of a DTA.
Answer C is incorrect. While it is true that encouraging international investment is a
purpose of a DTA, it is not its principal purpose.
Answer D is correct. The key word in the question is ‘principal’. The principal purpose of a
DTA is to allocate taxing rights, specifically where a person resident in jurisdiction A derives
income or gains from jurisdiction B, and vice versa.

Question 10
Answer A is incorrect. Financial institutions must make periodic filings, not the account
holders themselves.
Answer B is incorrect. The IRD is not required (and so not authorised) to do anything more
than it would be required and authorised to under Hong Kong law to obtain information
from taxpayers.
Answer C is correct. The starting point for all CRS reporting requirements is appropriate
due diligence.
Answer D is incorrect. It is in general not open for the jurisdiction to which a request was
made to look behind the legal basis, as a matter of foreign law, of the request.

Question 11
Answer A is incorrect. Taxpayer may benefit from reduced WHT rates under a DTA.
Answer B is incorrect. Allocation of taxing rights between contracting jurisdictions is one of
the principal advantages of a DTA.
Answer C is incorrect. This is an important element of legal certainty, which decreases the
burden of verifying matters of foreign law when advising on DTAs.

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Answer D is correct. The proper characterisation of an income stream or gain will at

least in part turn on the domestic law of the jurisdiction of source. This warrants further
investigation and it would be imprudent not to seek the advice of local practitioners in the
event of doubt.

Question 12
Answer A is incorrect. A tax credit is not a deduction under s.16(1), but a reduction in tax
payable in Hong Kong.
Answer B is correct. A tax credit means that taxpayers claiming the credit will be credited in
their jurisdiction of residence for tax paid on income or gains in the jurisdiction of source:
to provide a credit is to avoid double taxation on the same income.
Answer C is incorrect. The reduction is not limited to WHT.
Answer D is incorrect. A tax credit is not a deduction in computing assessable income, but
a reduction in tax after assessable income has been computed in accordance with the
prevailing domestic rules.

Question 13
The tax professional should resign from the engagement, notify the IRD of the resignation,
and consider notifying the IRD and the external auditors of the issue that prompted the
resignation.

Question 14
(a) Anti-avoidance provisions, both general and specific

(b) Ramsay principle

EXAM PRACTICE

QUESTION 1
Mr. Wong was the accountant of Spring Trading Ltd (Spring). Spring was running a chain of
Korean restaurants in Hong Kong. The business of Spring dropped significantly since 2017,
and tax losses in total of HK$20 million were accumulated. Mr. Wong was very anxious that
Spring might not be able to continue its business and was discussing with Spring’s director,
Miss Cheung, about how to save Spring. They noticed that Spring’s holding company, Winter
Investment Ltd (Winter) was very profitable. The main business of Winter was investment
holding and 80% of Winter’s income was royalty income, while the remaining 20% income
comprised rental from overseas properties and interest from overseas bank deposits. All
royalty income of Winter was derived from licencing of intellectual properties developed by
Winter in Hong Kong and such intellectual properties were also used in Hong Kong. Hence
the royalty income was Hong Kong source and chargeable. Winter’s rental income and
interest income have been accepted by the IRD as offshore source and non-taxable. For
the year ended 31 December 2018, Winter derived royalty income of HK$100 million. Both
Mr. Wong and Miss Cheung expected Spring would continue to suffer loss and Winter would
continue to earn huge royalty income in the coming years. So, they contemplated that for

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the year 2019, Spring would charge a consultancy fee of HK$10 million to Winter for royalty
collection and intellectual property management service provided. By doing so, the financial
position of Spring could be improved. They both did not have much taxation knowledge and
hence they would like to have a tax adviser to answer the following questions:

(a) Would the arrangement of charging consultancy fee be subject to queries by the IRD? If
so, what questions are the IRD likely to raise?

(b) What IRO provisions the IRD can invoke to challenge the arrangement?

(c) What would be the tax impacts if, instead of charging the consultancy fee, Winter
assigns certain intellectual properties to Spring so that Spring can have royalty
income to set off its trading loss (assuming the assignment consideration is based on
market prices)?

Required:

Assuming you were Spring’s tax adviser, draft an email to address the questions raised by
Mr. Wong and Miss Cheung.

QUESTION 2
Smart JV Company (Smart JV) was a joint venture company set up and jointly owned by a
Hong Kong company, Handsome Ltd (Handsome), and a Mainland company, Charming Ltd
(Charming). Handsome and Charming each owned 50% shareholding in Smart JV. Handsome
is wholly owned by Holmes Ltd, which was incorporated and based in Country A. There
is no tax treaty/arrangement between Country A and Hong Kong, and Country A and the
Mainland. Handsome carried on financial advisory business in Hong Kong.

Handsome has developed a financial analysis software, namely, FinX. With the
authorisation given by databases owners, FinX can access and extract data from the
databases, and perform various models of financial simulation and analysis swiftly.
Handsome paid royalty (Royalty-1) to various content developers in overseas for using their
databases. In supporting Smart JV’s operation, Handsome allowed Smart JV the right to
modify FinX for developing similar systems suitable for its use in the China market. Smart JV
paid a royalty (Royalty-2) to Handsome in this regard. Handsome’s IT team travelled to the
Shenzhen office of Smart JV and provided technical support to Smart JV on modifying FinX.

For the year ended 31 December 2019, it was expected Smart JV would distribute a dividend
of RMB 1 million to Handsome, which would then pay the entire sum as dividend to Holmes.

A potential investor had approached the management of Handsome about acquisition

of 10% shareholding in Smart JV. If agreed by the management, the transaction would take
place in early 2020.

Required:

(a) State the conditions under which a Hong Kong resident company would be subject to
Corporate Income Tax (CIT) in mainland China in accordance with the DTA between
mainland China and Hong Kong.

(b) Analyse the Chinese CIT impact (in the context of the DTA only) in respect of Royalty-2.

(c) Analyse the Hong Kong profits tax position in respect of Royalty-2 and Royalty-1.

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(d) Analyse the Chinese CIT impact (in the context of DTA only) and Hong Kong profits tax
impact in respect of the dividend of RMB 1 million received by Handsome and paid
to Holmes.

(e) Analyse the Chinese CIT impact (in the context of DTA only) and Hong Kong profits tax
impact of the potential disposal of 10% shareholding in Smart JV.

ANSWERS TO EXAM PRACTICE

QUESTION 1
To: Miss Cheung and Mr. Wong

From: [name of the tax adviser]

Subject: Spring Trading Ltd (Spring) – Consultancy Arrangement with holding company

Dear Both,

I refer to your email regarding the Hong Kong tax implication of the proposed arrangement
of charging a consultancy fee from Spring to its holding company, Winter Investment Ltd
(Winter). In essence the following three questions were raised.

(a) Would the arrangement of charging consultancy fee be subject to queries by the IRD? If
so, what questions are the IRD likely to raise?

(b) What IRO provisions the IRD can invoke to challenge the arrangement?
(c) What would be the tax impacts if, instead of charging the consultancy fee, Winter
assigns certain intellectual properties to Spring so that Spring can have royalty
income to set off its trading loss (assuming the assignment consideration is based on
market prices)?

Based on your information provided, I would like to provide my advice to address your
questions in the context of Hong Kong profits tax as follows:

(a) Would the arrangement of charging consultancy fee be subject to queries by the IRD? If
so, what questions are the IRD likely to raise?

It is very likely that the IRD will raise an enquiry on the proposed arrangement between
Spring and Winter. It is likely that the IRD will request information such as documentary
evidence of the intellectual property management and royalty collection services
provided by Spring, details of staff and resources that Spring would apply to provide
the services, risk to be borne by Spring in delivery of the services, reasons that Spring
was appointed for intellectual property management and royalty collection purposes, a
copy of the service fee agreement, basis of the service fee, board’s minutes approving
the agreement or payment of service fee and documentary evidence of the payment of
the service fee, justification that the service fee is determined on an arm’s length basis,
and so on.

(b) What IRO provisions the IRD can invoke to challenge the arrangement?

S.68(4) of the IRO provides that the burden of showing an assessment to be excessive
is on the taxpayer. Consequently, it is incumbent on Spring to adduce evidence that the
service fee was incurred for real and commercially relevant services. Otherwise, one
or more of the general anti-avoidance provisions in ss.61 and 61A may apply such that

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a deduction is not allowed for the service fee, on the basis that it is not in substance
an expenditure or outgoing incurred in the production of taxable profits within the
meaning of s.16(1). Note that simply because some of the service fee is deductible on
the terms of s.16(1) does not mean that all of it is. Consider also whether the service
fee was contracted on an arm’s length basis and is therefore consistent with the
requirements in s.50AAF.

The amount of fee in excess of the normal market level might be disallowed under
s.17(1)(b) as not being expended for the purpose of earning chargeable profits. In order
for a sum to be deductible under s.16(1) it must be shown as a matter of fact and law
that it was actually incurred in the production of taxable profits. If that were not, in
reality, the case, and the current structure were simply a means of re-allocating profits
between associated companies, the general anti-avoidance provision in s.61A could be
applied by the IRD to disallow a deduction for the expenditure the taxpayer alleges was
incurred. S.61A may be applied in whatever manner the deputy commissioner thinks
appropriate, including denying a portion of the consultancy fee, which is excessively
charged over the arm’s length level. In applying s.61A the burden of proof is on the
commissioner to show that it applies to a given transaction and arrangement.

Where services are indeed provided by Spring to Winter, if the consultancy fee
charged is not on arm’s length basis, the IRD can also invoke s.50AAF-Transfer Pricing
Rule 1 to adjust the profit/loss position of Spring and Winter.

As there is no change in the shareholdings of Spring, s.61B is not applicable under

the circumstances.

(c) What would be the tax impacts if, instead of charging the consultancy fee, Winter
assigns certain intellectual properties to Spring so that Spring can have royalty
income to set off its trading loss (assuming the assignment consideration is based on
market prices)?

It would appear that the transaction has taken place on an arm’s length basis, or
otherwise in any event at market value. Accordingly, there has apparently been no tax
avoidance and it seems unlikely that a general anti-avoidance provision would apply in
this case. That said, s.61A may nonetheless be applied by the IRD if it considered that
having regard for the various factors enumerated in that section, it would objectively
be concluded that the sole or dominant purpose of the transaction was to obtain a
tax benefit.

Spring cannot get any deduction on the acquisition cost of the intellectual
properties as such intellectual properties are acquired from an associated company.
Ss.16E and 16EA are not applicable. The sale proceeds on assignment of the intellectual
properties are capital in nature and not taxable to Winter under s.14 as such properties
have been developed by Winter and Winter has derived royalty income from them for
many years. However, if Winter has claimed deduction under s.16B in respect of the
development cost, the sale proceeds would be deemed taxable. The taxable amount
would be limited to the deduction previously claimed.

Spring and Winter may be able to defend themselves on the basis that the
transaction is made for the purpose of group business restructuring rather than
obtaining a tax benefit. In restructuring the group business, Spring will take up all major
business operations (trading and licencing of intellectual properties) while Winter will
become an investment holding company with minimal operational activities of holding

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deposits and overseas properties. With the group business restructuring, the financial
position of Spring will improve. The transaction will therefore have a commercial
substance other than the tax benefit. There should be sufficient documentary evidence,
such as financial studies and correspondences with a third party such as banks to
substantiate this commercial reason. It should clearly demonstrate that continuing
deteriorating financial position of Spring will lead to its bankruptcy and result in severe
negative impact on the group as a whole.

Hope the above advice is useful to you. If you have any questions, please
let me know.

Best regards,

Tax Adviser

QUESTION 2
(a) According to the DTA, the profits of a Hong Kong enterprise shall be taxable only in
Hong Kong unless the enterprise carries on business in the Mainland through a PE.

If the Hong Kong enterprise carries on business through a PE in the Mainland, the
profits of the enterprise may be taxed on the Mainland but only to the extent of those
attributable to that PE.

The term PE means a fixed place of business that is defined to include:

(i) a place of management;

(ii) a branch;

(iii) an office;

(iv) a factory;

(v) a workshop;

(vi) a mine, an oil or gas well, a quarry or any other place of extraction of natural
resources; and

(vii) an agency with general authority to conclude contract.

For consultancy services, if the services have been furnished in one side for the same
project or connected projects for a period or periods exceeding in the aggregate 183 days
in any 12-month period, the provision of services will be treated as a PE in that side.

PE does not cover facilities or a fixed place of business for:

• storage, display or delivery of goods;

• purchasing goods; and

• collecting information or other preparatory or ancillary activities

belonging to the enterprises.

(b) Chinese CIT impact

Assuming Handsome did not constitute any PE in mainland China:

• If Handsome does not maintain a PE in mainland China, it will only be subject to CIT
on a withholding basis in respect of the royalty received from Smart JV for granting
Smart JV the right to modify FinX in the Mainland.

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• The withholding tax rate is 7% on the gross royalty, without any deduction
according to the DTA, if Handsome is the beneficial owner of the royalty.

• Handsome should be regarded as the beneficial owner because it developed

FinX and owned the proprietary interest in the software. Also, it would perform
substantial operation for the purpose to earn the royalty income as it sent staff to
Smart JV’s office to provide technical support on modifying FinX.

If Handsome constitutes a PE in mainland China:

• As Smart JV sent staff to provide technical support to Smart JV, Handsome may be
regarded as maintaining a PE in the Mainland if:

°° The number of days Handsome’s staff working in the Mainland is more

than 183 days within any 12-month period commencing or ending in a
taxable year; or

°° There is a fixed place in mainland China at the disposal of Handsome when it

renders the services in the Mainland (for instance at Smart JV’s office).

• If Handsome is regarded as maintaining a PE in the Mainland, its net profits

attributable to the PE will be taxable. If this is the case, the gross royalty fee less the
relevant expenses will be subject to CIT at a rate of 25%.

• Whether being taxed at 7% on withholding basis or being taxed at 25% on net profit
(with tax adjustment) is more beneficial depends on the level of operating expenses
of Handsome in this regard.

(c) Hong Kong profits tax impact

Applying the operations test, the IRD will regard Royalty-2 received from Smart JV as
derived from Hong Kong. It is because Handsome developed FinX in Hong Kong. The
place of usage is not relevant (DIPN No. 49).

Technically, Handsome can counter argue that the place of usage is more critical
for generation of Royalty-2. Handsome provided on-site technical support to Smart JV
for earning Royalty-2. Hence, Royalty-2 should be distinguished from simply licencing
out a self-developed intellectual property as illustrated in DIPN No. 49. Alternatively,
Handsome may argue that a portion of Royalty-2 should be attributable to the technical
support services rendered in mainland China. To strengthen this argument, Handsome
may need to have a professional valuation to justify a reasonable split of the fee into
a real royalty fee and a real service fee. The royalty portion was purely received for
the right to modify FinX for development of new systems, whereas the service fee was
received just for the technical support services rendered in mainland China. However,
it may be hard to convince the IRD to accept this approach as the IRD states that in
general it only allows apportionment for manufacturing and service income. Whether
Royalty-2 is a service income and eligible for apportionment is subject to dispute.

Handsome’s payment of Royalty-1 to overseas companies would be deductible

if it is incurred in the production of assessable profits (s.16(1)). If all income derived
from using the databases are subject to profits tax in Hong Kong, Royalty-1 should be
deductible.

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Royalty-1 was paid for the right to assess and extract data from the overseas
companies’ databases and it would be deemed as taxable under s.15(1)(b) because
Handsome used the right in Hong Kong. In accordance with s.21A, the assessable
profits would be 30% on Royalty-1. Handsome needs to withhold, report (in BIR Form
54), and pay tax for and on behalf of the overseas databases’ owners. The two-tiered
profits tax rates would apply if there is no connected entity of the overseas databases
owners that is nominated for the two-tiered rates.

(d) Dividend

Chinese CIT on Dividend from Smart JV to Handsome:

For dividend paid to a Hong Kong resident beneficial owner, which does not
maintain any PE in mainland China and has been holding 25% or more shareholding of
a Chinese company for a period of not less than 12 months, the withholding CIT rate is
5%. Hence, the CIT liability for the case is RMB 50,000 (i.e. RMB 1 million × 5%).

However, as Handsome will distribute 100% of the dividend to Holmes, there might
be a risk that Handsome is not regarded as a beneficial owner of the dividend and
cannot enjoy the reduced withholding tax rate. If the reduced 5% rate does not apply,
the normal withholding tax rate of 10% will apply.

Hong Kong profits tax impact:

Dividend received from Smart JV is offshore in nature and non-taxable

to Handsome.

Dividend distributed by Handsome to Holmes is not subject to any withholding tax

in Hong Kong.

(e) Disposal of shares

Chinese CIT impact:

Gain derived from the alienation of shares of a Mainland company by a Hong Kong
company representing 25% or more of the entire shareholding of the Chinese company
may be subject to CIT in the Mainland.

As Handsome held 50% shareholding in Smart JV, disposal of 10% shareholding in

Smart JV would be subject to income tax in mainland China at 10%.

Hong Kong profits tax impact:

Gain on disposal of shares in Smart JV is capital in nature and not taxable in

Hong Kong.

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 11
Transfer Pricing

CHAPTER TOPIC LIST

11.1 Transfer Pricing Overview 11.4.2 Application Procedures

11.4.3 Benefits of an Advance
11.2 Regulatory Framework
Pricing Arrangement
11.2.1 Rule 1
11.2.2 Rule 2 11.5 Relief from Double Taxation
11.5.1 Economic Double Taxation
11.3 Documentation Requirements
11.5.2 Juridical Double Taxation
11.3.1 Local and Master File
11.3.2 Country-by-country 11.6 Tax Planning and Transfer
Reporting Pricing
11.6.1 Determining Comparability
11.4 Advance Pricing Arrangements
11.6.2 Transfer Pricing Methodologies
11.4.1 Key Points of the Advance
Pricing Arrangement
Framework

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LEARNING OUTCOMES

PRINCIPAL LO5: ADVISE ON HONG KONG TAX PLANNING IDEAS AND STRATEGIES TO ENHANCE
TAX EFFICIENCY
LO5.06: Advise on transfer pricing
5.06.01 Advise on transfer pricing arrangement in relation to tax planning
5.06.02 Advise on the issues, including advantages and application procedures, relating to the
advance pricing arrangement
5.06.03 Apply DIPN No. 45, 46 and 48
LO5.07: E
 xplain and advise on the use of double taxation agreements/arrangements (DTAs) for
tax planning
5.07.11 Advise on transfer pricing adjustments in the context of DTAs

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OPENING CASE

BVI GROUP

B VI Group is a multinational group specialising in manufacturing and selling furniture items.

The ultimate parent company is BVI Limited (incorporated and tax resident in British Virgin
Islands (BVI)). BVI Limited has two wholly owned subsidiaries, HK Limited (incorporated and tax
resident in Hong Kong) and UK Limited (incorporated and tax resident in the United Kingdom).
BVI Limited has a representative office in Hong Kong performing the function of finding reliable
suppliers of raw materials for HK Limited at a very low cost. The BVI Limited offers legal,
financial and HR supports to the HK office.

HK Limited manufactures the furniture items in Hong Kong. Instead of selling the products
directly to customers in the UK, HK Limited sells the products to UK Limited which will then
promote the products and sell them to the final customers in the UK. In 2019, HK Limited
employed a total of 150 employees and had a revenue of HK$500 million. In respect of one of
the furniture items, chairs, the cost is HK$100 per chair, which is ultimately sold to customers in
the UK at the equivalent of HK$500 per chair.

The group chief financial officer has heard about the new transfer pricing legislation in
Hong Kong. He wants to know how the selling prices of the furniture items from HK Limited to
UK Limited should be set and what documents it needs to keep.

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OVERVIEW

The Hong Kong transfer pricing landscape has witnessed significant changes in recent times.
The Inland Revenue (Amendment) (No. 6) Ordinance of 2018 was enacted on 13 July 2018. It
has introduced two fundamental transfer pricing rules into the Inland Revenue Ordinance
(IRO). It has also implemented a ‘three-tier’ transfer pricing documentation requirement
in Hong Kong. The existing DIPNs on the subject, such as DIPN No. 45 (Relief from Double
Taxation due to Transfer Pricing or Profit Reallocation Adjustments), DIPN No. 46 (Transfer
Pricing Guidelines – Methodologies and Related Issues) and DIPN No. 48 (Advance Pricing
Arrangement), are likely to be updated in due course.

This chapter provides an overview of transfer pricing. The chapter explains the two
fundamental transfer pricing rules and the documentation requirements in Hong Kong. It
also illustrates how a taxpayer can obtain some certainty by applying for an advance pricing
arrangement. Guidance is also provided on how to obtain relief from double taxation as a
result of transfer pricing adjustments. We shall further consider how taxpayers can do tax
planning in the transfer pricing context. Throughout the chapter, references will be made
to DIPNs 45, 46 and 48 to the extent that they are consistent with the new transfer pricing
regulatory framework. In order to have a further and comprehensive understanding on the
Hong Kong transfer pricing regime, candidates shall also make reference to the DIPNs 58,
59, and 60.

1 1 . 1
TRANSFER PRICING OVERVIEW

It is very common for a multinational enterprise group to have several subsidiaries that operate
in different countries around the world. These subsidiaries would be tax resident and liable to
pay tax in many jurisdictions. It is also common for companies in the same group to transact
with each other. For example, in the Opening Case, there are transactions between HK Limited
and UK Limited.

Transfer pricing is concerned with the prices charged between related parties for the
transfer of goods, services and intangible property, and the interests charged between
related parties for financing activities. Related parties include parent and subsidiaries or
other companies in a group (see Section 11.2 for the definition). Since the parties are related,
it offers flexibility of structuring and tax planning opportunities. As an example, there would
be an incentive to set the transfer prices in such a way that most of the profits would fall into
the low tax jurisdiction. In the Opening Case, the total profit from selling a chair is HK$400
(HK$500 – HK$100). Since the profits tax rate in Hong Kong is lower than the corporate tax

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rate in the UK, there is an incentive to set the transfer price as high as possible, for example,
HK$450, so that HK Limited earns a profit of HK$350 (HK$450 – HK$100) and the UK Limited
only earns a profit of HK$50 (HK$500 – HK$450).

Obviously, tax authorities want to control how enterprises set transfer prices between
related parties. This is where the arm’s length principle becomes relevant. According to the
arm’s length principle, transactions between independent enterprises are used as a benchmark
to determine how profits and expenses should be allocated for the transactions between
related parties. It compares what an enterprise has transacted with its related party with what
a truly independent enterprise would have done in the same or similar circumstances.

If transfer pricing does not follow the arm’s length principle, the tax liabilities of the parties
will be distorted. The basic purpose of transfer pricing legislation is to test whether related-
party transactions are at arm’s length and, if not, to empower tax authorities to adjust the
transactions so that tax would be charged as if they were at arm’s length. In the Opening Case,
the Inland Revenue Department (IRD) may look at what the selling price of the chair would be
if UK Limited was an unrelated, independent enterprise as the benchmark. Then, the IRD will
compare the transfer price set by HK Limited (HK$450) against the benchmark. If the transfer
price set by HK Limited is materially different from the benchmark, the IRD may adjust the
transfer price that will then impact HK Limited’s Hong Kong profits tax liability.

Key Learning Point

Transfer pricing is concerned with the prices charged between related parties, such as for
the transfer of goods, services and intangible property, as well as the interests charged for
financing activities.

1 1 . 2
REGULATORY FRAMEWORK

In a globalised world, it has become a lot easier for multinationals to reduce their tax liability by
reducing the tax base and shifting profits to low tax jurisdictions. Therefore, the Organisation
for Economic Co-operation and Development (OECD) began a major project to tackle Base
Erosion and Profit Shifting (BEPS) in 2013. In 2015, the OECD produced 15 action plans, some of
which are related to transfer pricing.

At the beginning of 2017, close to 100 jurisdictions committed to implementing the BEPS
outputs through their membership in the OECD Inclusive Framework on BEPS implementation.
Hong Kong is also a member of the OECD Inclusive Framework. As a result, Hong Kong has to
amend its tax legislation in order to implement the BEPS outputs.

The Inland Revenue (Amendment) (No. 6) Ordinance of 2018 was enacted on 13 July
2018. It has introduced two fundamental transfer pricing rules into the IRO. Rule 1 targets
transactions between two related companies whereas Rule 2 targets transactions within the
same company (e.g. between the head office and its branch). This section describes these
transfer pricing rules.

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11.2.1 Rule 1
Under s.50AAF of the IRO, the IRD is empowered to adjust a taxpayer’s income or loss
according to the arm’s length principle if the following conditions are satisfied:

(a) A provision (actual provision) has been made or imposed as between two persons (each
an affected person) by means of a transaction or series of transactions;

(b) The participation condition is met under s.50AAG – the condition is met if, at the time
of the making or imposition of actual provision: (i) one of the affected persons was
participating in the management, control or capital of the other affected person; or
(ii) the same person or persons was or were participating in the management, control
or capital of each of the affected persons;

(c) The actual provision differs from the provision that would have been made or imposed
as between independent persons (arm’s length provision); and

(d) The actual provision confers a potential advantage in relation to Hong Kong tax on an
affected person (advantaged person).

The ‘transaction or series of transactions’ in criterion (a) is interpreted in s.50AAI as any

operation, scheme, arrangement, understanding and mutual practice. A series of transactions
is not prevented from being included in the scope referred to as ‘series of transactions’ in
criterion (a), even if one or more of the following applies:

(i) There is no transaction in the series to which both those persons are parties;

(ii) The persons are not included in the transactions or the arrangement composed with
the transactions;

(iii) There is one or more transactions in the series to which neither of those persons is a party.

Pursuant to s.50AAH, in applying criterion (b), a person (person A) is participating in the

management, control or capital of another person (person B) only if:

(a) Person B is a corporation, partnership, trustee or a body of persons; and

(b) Person B is controlled by person A.

Regarding subsection [b], person B is controlled by person A if:

(i) Person A has the power to secure that the affairs of person B are conducted according
to person A’s wishes (such as when person A owns more than half of the shareholding
or voting interest directly or indirectly in person B); or

(ii) Person B is accustomed or under an obligation (whether legally enforceable or not) to

act in accordance with person A’s directions.

Under s.50AAF(2), the cases in which the actual transaction is to be taken as not at arm’s length,
as mentioned in criterion (c), include the case where provision is made or imposed as between two
persons but no provision would have been made or imposed as between independent persons.

According to the interpretation of ‘potential advantage’ in criterion (d) provided in s.50AAJ,

the transaction or series of transactions would be regarded as conferring potential advantage if
making the actual provision has either or both of the following effects:

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(i) A smaller amount would be taken to be the amount of the person’s income;

(ii) A larger amount would be taken to be the amount of the person’s loss.

The effect could be in relation to Hong Kong or foreign tax.

Pursuant to s.50AAF(3), upon notice by an assessor, the taxpayer must prove that its
income or loss as stated in the tax return is calculated according to the arm’s length principle.
Under s.50AAF(5), if the taxpayer fails to prove this, the assessor will estimate the arm’s length
profit or loss and issue a revised assessment accordingly.

11.2.1.1 DIPN No. 59 ‘Transfer Pricing between Associated Persons’

DIPN No. 59, issued in July 2019, offers guidance on the application of the general principles
related to transfer pricing Rule 1, consistency with the Organization for Economic Cooperation
and Development (OECD) guidance, locality of profits, recharacterisation of related-party
transactions, exempted domestic transactions, grandfathered transactions, and arm’s length
price. Transfer pricing Rule 1 applies to all years of assessment beginning on or after 1 April
2018; however, transactions or income accrued before 13 July 2018 are grandfathered.

DIPN No. 59 aims to clarify consistency with the OECD rules (Transfer Pricing Guidelines
2017). However, there may be situations when the OECD rules cannot provide complete
compliance with IRD requirements. Under DIPN No. 59, the IRD states that it prefers the highest
level of consistency with the OECD rules that still complies with the local requirements. In
addition, a taxpayer must be able to demonstrate that reasonable effort has been made to
comply with the arm’s length principle, which is also supported by the OECD. Should a taxpayer
fail to do so, the IRD can apply administrative penalties.

In some cases, a domestic transaction will not result in any Hong Kong tax difference and
can be exempted so long as certain conditions are met. Specifically, such domestic transactions
between related parties do not give rise to a Hong Kong tax advantage. DIPN No. 59 also
clarifies the relationship between transfer pricing and locality of profits. The arm’s length price
of a related party transaction must be determined first; then the broad guiding principle (see
DIPN No. 21) would be applied to determine the source of profits.

DIPN No. 59 also outlines the recharacterisation of related party transactions by the IRD.
The IRD can, having considered all facts and circumstances, disregard or recharacterise a
transaction if it concludes that the transaction’s substance differs from its form, or in such
cases where non-related entities would not have characterised or structured the transaction in
the same manner as related parties have.

To avoid potential tax enquiries, Hong Kong taxpayers should evaluate their existing
operations to ensure they are compliant with the guidance as contained in DIPN No. 59.

Illustrative Example 1 – Transfer Pricing Rule 1

In the Opening Case, there was a series of transactions between HK Limited and UK
Limited. HK Limited and UK Limited are related parties because the same person
(BVI Limited) controls both HK Limited and UK Limited by holding more than half of
their shares. In fact, both HK Limited and UK Limited were BVI Limited’s wholly owned
subsidiaries. If the sale of furniture items from HK Limited to UK Limited was not at arm’s
length and, as a result, HK Limited had a smaller assessable income, then the IRD is

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Illustrative Example 1 (continued)

empowered to adjust HK Limited’s profits. As an illustration, assume that there are two
independent companies shown as below conducting similar business activities as HK
Limited in Hong Kong, and HK Limited’s net profit margin is 5%.

Company A Company B
Description of Manufacture of furniture and operation Manufacture of furniture
business activities of shops for resales
Net profit margin 10% 3%

Company A shall be rejected as a comparable to HK Limited because of the extra resale

function that the tested party (i.e. HK Limited) does not perform. In terms of Company
B, the income of HK Limited may not be adjusted if the comparable companies found
are at a similar level of Company B because there is no potential advantage regarding
Hong Kong tax.

11.2.2 Rule 2
Under s.50AAK(1), a non-resident taxpayer who has a permanent establishment in Hong Kong
will be regarded as carrying on a trade, profession or business in Hong Kong. S.50AAK(2)
then provides that the income or loss of the non-resident taxpayer that is attributable to the
Hong Kong permanent establishment shall be calculated as if it was a separate unrelated,
independent entity that engaged in the same or similar activities under the same or similar
conditions. This rule is of particular relevance to banks or insurance companies because, for
regulatory and capital requirements, foreign banks and insurance companies usually operate
in Hong Kong through a branch rather than incorporate a separate company. It is worth noting
that the credit ranking shall be taken into account when applying the arm’s length principle
and finding the comparables. Pursuant to s.50AAK(4), the credit ranking of the Hong Kong
permanent establishment is assumed as the same level as that of the foreign head office
company. Additionally, the Hong Kong permanent establishment is assumed to have the equity
and loan capital that it is reasonably expected to have in view of its business activities.

Under s.50AAK(7), on notice by an assessor, the taxpayer must prove that its income or loss
attributable to the permanent establishment as stated in the tax return is calculated according
to the arm’s length principle. If the taxpayer fails to prove this, the assessor will estimate the
arm’s length amount and issue a revised assessment accordingly.

11.2.2.1 DIPN No. 60 ‘Attribution of Profits to Permanent Establishments in Hong Kong’

DIPN No. 60, issued in July 2019, offers guidance on the application of the transfer pricing Rule
2 as codified in s.50AAK, including the application of the separate and independent enterprise
principle, determination of profits attributable to a Hong Kong permanent establishment of a
non-Hong Kong resident person, definition and types of permanent establishments, etc.

DIPN No. 60 clarifies that while Rule 2 in s.50AAK requires the income or loss of a non-Hong
Kong resident person attributable to the person’s permanent establishment in Hong Kong to
be determined as if the permanent establishment were a distinct and separate enterprise, the

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provisions in s.50AAK have not changed the rules that define a permanent establishment. If the
non-Hong Kong resident person is a tax resident of a jurisdiction which has a DTA with Hong
Kong, it is necessary to refer to the relevant DTA to determine whether the non-Hong Kong
resident person has a permanent establishment in Hong Kong. If the non-Hong Kong resident
person is not a tax resident of a jurisdiction which has a DTA with Hong Kong, it is necessary to
refer to Part 3 of Schedule 17G to determine whether the non-Hong Kong resident person has
a permanent establishment in Hong Kong (See Chapter 8 for details).

DIPN No. 60 also clarifies that the broad guiding principle as explained in DIPN No. 21
(Revised) would not be affected as a result of the enactment of Rule 2. Rule 2 requires the
attribution of the profits of a non-Hong Kong resident person to its permanent establishment
in Hong Kong as if the permanent establishment were a distinct and separate enterprise,
taking into account the functions performed, assets used and risks assumed by the non-Hong
Kong resident person through the permanent establishment. After the attribution of profits
to the permanent establishment in Hong Kong, the broad guiding principle would be applied
to determine whether such profits should be taxed, and, if so, to what extent. In deciding the
source of profits, the broad guiding principle is to see what has been done to earn the profits in
question and where the operations have been performed (See Chapter 3 for details).

Illustrative Example 2 – Transfer Pricing Rule 2

In 2018, BVI Limited (with a credit ranking as BBB) granted a loan to the HK
representative office at 6% interest rate to finance its material procurement activities.
Assume that the fair market interest rate for companies with credit ranking as BBB is 5%.
Regardless of the terms and conditions in the loan contract, the interest rate of the intra-
company loan shall be adjusted to 5%, the rate at which an entity with the same credit
ranking as the company would charge for independent loans between third parties.

Key Learning Point

Transfer Pricing Rule 1 empowers the IRD to adjust the transfer price for transactions
between two related parties.

Transfer Pricing Rule 2 empowers the IRD to adjust the transfer price for transactions
between two parts of the same company, for example, head office and branch.

Knowledge Check Question

Question 1
Explain the two fundamental transfer pricing principles under the IRO.

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1 1 . 3
DOCUMENTATION REQUIREMENTS

The Inland Revenue (Amendment) (No. 6) Ordinance has introduced a new Part 9A into the
IRO, which implements a ‘three-tier’ transfer pricing documentation requirement in Hong Kong
consisting of the following:

1. Local file;

2. Master file; and

3. Country-by-country (CbC) reporting.

In July 2019, the IRD issued DIPN No. 58 ‘Transfer Pricing Documentation and Country-
by-Country Reports’, which clarifies a number of issues surrounding the documentation of
transfer pricing and CbC reports. The IRD has clarified that it will follow an OECD-compliant
approach to documentation of transfer pricing. This centers on a three-tiered approach
including all of the following:

1. A CbC report containing information related to the global allocation of income and
taxes paid as well as certain indicators of the location of economic activities of a
multinational enterprise (MNE) group. Such a report requires aggregate tax information
for the jurisdictions involved. This should include income allocated, taxes paid and
economic indicators related to economic activities (e.g. number of employees, stated
capital, retained earnings, tangible assets for each jurisdiction in which the MNE
operates, etc.).

2. A master file, typically prepared by the ultimate parent entity of a group, containing
standardised information relevant for all constituent entities of the group. This contains
a high-level overview of the group’s global operations and policies (i.e. organisational
structure, description of business, intangibles, intercompany financial activities and
financial and tax positions).

3. A local file referring to material transactions of a specific constituent entity of the

group. The local file is more detailed than the master file and contains transactional
information that can be used for transfer pricing analysis. Note that the local file does
not need to contain all cross-border transactions. It is up to the taxpayer to determine
which transactions are material and necessary to ensure comparability.

Note that the IRD does not require the taxpayer to file the master file and local file, but the
taxpayer must declare whether this documentation was prepared. Typically, these two files are
updated annually.

11.3.1 Local and Master File

Unless exempted, Division 2 of Part 9A of the IRO requires that a Hong Kong entity of a
corporate group that is required to prepare consolidated financial statements must prepare,
within nine months after the end of each accounting period of the entity, a local file. In
addition, the entity must also prepare, within nine months after the end of the accounting
period of the group, a master file. The entity must retain the files for a period of not less than

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seven years after the end of the entity’s accounting period. The files must be in the English or
Chinese language.

For the local file, it must report some prescribed information specified in Schedule 17I of
the IRO at the entity level such as:

1. Subject entity related:

a. A description of the management structure of the subject entity, an organisation
chart of the subject entity, and a description of the individuals to whom the subject
entity’s management reports and the territory or territories in which the individuals
maintain their principal offices;

b. A detailed description of the business and business strategy; and

c. A list of key competitors.

2. Controlled transaction related:

a. A description of the material controlled transactions and the context where the
transactions took place;

b. The amount of payments and receipts among the subject entity and its
associated entities;

c. An identification of the subject entity’s associated entities involved;

d. Copies of all material agreements concluded by the subject entity with any of its
associated entities;

e. A detailed comparability and functional analysis of the subject entity and the
relevant associated entities;

f. An indication of the most appropriate transfer pricing method and the reasons for
selecting that method;

g. An indication of which associated entity is selected as the tested party and the
reasons for that selection;

h. A summary of the important assumptions made in applying the transfer pricing

methodology;

i. If applicable, an explanation of the reasons for performing a multi-year analysis;

j. A list and description of the selected comparable uncontrolled transactions (internal

or external), if any, and information on the financial indicators that are relied on
in the transfer pricing analysis, including a description of the comparable search
methodology and the source of such information;

k. A description of any comparability adjustments performed, and an indication

of whether adjustments have been made to the results of the tested party, the
comparable uncontrolled transactions, or both;

l. A description of the reasons for concluding that the controlled transactions were
priced on an arm’s length basis based on the application of the selected transfer
pricing method;

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m. A summary of financial information used in applying the transfer pricing

methodology; and

n. A copy of existing unilateral, bilateral and multilateral advance pricing agreements

and arrangements and other tax rulings that are related to the controlled
transactions.

3. Financial information related:

a. The subject entity’s audited financial statements for the subject accounting period
or, if no audited financial statements exist, the subject entity’s existing unaudited
statements for the subject accounting period;

b. Information and allocation schedules showing how the financial data used in
applying the transfer pricing method may be tied to the financial statements; and

c. Summary schedules of the financial data relating to the comparables used in the
analysis and the sources from which that data was obtained.

For the master file, it must report some prescribed information specified in Schedule 17I of
the IRO at the group level such as:

1. In relation to organisational structure, a chart illustrating:

a. The group’s legal and ownership structure; and

b. If the group is a multinational enterprise group, geographical location of constituent

entities of the group.

2. In relation to description of the group’s business:

a. A general written description of the group’s business, including important drivers of

business profits;

b. A description of the supply chain for the group’s five largest products or service
offerings by turnover and for any other products or services amounting to more
than 5% of group turnover;

c. A list and brief description of important service arrangements (other than those
relating to research and development services) between constituent entities of
the group, including a description of the capabilities of the principal locations
providing the services and transfer pricing policies for allocating services costs and
determining prices to be paid for the services;

d. A description of the main geographic markets for the group’s products and services
that are referred to in subparagraph (b);

e. A brief written functional analysis describing the principal contributions to value

creation (including key functions performed, important risks assumed, and
important assets used) by individual constituent entities within the group; and

f. A description of important business restructuring transactions, acquisitions and

divestitures occurring during the corresponding accounting period of the group.

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3. In relation to the group’s intangibles:

a. A general description of the group’s overall strategy for the development,

ownership and exploitation of intangibles, including location of principal research
and development facilities and location of research and development management;

b. A list of intangibles or categories of intangibles of the group that are important for
transfer pricing purposes, identifying which constituent entities of the group legally
own or effectively control the intangibles;

c. A list of important agreements among the group’s constituent entities related to

intangibles;

d. A general description of the group’s transfer pricing policies related to research and
development and intangibles; and

e. A general description of any important transfers of interests in or control

of intangibles among the group’s constituent entities during the group’s
corresponding accounting period, including the constituent entities, territories and
compensation involved.

4. In relation to the financial activities between constituent entities of the group:

a. A general description of how the group is financed, including important financing

arrangements with unrelated lenders;

b. The identification of any constituent entity (financing entity) of the group that
provides a central financing function for the group, including the territory under
whose laws the financing entity is organised and the place of effective management
of the financing entity; and

c. A general description of the group’s general transfer pricing policies related to

financing arrangements among the group’s constituent entities.

5. In relation to the group’s financial and tax positions:

a. The group’s consolidated financial statements for the corresponding accounting

period; and

b. A list and brief description of the group’s existing unilateral advance pricing
agreements and arrangements and other tax rulings relating to the allocation of
income among territories.

An entity is not required to prepare a local file or a master file if any two of the following
conditions are satisfied in respect of the entity’s accounting period:

1. The total amount of the entity’s revenue for the accounting period does not exceed
HK$400 million;

2. The total value of the entity’s assets at the end of the accounting period does not
exceed HK$300 million; and

3. The average number of the entity’s employees during the accounting period does not
exceed 100.

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In respect of the local file, an entity is not required to report a category of related-party
transactions if the total amount of that category of transactions undertaken by the entity does
not exceed the following thresholds in an accounting period:

• For transfers of properties (excluding financial assets and intangibles): HK$220 million;

• For transactions in respect of financial assets: HK$110 million;

• For transfers of intangibles: HK$110 million; and

• For any other transactions: HK$44 million.

If an entity is not required to prepare a local file in respect of all of the preceding categories
of transactions, then it is also not required to prepare the master file.

11.3.2 Country-by-country Reporting

Division 3 of Part 9A of the IRO follows the OECD CbC reporting requirements, under which
a CbC report must be filed in respect of a group whose annual consolidated group revenue
reaches the specific threshold amount to provide annually and for each tax jurisdiction in which
the group does business, information such as the amount of revenue, profit before tax, tax
paid and accrued, capital and assets.

Under Division 3 of Part 9A of the IRO, if the ultimate parent company of a multinational
enterprise group is tax resident in Hong Kong, then the Hong Kong parent company must file
a CbC report if the group’s total consolidated group revenue meets the specified threshold
amount of HK$6.8 billion. A multinational group means a group that is required to prepare
consolidated financial statements and has two or more enterprises that are tax resident in
different jurisdictions (or has a single enterprise that is tax resident in one jurisdiction with a
permanent establishment that is tax resident in another jurisdiction). However, if:

1. The ultimate parent company of a multinational enterprise group is tax resident outside
Hong Kong (e.g. in Country R);
2. The total consolidated group revenue was at least the equivalent of €750 million as at
January 2015 or a lower amount as specified by Country R; and

3. One of the group companies is tax resident in Hong Kong;

then, the Hong Kong company must inform the IRD, within three months after the end of the
accounting period, of some details of the ultimate parent company in order to enable the IRD
to obtain a CbC report directly from Country R.

In the case that the IRD is unable to obtain the CbC report from Country R, the Hong Kong
entity of this reportable multinational group may have secondary obligation to be required to
file a CbC return with the Commissioner if any of the following conditions are met:

1. The ultimate parent company is not required to file a CbC report in its jurisdiction of tax
residence (Country R);

2. Country R has a current international agreement with Hong Kong providing for the
automatic exchange of tax information but, by the deadline for filing the CbC return,
there is no exchange arrangement in place between Country R and Hong Kong for CbC
reports; and

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3. There has been a systemic failure to exchange CbC reports by Country R, which has
been notified to the Hong Kong entity by the Commissioner.

However, the Hong Kong entity may be released from the secondary obligation if:

1. Another Hong Kong entity of the reportable group has filed the CbC return for the
relevant period; and

2. A CbC report is filed by the reportable group’s surrogate parent entity resident in
another jurisdiction (Country S) and exchange mechanisms are in place between
Country S and Hong Kong.

For CbC reporting purposes, the multinational group may nominate another group
company as the surrogate parent company. Effectively, the surrogate parent company will be
considered as the ultimate parent company for all of the preceding provisions.

For accounting periods beginning on or after 1 January 2018, each obligated Hong Kong
entity of a reportable group must file a written note with the Commissioner, informing the
Commissioner of the primary information regarding the Hong Kong entity/entities and the
ultimate parent entity, within three months after the end of the accounting period. The filing
deadline of a CbC return shall be the earlier of the following dates:

• The date on which a period of 12 months after the end of the accounting period
expires; and

• The date specified in an assessor’s note.

Whereas, the filing deadline may apply a foreign filing date if the following
conditions are met:

• A Hong Kong entity (not being a HK ultimate parent entity) is required under s.58F; and

• The date by which a CbC report for the accounting period is required to be filed by the
laws or regulations of the jurisdiction of tax residence of the surrogate parent entity
concerned (foreign filing fate) is later than the Hong Kong CbC return filing deadline.

A reportable group’s ultimate parent company resident for tax purpose in Hong Kong may
voluntarily file a CbC return for an accounting period beginning on or after 1 January 2016 but
before 1 January 2018. The filing schedule applies to reportable ultimate parent companies. For
Hong Kong entities of secondary obligation to file the CbC return for its reportable group, the
filing schedule is based on requirements by local tax authorities.

The CbC reporting requirement consists of two main templates. The first template requires
the reportable group to disclose financial and other data by jurisdiction. The second template
requires the group to disclose its scope of business activities in each tax jurisdiction. Taxpayers
are required to submit the information to the IRD electronically in the form of an XML
document. Exhibits 11.1 and 11.2 illustrate the types of information that is required for CbC
reporting.

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Name of the MNE group:

Accounting period concerned:
Currency:
Tax Revenues Profit Income Income Stated Accu- Number Tangible
juris- (loss) tax paid tax capital mulated of assets
diction Un- Related Total before (on cash accrued earnings emp- other
related party income basis) – current loyees than cash
party tax year and cash
equi-
valents

EXHIBIT 11.1 Overview of allocation of income, taxes and business activities by tax jurisdiction

Name of the MNE group:

Accounting period concerned:
Main business activities
Tax jurisdiction of organisation
Constituent entities resident

or incorporation if different

Purchasing of procurement

entity to be specified in the

Research and development

activity of the constituent

management or support

‘Additional Information’
Holding shares or other
from tax jurisdiction of

Provision of services to

Internal group finance

in the tax jurisdiction

Others (nature of the

intellectual property

Sales, marketing or

Regulated financial

equity instruments
Holding/managing

Manufacturing or

unrelated parties
Administrative,
Tax jurisdiction

distribution
production

Insurance
residence

Dormant
services

services

section)
1.
2.
1.
2.

EXHIBIT 11.2 List of all the constituent entities of the MNE group included in each aggregation
per tax jurisdiction

The data presented per country – especially the financial data – is based on aggregated
numbers, rather than a normal accounting-based consolidation.

Considering the complex business activities in which an MNE can be involved, the practical
question would be what is the source of ‘such activities performed’ filed in the CbC reports
(e.g. a functional analysis or a summary of its activities based on the chamber of commerce
registration).

CbC reports are to be exchanged automatically with tax authorities in different jurisdictions
under the relevant exchange of information arrangements. For discussion of the exchange of
information arrangements, please refer to Section 10.5.3.7 of Chapter 10.

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Illustrative Example 3 – Documentation Requirements

In the Opening Case, HK Limited will be required to prepare a local file and a master
file unless any two of the following conditions are satisfied in respect of the entity’s
accounting period:

1. The total amount of the entity’s revenue for the accounting period does not exceed
HK$400 million.

2. The total value of the entity’s assets at the end of the accounting period does not
exceed HK$300 million.

3. The average number of the entity’s employees during the accounting period does
not exceed 100.

Since HK Limited’s total revenue was HK$500 million and it had 150 employees, it is
over the threshold for these two conditions. Thus, it is not exempt from preparing the files.

Furthermore, if the group’s consolidated revenue exceeded the equivalent of EUR750

million, HK Limited would have to notify the IRD within three months after the end of the
accounting period in order for the IRD to obtain the group’s CbC report from BVI.

Key Learning Point

There is a ‘three-tier’ transfer pricing documentation requirement in Hong Kong. The local
file reports prescribed information at the entity level. The master file reports prescribed
information at the group level. The CbC report requires a multinational enterprise group to
disclose financial data and other business information of its entities by jurisdiction.

Knowledge Check Questions

Question 2
Explain when a company is required to prepare a local file and master file in respect of
transfer pricing transactions.

Question 3
Explain when a Hong Kong company is required to file a CbC report.

1 1 . 4
ADVANCE PRICING ARRANGEMENTS

Pursuant to DIPN No. 48, paragraph 4, an advance pricing arrangement (APA) is defined as
‘an arrangement that determines, in advance of controlled transactions, an appropriate set of
criteria (e.g. method, comparables and appropriate adjustments thereto, critical assumptions
as to future events) for the determination of the transfer pricing for those transactions over

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a fixed period of time’. An APA allows taxpayers to reach agreement with the IRD on the
transfer pricing methodology as the issues arise rather than years later under IRD enquiry
or investigation. It is most suitable for complex transactions with high transfer pricing risk
such as those where few comparables can be found, a significant amount of tax is involved,
or significant profits are shifted out of Hong Kong. An APA helps to prevent costly and
time-consuming transfer pricing audits and litigations. An APA may also be extended in order
to prolong the advantages.

An APA can be unilateral, bilateral or multilateral. A unilateral APA is an agreement between

the taxpayer and the Commissioner only. It does not involve a tax treaty partner and does not
guarantee that the tax treaty partner will accept the terms of the APA. A bilateral APA is an
arrangement between the Commissioner and the tax authority of a DTA partner. It is made
under the Mutual Agreement Procedures article of a DTA. It guarantees that tax treaty partners
will accept the terms of the APA and therefore the risk of double taxation will be eliminated.
A multilateral APA is similar to a bilateral APA except the tax authorities of more than two
jurisdictions are involved in the agreement.

The IRD introduced the APA scheme in April 2012 under its power of general administration
of the IRO through the issuance of DIPN No. 48, which sets out the detailed application
procedures. DIPN No. 48 has set the following minimum threshold for an APA application
based on the nature of the related-party transaction as follows:

• HK$80 million per year for purchase and sale of goods;

• HK$40 million per year for provision of services;

• HK$20 million per year for the use of intangibles (e.g. royalty);

• Business profits of HK$20 million per year if it relates to the attribution of profit to a
permanent establishment in Hong Kong; and

• HK$20 million per year if it relates to transactions other than the above.

It is also the IRD’s position as stated in DIPN No. 48 that it views bilateral or multilateral APA
applications more favourably than a unilateral APA in terms of the level of certainty provided.

Recently, the Inland Revenue (Amendment) (No. 6) Ordinance 2018 has introduced a
statutory APA system into the IRO. In particular, s.50AAP of the IRO provides that the IRD
may make an advance pricing arrangement with a taxpayer if the IRD considers it appropriate.
Therefore, it seems that the IRD has a wide discretion in whether to accept an APA application
or not under the statutory regime.

11.4.1 Key Points of the Advance Pricing Arrangements Framework

11.4.1.1 Content of Hong Kong Advance Pricing Arrangements
Pursuant to s.50AAP of the IRO, the APA must contain the following subjects:

1. The name of the person to which the arrangement applies;

2. The transactions covered by the arrangement, if applicable;

3. The period covered by the arrangement;

4. The methodology as agreed between the Commissioner and the person for
determining the income or loss of the person;

5. The critical assumptions on which the agreed methodology is based;

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6. The person’s obligations under the arrangement; and

7. Any other terms as agreed between the Commissioner and the person.

The IRD provides a flexibility to the taxpayers by limiting APA applications to specified
controlled transaction instead of covering all of the transfer pricing issues of a taxpayer.
S.50AAQ(4) of the IRO also provides a ‘rollback’ clause as suggested in BEPS Action 14 to
taxpayers to allow the APA to cover a previous period under the condition of not affecting tax
liability of the taxpayers.

11.4.1.2 Assurance Provided by Advance Pricing Arrangements

An APA process requires a prudent and appropriate design of predictions and critical
assumptions based on the awareness and knowledge of facts and circumstances. At the
conclusion of an APA process, the Commissioner is bound by the terms suggested therein
with no transfer pricing adjustment to be made as long as the taxpayer follows the terms of
agreements. Pursuant to s.50AAR of the IRO, the Commissioner is allowed to revoke, cancel or
revise an APA if

1. Any condition or critical assumption is no longer met;

2. The person has failed to comply with its obligations; or

3. Incorrect information has been provided in the application for the APA.

11.4.1.3 Time Frame
Pursuant to DIPN No. 48, the tentative timeframe for concluding an APA is 6 months for
the early engagement stage; and 18 months for the APA application stage. For bilateral or
multilateral APAs, the timeframe would also depend on the progress of negotiation with the
competent authorities of the relevant DTA territories. Generally, a longer timeframe is required
in more complex cases.

11.4.1.4 Threshold
Pursuant to s.50AAP(3) of the IRO, an application for APA may be refused by the
Commissioner if:

1. The APA is to apply to more than one person, and any of the persons has income or
loss to be computed for the purpose of Hong Kong tax, but is not the one (or one of the
persons) making the application for the APA, and the person fails or refuses to join in
the application; or

2. If any fee or deposit for the fee payable for the application for APA is not paid.

Although the nature of APA proceedings may de facto limit the accessibility to large
taxpayers, the tax administrations need to consider the equality and uniformity to all taxpayers
involved in multinational transactions, as suggested in OECD TP Guidelines.

In terms of Hong Kong practice, any Hong Kong resident enterprise or a non-resident
enterprise with a permanent establishment in Hong Kong, chargeable to Hong Kong profits
tax and having controlled transactions, may apply for an APA. Conversely, the IRD grants the
Commissioner rights to refuse APA applications without providing specific grounds, in addition
to the threshold quantities for applying for an APA as stated above.

While the above thresholds are operated consistently, the Commissioner after taking into

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 TAXATION

account the number and relative size of the transactions, the transfer pricing risk and the
likely attitude of the DTA territories, may relax the eligibility criteria to allow a person access to
the APA process. Besides, the Commissioner expects to consider bilateral or multilateral APA
applications rather than unilateral APA applications except where:

1. the person or associated persons are resident in a jurisdiction with which Hong Kong
has no DTA;

2. the relevant DTA territory has no APA process or will not process the bilateral or
multilateral APA application;

3. the bilateral or multilateral APA sought is not technically meaningful and cost-effective
from Hong Kong’s perspective (e.g. Hong Kong is at the hub of arrangements with
associated persons in many different jurisdictions and the trade flows involved with any
one particular jurisdiction are relatively modest in scale); or

4. most of the transfer pricing risk lies in Hong Kong.

11.4.1.5 Enhancement of Mutual Expectation

While the APA process is a statutory one, it is a co-operative process requiring a relationship of
mutual trust to achieve an effective outcome. In building mutual trust as part of a constructive
relationship, expectations that the stakeholders may have of each other include the following:

(a) all parties will co-operate fully with each other, including undertaking open and ongoing
dialogue in the development of the APA;

(b) each APA request will be treated on its merits according to its own facts;

(c) each party will act transparently, in particular each party will disclose all relevant and
material facts;

(d) each party will provide prompt and complete replies to any reasonable queries.

11.4.2 Application Procedures

Any enterprise that is resident in Hong Kong or any enterprise that is not resident in Hong Kong
but have a permanent establishment in Hong Kong that is chargeable to profits tax may apply
for an APA.

DIPN No. 48 sets out five stages to the APA process:

• Stage 1: Pre-filing;

• Stage 2: Formal application;

• Stage 3: Analysis and evaluation;

• Stage 4: Negotiation and agreement; and

• Stage 5: Drafting, executing and monitoring.

These five stages will now be described in detail.

(Note that in the new version of DIPN No. 48 (Revised) issued in July 2020, the APA
process has been revised to reflect a principle-based approach, a more streamlined process,
and revamped procedures to improve timeliness. This revised APA process was issued
after the examination cut-off date of 31 May 2020 and thus will not be examined in the

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examinations in 2021.)

11.4.2.1 Stage 1: Pre-filing
Before making a formal application for an APA, the taxpayer should request for a pre-filing
meeting by writing well in advance to the ‘Senior Assessor (APA)’ in the Tax Treaty section
of the IRD, because pre-filing meetings should commence at least six months before the
anticipated commencement date for the APA. Next, the enterprise should submit the APA
proposal together with a draft APA case plan (a structured timeline and work plan) to the IRD
no later than one month before the scheduled pre-filing meeting date. The APA proposal and
its supporting information/documentation should describe the specific transactions, products,
businesses or arrangements that will be covered by the APA. In addition, the proposal should
also describe the proposed transfer pricing methodology, assumptions underpinning the
proposal and any pertinent collateral tax issues raised by the proposed methodology.

The purpose of the pre-filing meeting is for the enterprise and the IRD to discuss the
requirements of the proposed APA. It also allows the IRD to make an informed judgement on
whether the application for an APA will be acceptable. The agenda for the pre-filing meeting will
normally include the following items:

1. Identify the nature and scope of the APA process – purpose of the APA process,
mutual expectations, the five stages of the APA process, exchange of information and
communication, collateral issues, if any;

2. Identify the specific matters to be agreed – bilateral or multilateral APA, new or renewal

APA, the term of the APA; and

3. Discuss in detail the APA process.

In the pre-filing meeting, the IRD will define the scope of the APA, identify the collateral
issues (if any) and work out the resolution approaches.

For illustration purposes, DIPN No. 48 has provided the following examples of possible
collateral issues:

1. Whether the covered controlled transactions involve a permanent establishment;

2. Whether the nature of income is royalty or business profits;

3. Whether the profits of an associated enterprise overseas are chargeable under s.20 of
the IRO (which has already been repealed);

4. Whether the covered controlled transactions constitute, include or relate to

transactions under ss.61 or 61A of the IRO (e.g. the business structure); and

5. Any legal issues on which the IRD has not taken a position.

After the pre-filing meeting, the IRD will decide whether or not to accept the enterprise into
the APA process. If the enterprise is accepted, it will be invited to submit a formal application.
However, if the enterprise is not accepted, the IRD will give reasons for that decision.

11.4.2.2 Stage 2: Formal Application

If the enterprise wishes to proceed, it should submit a formal application within the time frame
previously agreed with the IRD at the pre-filing stage. As the IRD anticipates that most APAs
would be bilateral or multilateral, the enterprise should also submit a formal APA application to
the tax authorities in other appropriate jurisdictions.

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The IRD does not prescribe a set format for an APA application. However, it should include
the following details:

1. A functional analysis and industry analysis;

2. Details of the proposed transfer pricing methodology;

3. The terms and conditions governing the application of the transfer pricing methodology
including critical assumptions;

4. Data showing that the transfer pricing methodology will produce an arm’s length result; and

5. Information/documentation as agreed in the pre-filing meeting.

Within one month, the IRD will enquire with the relevant tax treaty partners to see whether
they wish to participate in the APA process. If yes, a timetable for the APA process will also be
established.

11.4.2.3 Stage 3: Analysis and Evaluation

After the enterprise has submitted the formal application, the IRD will analyse and evaluate
the data submitted. During the process, the IRD may contact the enterprise to discuss and
clarify the information/document submitted or to request for any other relevant information/
document. The general approach of the IRD is to perform a critical analysis of the APA
application rather than undertaking original work to establish the arm’s length outcome. In
other words, the IRD will analyse and evaluate the APA application and determine whether the
proposed transfer pricing methodology is appropriate or not. If the IRD does not agree with the
enterprise, the IRD will seek to reach a mutually acceptable agreement with the enterprise.

In complex cases, the IRD may request the enterprise at its own expense to provide an
independent expert who will review and evaluate the enterprise’s proposed transfer pricing
methodology. The expert is expected to comment critically on the enterprise’s economic study,
address any questions and concerns that the IRD may have and provide an opinion whether
the proposed transfer pricing methodology is supportable under the arm’s length principle.

The IRD will consider the independent expert’s opinion in analysing and evaluating the
enterprise’s APA application. Finally, the IRD may also hire its own expert, at its own expense, to
review the enterprise’s proposal or the independent expert’s opinion.

11.4.2.4 Stage 4: Negotiation and Agreement

After the IRD has completed the analysis and evaluation of the APA application, the enterprise
will submit an application for a mutual agreement procedure (MAP) to the IRD. Then, the IRD
will endeavour to reach an agreement on the APA terms with the DTA partner(s) in consultation
with the enterprise. The IRD will prepare the draft APA terms in consultation with the enterprise
to ensure that they have a common understanding of the issues to be agreed in the APA. They
will also form the basis for negotiation with the DTA partner(s).

While the enterprise does not have a right to be present at competent authority
negotiations, it may be allowed to be present if all competent authorities agree. If this
permission is not forthcoming, the IRD may give the enterprise an opportunity to present its
case to the IRD representative alone.

If agreement is reached after negotiation with the DTA partner(s), the IRD will formalise a MAP
arrangement with the DTA partner(s) in consultation with the enterprise. The MAP arrangement
will specify the acceptable transfer pricing methodology, its application and critical assumptions.

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The enterprise has the right to accept or reject the MAP arrangement. If the enterprise rejects it,
the APA process will come to an end and the enterprise will not be offered any unilateral APA.

If the IRD is unable to reach an agreement with the DTA partner(s), then the IRD may offer a
unilateral APA to the enterprise if it also agrees.

11.4.2.5 Stage 5: Drafting, Executing and Monitoring

If the enterprise accepts the MAP arrangement, the IRD will enter into a bilateral/multilateral
APA with the DTA partner(s).

It is generally expected that a concluded APA would contain at least the following
information:

1. The names and addresses of the parties to the APA;

2. The controlled transactions covered by the APA;

3. The period and tax years covered by the APA;

4. The agreed transfer pricing methodology and its application to the covered controlled
transaction (e.g. the calculation of gross profit or net operating profit margin);

5. If applicable, the arm’s length range agreed under the APA;

6. A definition of relevant terms which have formed the basis of calculating the transfer
pricing methodology (e.g. sales, cost of sales, operating profit, etc.);

7. The accounting standards on which the financial statements are based;

8. Critical assumptions on which the transfer pricing methodology is based;

9. Procedures to be followed if it is necessary to make compensating adjustments; and

10. The enterprise’s consequential obligations as a result of the agreement to the

APA (e.g. the enterprise’s obligation to submit annual compliance reports and the
enterprise’s record keeping requirements).

An APA will have prospective application and will apply to future transactions only. The
commencement date will be discussed at the pre-filing stage and will be specified in the APA.
An APA is generally valid for three to five years and, if certain conditions are satisfied, may be
extended on the same terms for a further period of three to five years with the consent of all
the parties to it, including the DTA partner(s).

11.4.3 Benefits of an Advance Pricing Arrangement

The following are the benefits of an APA:

• An APA provides greater certainty on the tax liability. The taxpayer can be certain that
the proposed transfer pricing methodology will be acceptable to the IRD.

• An APA ensures a fair application of the arm’s length principle. Through negotiations
between the taxpayer, the IRD and other tax jurisdictions during the APA process, it
ensures that the arm’s length determination will be acceptable to everyone.

• An APA reduces the risk of double taxation. If the APA is bilateral in nature, it ensures
that the other jurisdiction will also accept the transfer price and therefore reduce the
risk of any double taxation.

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• An APA avoids the risk of audit and penalty. Transfer pricing audits are costly and time
consuming. If the IRD has already accepted the proposed transfer pricing methodology,
there is less chance that the company will be selected for audit as long as it applies the
agreed methodology.

• Typically, APAs are being requested for the more complex type of intercompany
transactions, which could have a significant impact on locally reported taxable income.

Illustrative Example 4 – Advance Pricing Arrangement

In the Opening Case, in order to be certain on whether the transfer prices are acceptable
to the IRD, HK Limited could apply for an APA. It should be noted that there are two
hurdles to overcome before applying for an APA. First, the threshold requirement
must be satisfied. Specifically, in relation to purchase and sale of goods, the minimum
threshold is HK$80 million per year. HK Limited satisfies this condition. Second, the IRD
anticipates that most APAs should be bilateral. As there is a DTA between Hong Kong and
the UK, the second condition is also satisfied.

Key Learning Point

There are five stages to the advance pricing arrangement process: (1) pre-filing; (2) formal
application; (3) analysis and evaluation; (4) negotiation and agreement; and (5) drafting,
executing and monitoring.

Knowledge Check Questions

Question 4
Identify the application stages of an advance pricing arrangement.

Question 5
Explain the benefits of an advance pricing arrangement.

1 1 . 5
RELIEF FROM DOUBLE TAXATION

Generally, there are two types of international double taxation: (1) economic double taxation;
and (2) juridical double taxation. Economic double taxation arises where two companies that
are resident in different jurisdictions are taxed on the same profit or income. Juridical double
taxation occurs where a company is taxed on the same profit or income in two different
jurisdictions.

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It should be noted that where the tax administration of another jurisdiction makes a
transfer pricing adjustment and no Double Taxation Agreement/Arrangement (DTA) exists
between Hong Kong and that jurisdiction, there will be no relief from any resultant double
taxation. Therefore, the following discussion assumes the existence of a relevant DTA between
Hong Kong and the foreign jurisdiction that is based on the OECD Model.

11.5.1 Economic Double Taxation

If a DTA partner jurisdiction has made a transfer pricing adjustment and the IRD considers it
as correct both in principle and amount, then the IRD will make a corresponding adjustment
(i.e. revise the Hong Kong tax assessment in accordance with the adjusted transfer price as
determined by the foreign jurisdiction) in accordance with the Associated Enterprises article
of the DTA (e.g. Article 9 of the OECD Model) and s.79 of the IRO. The claim must be made
within six years of the end of the relevant year of assessment. To enable a DTA state to give
effect to its relevant DTA obligations and general domestic law provisions, the Commissioner
will, on request, exchange information about any transfer pricing adjustment it makes with
the competent authority of a DTA partner state, unless the DTA does not contain a provision
specifically directed at the obligation to provide relief from economic double taxation.

If a DTA partner jurisdiction has made a transfer pricing adjustment, but the IRD does not
consider it as correct either in principle or amount, then the IRD will not be obliged to make any
corresponding adjustment. For example, the Commissioner will not accept a sum as a non-taxable
dividend even if the tax administration of a DTA state treats the profits shifted to a Hong Kong
enterprise to be a ‘deemed dividend’. The nature of the sum accrued to the Hong Kong enterprise
would remain unchanged. A trading receipt will continue to be assessed as a trading receipt under
the IRO though it is deemed by the tax administration of a DTA partner state as dividend paid to
the Hong Kong enterprise. However, the taxpayer may request the competent authorities of Hong
Kong and the foreign jurisdiction to resolve the disagreement under the MAP article (e.g. Article 25
of the OECD Model). It is important to note that the MAP procedure only requires the competent
authorities to consult with each other with a view to resolving double taxation but it does not
compel agreement. If the competent authorities cannot reach any agreement, no relief will be
available to the taxpayer. If an agreement can be reached, the IRD will adjust the Hong Kong
taxpayer’s assessment under s.50AAN of the IRO. The claim must be made within six years of the
end of the relevant year of assessment or the end of two years from the date when the transfer
pricing adjustment is made by the foreign jurisdiction, whichever is the later.

Where no double tax agreement exists, there are no provisions under the IRO permitting an
exemption of the profits or a deduction where no expenditure has been incurred. Conclusively,
no transfer pricing adjustment by a non-DTA state can be made to the profits of the Hong Kong
enterprise.

Illustrative Example 5 – Economic Double Taxation

(Adapted from Example 1 of DIPN No. 45)

Company F is a resident in Country F, a DTA state, and provided goods for no

consideration to its wholly owned subsidiary, Company HK, a company resident in
Hong Kong. Country F subjected Company F to tax audit and increased the profits
of Company F by HK$100,000 on the basis that if Company F and Company HK had
transacted with each other on an arm’s length basis, Company HK would have paid
Company F HK$100,000 for the goods.

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Illustrative Example 5 (continued)

The resultant economic double taxation may be relieved by:

1. The Commissioner agreeing that HK$100,000 reflects an arm’s length price and
reduces the tax payable by Company HK accordingly (i.e. reduce HK$16,500 of tax if
the profits tax rate is 16.5%); or

2. The tax administration of Country F being convinced that its adjustment is incorrect
and accordingly reduces the additional tax payable by Company F (e.g. through
domestic review, objection or appeal processes in Country F); or

3. The reaching of agreement between both competent authorities under the MAP
Article of the relevant DTA.

Apply and Analyse 1
In the Opening Case, assume the transfer price was set at HK$450 per chair so that HK
Limited earns a profit of HK$350 (HK$450 – HK$100) and the UK Limited only earns a
profit of HK$50 (HK$500 – HK$450). If the UK tax authority does not agree and adjusts the
transfer price to the equivalent of HK$200 so that UK Limited now earns a profit of HK$300
(HK$500 – HK$200), explain what the group can do in order to alleviate the resultant
double taxation.

Analysis

This is a case of economic double taxation. HK Limited is allocated a profit of HK$350

and UK Limited is allocated a profit of HK$300 for a total of HK$650. However, the actual
profit made by the group was only HK$400 (HK$500 – HK$100). First, the group can try
to persuade the UK tax authority that the transfer price it assessed is incorrect. Second,
the group can ask the HK IRD to accept the transfer price set by the UK tax authority and
adjust the profit made by HK Limited. Third, the group may request the HK and UK tax
authorities to enter into a mutual agreement procedure under the DTA between HK and
the UK in order to agree on the transfer price.

11.5.2 Juridical Double Taxation

If a DTA partner jurisdiction has made a profit reallocation adjustment and the IRD considers
it as correct both in principle and amount, then the IRD will allow the Hong Kong company to
claim a tax credit under s.50 of the IRO for the foreign tax paid. The tax administration of a DTA
state may make a profit reallocation adjustment to:

1. A Hong Kong enterprise carrying on business through a permanent establishment in

the DTA state; or

2. An enterprise resident in the DTA state carrying on business through a permanent

establishment in Hong Kong.

The Commissioner will provide relief from juridical double taxation only to the extent
that the Commissioner agrees both in principle and in amount with the profit reallocation

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adjustment made by the DTA state. The claim must be made not later than two years after the
end of the relevant year of assessment.

If a DTA partner jurisdiction has made a transfer pricing adjustment but the IRD does not
consider it as correct either in principle or amount, then the IRD will not be obliged to grant the
foreign tax credit. However, the taxpayer may request the competent authorities of Hong Kong
and the foreign jurisdiction to resolve the disagreement under the MAP Article (e.g. Article 25 of the
OECD Model). There are two stages to the mutual agreement procedure. The first stage involves
the taxpayer and the competent authority of its residence state. The second stage involves the
endeavours of the competent authorities of both states to resolve the case. The claim must be made
within six years of the end of the relevant year of assessment or the end of two years from the date
when the transfer pricing adjustment is made by the foreign jurisdiction, whichever is the later.

Pursuant to DIPN No. 45, where juridical double taxation arises for a Hong Kong enterprise
that is subject to a profit reallocation adjustment made by a non-DTA partner state, the profit that
has been subject to double taxation will not be excluded from taxation in Hong Kong because the
profit has been properly assessed to profits tax as Hong Kong sourced profits. Neither can relief
by way of a tax credit be provided under s.50 of the IRO in the absence of a DTA.

Illustrative Example 6 – Juridical Double Taxation

(Adapted from Example 6 of DIPN No. 45)

Company HK is a Hong Kong enterprise subject to profits tax in Hong Kong. It carries on
business in Country F, a DTA state, through a permanent establishment. Company HK
lodged tax returns in both Hong Kong and Country F, returning a profit for tax purposes
of HK$10 million in Hong Kong, of which HK$3 million was attributable to the permanent
establishment in Country F and HK$7 million was profit sourced in Hong Kong under Hong
Kong tax laws. The tax administration of Country F subsequently audited the tax return
of the permanent establishment, and determined that non-arm’s length transactions
between the Hong Kong head office and the permanent establishment had resulted in an
understatement of the profits attributable to the permanent establishment. Country F’s
tax administration concluded that the profits of the permanent establishment should have
been HK$4 million and deemed those profits to have been derived in Country F. Country
F accordingly reallocated an additional HK$1 million of Company HK’s profits to the
permanent establishment, making a total of HK$4 million attributable to it and imposed
additional tax on Company HK.

The resultant juridical double taxation may be relieved by:

1. The Commissioner agreeing that the profit attributable to the permanent

establishment in Country F should have been HK$4 million and allowing a tax credit
for the additional foreign taxes paid;

2. The tax administration of Country F being convinced that its adjustment is incorrect
and accordingly reduces the additional tax payable (e.g. through domestic review,
objection or appeal processes in Country F); or

3. The reaching of agreement between both competent authorities (e.g. under the
MAP Article of the relevant DTA).

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Key Learning Point

In relation to transfer pricing adjustment by another jurisdiction, the IRD will not give any
relief if there is no DTA between Hong Kong and the other jurisdiction.

If there is a DTA between Hong Kong and the other jurisdiction, the IRD may agree to give
a corresponding adjustment (that is, adjust the transfer prices of the Hong Kong taxpayer)
or grant a tax credit if it is satisfied that the transfer pricing adjustment or profit reallocation
made by the other jurisdiction is in accordance with the arm’s length principle. If the IRD
does not so agree, the taxpayer may request the IRD and the other jurisdiction to enter into
a mutual agreement procedure under the DTA in order to attempt to resolve the difference.

Knowledge Check Question

Question 6
Explain what relief the IRD may give in relation to transfer pricing adjustments.

1 1 . 6
TAX PLANNING AND TRANSFER PRICING

Under transfer pricing, the arm’s length principle requires taxpayers to charge the same price,
royalty or other fee in relation to a related-party transaction as that which would be charged
by independent companies in similar circumstances (in a hypothetical unrelated or benchmark
transaction). Therefore, any tax planning must ensure that the arm’s length principle is observed.
In practice, the arm’s length principle can be implemented in four steps as follows:

1. Characterise the related-party transaction;

2. Select the most appropriate transfer pricing methodology;

3. Apply the most appropriate transfer pricing methodology; and

4. Implement support processes to ensure adjustments are made to any material changes
in the circumstances.

Comparability is central to the application of the arm’s length principle. The critical question
is whether the benchmark transaction is indeed comparable to the related-party transaction
in question.

11.6.1 Determining Comparability

In determining comparability, DIPN No. 46 has referred to a number of factors identified
by the OECD:

1. Characteristics of the property or services;

2. Functions performed, assets or resources contributed, risks assumed;

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3. Contractual terms (e.g. duration, rights, payment options, etc.);

4. Economic and market circumstances; and

5. Business strategies (e.g. market penetration, research and development commitments,

market positioning, etc.).

In other words, in order for the benchmark transaction and the related-party transaction to
be comparable, the preceding factors should be comparable as well.

11.6.1.1 Characteristics of the Property or Services

The characteristics of the property or services between the benchmark transaction and the
related-party transaction should be similar. Here, the focus should be on those attributes or
characteristics that are considered of value to the customers. These may include intangible
benefits of design, trademark, and perceived quality. In the Opening Case, the benchmark
transaction and the related-party transaction between HK Limited and UK Limited should be
selling chairs of comparable quality.

11.6.1.2 Functions Performed, Assets or Resources Contributed, Risks Assumed

In order for the benchmark transaction and the related-party transactions to be comparable,
the functions performed, assets used and risks assumed by the companies in both transactions
must also be comparable. The critical part of the analysis is to ascertain which are the most
economically important functions, assets and risks and how these relate to the value of the
transaction. In the Opening Case, the IRD may consider a transaction between HK Limited and
an unrelated company in the UK as the benchmark transaction. However, if this unrelated
company performs a lot more or a lot less than what is performed by the related UK Limited,
the two transactions would not be comparable.

11.6.1.3 Contractual Terms
Contractual terms between the transacting companies include (1) credit and payment terms;
(2) volume, duration, product and service liabilities of the parties; and (3) warranties and
exchange risk. For example, if one transaction (e.g. the benchmark transaction) has a payment
period of 30 days and the other one (e.g. the related-party transaction) has a payment period of
90 days, the two may not be comparable. However, it is possible to make adjustments in order
to account for that difference.

11.6.1.4 Economic and Market Circumstances

The markets in which the independent and the associated companies operate should be
comparable. If not, the differences should not have a material impact on price or be able to
be appropriately adjusted if they do have a material effect. In the Opening Case, assuming
HK Limited sells the chairs to another unrelated entity in the UK, then the markets would be
comparable. However, if HK Limited sells the chairs to an unrelated company in France, the
markets are different but it could be argued that the markets are comparable because chairs
would be selling at almost the same prices in both UK and France.

11.6.1.5 Business Strategies
In a multinational group, business strategies of the group are usually formulated by the
parent company and implemented by the subsidiaries. In transfer pricing context, the issue is
whether an independent company might have participated in these strategies. For example,

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a multinational group of computer product may pursue a market penetration strategy in

Hong Kong. Thus, the Hong Kong related company may spend a lot of money on promoting
the product resulting in a low current profit in anticipation for a high future profit. If the Hong
Kong company were unrelated, would it agree to spend so much money on promotion without
adequate compensation?

The comparison of an intercompany transaction with a same transaction between third

parties requires enough price data from the market place. If such data of comparable prices is
not available, the comparison moves to the level of profit made by the group entity (so called
‘tested party’) versus the profit-making third-party entities. In this case, databases are available
to retrieve such comparable profit information.

11.6.2 Transfer Pricing Methodologies

DIPN No. 46 refers to the OECD Transfer Pricing Guidelines on transfer pricing methodologies.
There are two groups of methods:

1. Traditional transaction methods; and

2. Transactional profit methods.

Traditional transaction methods comprise:

1. The comparable uncontrolled price method;

2. The resale price method; and

3. The cost plus method.

Transactional profit methods comprise:

1. The profit-split method; and

2. The transactional net margin method.

The newest 2017 OECD Guidelines to Transfer Pricing has given equal footing to all
methods, although traditional transaction methods are preferred.

11.6.2.1 Comparable Uncontrolled Price Method

The comparable uncontrolled price method compares the price for property or services
transferred in a related-party transaction to the price charged for a similar, comparable
transaction between independent parties. If the unrelated transaction is comparable to the
related transaction in all material respects, the price in the unrelated transaction (comparable
uncontrolled price) becomes a benchmark. There are two possible types of comparison:
(1) internal comparable uncontrolled price where the price to the related-party transaction
is compared to another transaction between the company and an independent party; and
(2) external comparable uncontrolled price where the price to the related-party transaction is
compared to another transaction between a third company and another independent party.

In order to apply the comparable uncontrolled price method reliably, there must be no
differences between the related-party transaction and the benchmark transaction or any
difference can be accounted for by way of adjustments.

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Illustrative Example 7 – Comparable Uncontrolled Price Method

(Adapted from Example A1 of DIPN No. 46)

Company HK, resident in Hong Kong, manufactures a precision cutting machine which it
sells at a price of HK$1 million to a Belgium subsidiary but at a price of HK$1.2 million to
an independent Belgium enterprise.

Application of the internal comparable uncontrolled price is straightforward. The

method directly and reliably reflects the arm’s length price. Assuming all other factors of
comparability such as contractual terms are the same, an amount of HK$200,000 should
be added to Company HK’s assessable profits.

11.6.2.2 Cost Plus Method

The cost plus method uses the costs incurred by the supplier of property or services in a
related-party transaction. Then, an appropriate markup is added to the cost. Ideally, the
markup should be determined by reference to markups on similar items sold at arm’s length by
the same seller enterprise or by comparable vendors. This method is particularly useful in the
following transactions:

• Sale of semi-finished goods between members of a group;

• Joint facility agreements or long-term buy and supply arrangements concluded between
associated enterprises; and

• Provision of services.

Illustrative Example 8 – Cost Plus Method

(Adapted from Example B1 of DIPN No. 46)

Company HK, resident in Hong Kong, is an enterprise specialising in the production of

printed circuit boards for an overseas associated enterprise. Under the arrangement,
Company HK would be provided with all the technical know-how used in the
manufacturing of the printed circuit boards.

Company C is an independent contract manufacturer of printed circuit boards in Hong

Kong. It sells the products to an independent German distributor. Company C, identified as
an external comparable enterprise, charges an average markup of 10%.

Assume Company HK incurred direct and indirect costs of HK$200 in producing one
unit; the arm’s length cost plus markup would be HK$20 (i.e. HK$200 × 10%).

11.6.2.3 Resale Price Method

The resale price method is based on the price in which a product that has been purchased
from a related party is then re-sold to an independent company. The resale price is reduced
by a resale price margin representing an appropriate profit to the company. The amount after
deducting the appropriate profit from the resale price represents the arm’s length price of the
transfer of property between the related parties. This method is most useful when the reseller

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performs all the functions that an independent reseller might be expected to perform and also
contributes little to the value of the product ultimately sold to unrelated party.

Illustrative Example 9 – Resale Price Method

(Adapted from Example C1 of DIPN No. 46)

Company HK resident in Hong Kong purchased fashion and apparel from its UK parent
company and sells them through various retail outlets in Hong Kong.

Company C, an independent distributor, purchases similar products from various suppliers

in the Far East, sells the same to end customers and earns an average gross margin of 40%.

Assume Company HK sold a particular line of women’s apparel that it purchased from
the UK parent company and derived sale proceeds of HK$200 million. The arm’s length
price for this line of apparel it purchased from the UK parent company should be HK$120
million (i.e. HK$200 million ÷ 100 million × (100 million − 40 million)).

11.6.2.4 Profit-Split Method
The profit-split method identifies the aggregate profit of the related companies and then
splits the profit between the companies based on an economically valid basis. For the purposes
of the profit-split method, the combined profit or loss must be calculated on the basis of
the most narrowly identifiable business activity for which data are available that include the
related-party transaction(s).

A functional analysis should be carried out to identify the real economic contribution made
by each enterprise to the process. Then, the profit should be split based on what enterprises
would have anticipated when the related-party arrangements were set up. It should also be
noted that the accounts of the related parties need to be put on a common basis in order for
the combined profit to be determined.

Illustrative Example 10 – Profit-Split Method

(Adapted from Example D1 of DIPN No. 46)

Company HK and Company F are associated enterprises resident in Hong Kong and
another tax jurisdiction respectively. Company F manufactures goods and sells them to
Company HK, which re-sells them retail or wholesale to independent enterprises. The
combined profit from the transaction is HK$60, being HK$20 to the manufacturer and
HK$40 reseller.

The profit split is 40/20 in Company HK’s favour. Assuming that the product is
‘yesterday’s technology’ and an independent enterprise would have discontinued stocking
the product, Company HK’s two-third share would not be sufficient.

If the stock is obsolete and unsaleable but Company HK has been required by the
holding company to buy the stock, the purchase price should be substantially reduced.

If the stock can be sold at a much-reduced price but only with considerable effort, the
purchase price should be reduced to a level that would allow a reasonable return for the
marketing and distribution effort and holding costs.

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Illustrative Example 10 (continued)

If the goods do not require a significant amount of marketing because of a high value
intangible developed by Company F and embedded in the product, Company F’s one-third
share may not be a sufficient reward for its value added.

11.6.2.5 Transactional Net Margin Method

The transactional net margin method examines the net profit margin relative to an appropriate
base such as sales, cost or assets that an enterprise realises from a related-party transaction.
This is then compared to the result achieved by independent enterprises on similar
transactions. The following ratios are useful for this purpose:

1. Ratio of net profit before tax to sales;

2. Ratio of net profit (before interest and tax) to sales;

3. Ratio of gross profit to operating expenses (also known as the Berry ratio);

4. Ratio of net profit before tax to shareholders’ funds;

5. Ratio of earnings before interest and tax to assets; and

6. Ratio of net profit (before interest and tax) to operating expenses and cost of goods sold.

Apply and Analyse 2
In the Opening Case, explain how HK Limited can apply the transfer pricing methodologies
in relation to the sale of the chairs to UK Limited.

Analysis
1. The comparable uncontrolled price method – If HK Limited also sells the chairs
to an unrelated company in the UK, this transaction can be used as an internal
comparable transaction; if another company in Hong Kong sells similar chairs to an
unrelated company in the UK under similar conditions, this transaction can be used
as an external comparable transaction.

2. The resale price method – Since the resale price is the equivalent of HK$500
per chair, the reasonable markup that would be earned by a similar distributor,
assuming it is unrelated to HK Limited, would be deducted to arrive at the transfer
price at which HK Limited sells the chairs to UK Limited.

3. The cost plus method – Since the cost per chair to HK Limited is HK$100, a reasonable
markup that would be earned by a similar manufacturer would be added to the cost
to arrive at the transfer price at which HK Limited sells the chairs to UK Limited.

4. The profit-split method – The total profit (ignoring other expenses) from selling the
chair is HK$400 per chair, this could be split between HK Limited and UK Limited
based on some economically valid basis such as the functions performed, assets
used and risks assumed by each of HK Limited and UK Limited.

5. The transactional net margin method – An appropriate ratio from a benchmark

transaction can be used to determine the net profit of the related-party transaction.

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Key Learning Point

In determining comparability, DIPN No. 46 has referred to a number of factors identified
by the OECD: characteristics of the property or services; functions performed, assets or
resources contributed, risks assumed by the transacting companies; contractual terms
(e.g. duration, rights, payment options, etc.); economic and market circumstances; and
business strategies (e.g. market penetration, research and development commitments,
market positioning, etc.).

There are two groups of acceptable transfer pricing methods: (a) traditional
transaction methods; and (b) transactional profit methods. On (a) traditional transaction
methods, they comprise: (1) the comparable uncontrolled price method; (2) the resale
price method; and (3) the cost plus method. On (b) transactional profit methods, they
comprise: (4) the profit-split method and (5) the transactional net margin method.

Knowledge Check Questions

Question 7
Identify the factors that affect comparability of independent third parties and the
tested party.

Question 8
Explain the five transfer pricing methodologies.

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SUMMARY

• Transfer pricing is concerned with the prices charged between related parties, such as for the
transfer of goods, services and intangible property.

• Transfer Pricing Rule 1 empowers the IRD to adjust the transfer price for transactions between
two related parties.

• Transfer Pricing Rule 2 empowers the IRD to adjust the transfer price for transactions between
two parts of the same company, for example, head office and branch.

• There is a ‘three-tier’ transfer pricing documentation requirement in Hong Kong. The local
file reports prescribed information at the entity level. The master file reports prescribed
information at the group level. The CbC report requires a multinational enterprise group to
disclose financial data and other business information of its entities by jurisdiction.

• There are five stages to the advance pricing arrangement process: (1) pre-filing; (2) formal
application; (3) analysis and evaluation; (4) negotiation and agreement; and (5) drafting,
executing and monitoring.

• In relation to transfer pricing adjustment by another jurisdiction, the IRD will not give any
relief if there is no DTA between Hong Kong and the other jurisdiction.

• If there is a DTA between Hong Kong and the other jurisdiction, the IRD may agree to give a
corresponding adjustment (that is, adjust the transfer prices of the Hong Kong taxpayer) or
grant a tax credit if it is satisfied that the transfer pricing adjustment or profit reallocation
made by the other jurisdiction is in accordance with the arm’s length principle. If the IRD does
not so agree, the taxpayer may request the IRD and the competent authority of the other
jurisdiction to enter into mutual agreement procedure under the DTA in order to attempt to
resolve the difference.

• In determining comparability, DIPN No. 46 has referred to a number of factors identified by

the OECD: characteristics of the property or services; functions performed, assets or resources
contributed, risks assumed by the transacting companies; contractual terms (e.g. duration,
rights, payment options, etc.); economic and market circumstances; and business strategies
(e.g. market penetration, research and development commitments, market positioning, etc.).

• There are two groups of acceptable transfer pricing methods: (a) traditional transaction
methods; and (b) transactional profit methods. On (a) traditional transaction methods, they
comprise: (1) the comparable uncontrolled price method; (2) the resale price method; and
(3) the cost plus method. On (b) transactional profit methods, they comprise: (4) the profit-split
method and (5) the transactional net margin method.

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MIND MAP
REGULATORY FRAMEWORK DOCUMENTATION REQUIREMENTS
Ss.50AAF and 50AAK Part 9A of IRO
• Rule 1 targets transactions between two Local file
related companies
Master file
• Rule 2 targets transactions within the same
company (e.g. head office and branch) Country-by-country (CbC) reporting
ADVANCE PRICING ARRANGEMENT
Application procedures
• Stage 1: Pre-filing
TRANSFER • Stage 2: Formal application
PRICING • Stage 3: Analysis and evaluation
• Stage 4: Negotiation and agreement
• Stage 5: Drafting, executing and monitoring
Benefits
• Provides greater certainty on the tax liability
• Ensures a fair application of the arm’s
length principle
• Reduces the risk of double taxation
RELIEF FROM DOUBLE TAXATION • Avoids the risk of audit and penalty
Economic double taxation TAX PLANNING AND TRANSFER PRICING
Juridical double taxation Factors for determining comparability
• Characteristics of the property or services
• Functions performed, assets or resources
contributed, risks assumed
• Contractual terms
• Economic and market circumstances
• Business strategies
Transfer pricing methodologies
• Traditional transaction methods
- Comparable uncontrolled price method
- Cost plus method
- Resale price method
• Transaction profit methods
- Profit-split method
- Transactional net margin method

Answers to Knowledge Check Questions

Question 1
Under Rule 1, the IRD is empowered to adjust a taxpayer’s income or loss according to the
arm’s length principle if the following conditions are satisfied: (a) a transaction (or a series
of transactions) has occurred between two related parties; (b) the parties are related either
because one party was participating in the management, control or capital of the other
party or the same person(s) was/were participating in the management, control or capital
of each of the related parties; and (c) the transaction was not at arm’s length and it confers
a Hong Kong tax advantage (i.e. a smaller amount of assessable income or a larger amount
of assessable loss) on one of the related parties.
Under Rule 2, the income or loss of a non-resident taxpayer that is attributable to its
Hong Kong permanent establishment shall be calculated as if it was a separate unrelated,
independent entity that engaged in the same or similar activities under the same or similar
conditions.

Question 2
Unless exempted, Division 2 of Part 9A of the IRO requires that a Hong Kong entity of
a corporate group that is required to prepare consolidated financial statements must
prepare, within nine months after the end of each accounting period of the entity, a local

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file. In addition, the entity must also prepare, within nine months after the end of the
accounting period of the group, a master file.

Question 3
If the ultimate parent company of a multinational enterprise group is tax resident in
Hong Kong, then the Hong Kong parent company must file a CbC report in respect of an
accounting period if the total consolidated group revenue was at least HK$6.8 billion in the
immediately preceding accounting period.

Question 4
The five stages to the advance pricing arrangement process are: (1) pre-filing; (2) formal
application; (3) analysis and evaluation; (4) negotiation and agreement; and (5) drafting,
executing and monitoring.

Question 5
An APA provides greater certainty on the tax liability. An APA ensures a fair application of
the arm’s length principle. An APA reduces the risk of double taxation. An APA avoids the
risk of transfer pricing audit and penalty.

Question 6
In relation to transfer pricing adjustment by another jurisdiction, the IRD will not give any
relief if there is no DTA between Hong Kong and the other jurisdiction. If there is a DTA
between Hong Kong and the other jurisdiction, the IRD may agree to give a corresponding
adjustment (that is, adjust the transfer prices of the Hong Kong taxpayer) or grant a tax
credit if it is satisfied that the transfer pricing adjustment or profit reallocation made by
the other jurisdiction is in accordance with the arm’s length principle. If the IRD does not so
agree, the taxpayer may request the IRD and the other jurisdiction to enter into the mutual
agreement procedure under the DTA in order to attempt to resolve the difference.

Question 7
The factors that affect comparability include: characteristics of the property or services;
functions performed, assets or resources contributed, risks assumed by the transacting
companies; contractual terms (e.g. duration, rights, payment options, etc.); economic and
market circumstances; and business strategies (e.g. market penetration, research and
development commitments, market positioning, etc.).

Question 8
The five transfer pricing methodologies are: (1) the comparable uncontrolled price
method – this method looks at the price of a comparable internal or external transaction;
(2) the resale price method – this method deducts an arm’s length profits to arrive at the
transfer price; (3) the cost plus method – this methods adds a reasonable markup to the
cost of a transaction; (4) the profit-split method – this method splits the aggregate profits
between related parties on economically valid basis; (5) the transactional net margin
method – this method considers an appropriate ratio to determine the arm’s length
net profit.

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EXAM PRACTICE

QUESTION 1
Based in Hong Kong, DEF Ltd is engaged in the distribution of soft drinks to customers in
China. For the southern China region, DEF Ltd has a representative office (a fixed place
of business) in Guangzhou. The representative office is responsible for liaising with local
independent distribution companies and promoting the soft drinks to them. For the
northern China region, DEF Ltd has set up a subsidiary which is registered in Beijing. DEF Ltd
sells the soft drinks to its Beijing subsidiary, which acts as DEF Ltd’s sole distribution agent in
the northern China region.

Please assume that the Double Taxation Arrangement between Hong Kong and
Mainland is identical to the OECD Model Treaty.

Required:

(a) Discuss and evaluate the appropriate transfer pricing method in relation to the
transactions with the Guangzhou representative office and the Beijing subsidiary.

(b) After a few years, both the Guangzhou and Beijing tax authorities perform tax audits
and make adjustments resulting in more profits being allocated to China. Advise DEF
Ltd whether it would be entitled to any relief for double taxation in Hong Kong.

(c) Explain the transfer pricing documentation that DEF Ltd is required to prepare.

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) For the services provided by the sales office in Guangzhou, cost plus method may be
appropriate. A benchmarking should be made with comparable service providers to
determine what the cost plus percentage should be. Note that the sales office would
be regulated by the Notice of the State Administration of Taxation (2010) No. 18 and
(2016) No. 28 in the case of insufficient information or passive book management.
Consequently, the taxable income would be calculated with a deemed profit level on
the cost plus basis of real expenses of the sales office.

For the sales to the Beijing subsidiary, one must determine the profits as if the
subsidiary is a separate entity engaged in distribution of soft drinks. In this case, the
comparable uncontrolled price (CUP) method may be appropriate if DEF Ltd also sells to
other unrelated distributors. If not, resale price method may be appropriate.

(b) According to Article 7 (Business Profits) of the OECD Model, if the Guangzhou tax
authority makes profit reallocation resulting in more profits being allocated to the China
sales office, the Hong Kong IRD shall consider to make an appropriate adjustment to
the amount of the tax charged on those profits.

According to Article 9 (Associated Enterprises) of the OECD Model, if the Beijing tax
authority makes transfer pricing adjustments resulting in more profits being allocated
to the China subsidiary, the Hong Kong Inland Revenue Department shall consider to
make an appropriate adjustment to the amount of the tax charged on those profits.

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 Transfer Pricing

If Hong Kong Inland Revenue Department refuses to make an appropriate

adjustment, DEF Ltd can present its case to the competent authority of the side of
which they are a resident (i.e. Hong Kong). The competent authority of Hong Kong
shall endeavour, if the objection appears to be justified and if it is not itself able to
arrive at a satisfactory solution, to resolve the case by mutual agreement with the
competent authority of the Mainland under Article 23 (Mutual Agreement Procedure).
However, there is no guarantee that the competent authorities will be able to resolve
the differences. Under the Organisation for Economic Co-operation and Development
(OECD) Model Convention, taxpayers may require the competent authorities to submit
any unresolved differences to arbitration.

(c) DEF Ltd has to prepare the local file and master file unless any of the following two
conditions were satisfied in respect of the accounting period: (1) the total amount of the
entity’s revenue for the accounting period does not exceed HK$400 million; (2) the total
value of the entity’s assets at the end of the accounting period does not exceed HK$300
million; (3) the average number of the entity’s employees during the accounting period
does not exceed 100.

However, DEF Ltd is not required to prepare a local file in respect of the transfer
of soft drinks to the subsidiary if the total amount of the transactions did not exceed
HK$220 million. DEF Ltd is also not required to prepare a local file in respect of the
services performed by the representative office if the total amount of the service fee
did not exceed HK$44 million. If DEF Ltd is not required to prepare local files in respect
of both categories of transactions, it is also not required to prepare a master file.

Furthermore, DEF Ltd is also required to undertake CbC reporting in respect of an

accounting period if the total consolidated group revenue was at least HK$6.8 billion in
the immediately preceding accounting period.

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 F u r t h er R e a d ing

F URTHER READING

Arnold, B.J. International Tax Primer, 4th edition. Alphen aan den Rijn, Netherlands: Kluwer Law
International, 2019.

Chow, W.S., Leung, S.M. and Mariani, S. Encyclopaedia of Hong Kong Taxation, Vol. 1–5,
Hong Kong: LexisNexis, latest issue.

King and Wood Mallesons. China Master Tax Guide 2021, 14th edn. Hong Kong: Wolters
Kluwers, 2021.

Forster, R. Tolley’s Tax Planning 2020–21. London: Tolley, LexisNexis, 2020.

Ho, P.K.W. and Mak, K.P.L Hong Kong Taxation and Tax Planning, 19th edn. Hong Kong: Pilot
Publishing, 2020.

Inland Revenue Department. A Brief Guide to Taxes Administered by the Inland Revenue
Department 2020–2021. Hong Kong: IRD, 2020.

Lau, A.M. and Olesnicky, M. (KPMG) Hong Kong Taxation: Law and Practice (2018–19 edn). Hong
Kong: Chinese University Press, 2019.

Lee, D. Advanced Taxation in Hong Kong, 18th edn. Hong Kong: Pearson, 2016.

Monroe, J.G. Monroe and Nock on the Law of Stamp Duties. London: Sweet & Maxwell, 2019.

PricewaterhouseCoopers (PWC). Hong Kong Master Tax Guide 2019/20, (28th edn). Hong Kong:
Wolters Kluwer, 2019.

Randall, S. Sergeant and Sim on Stamp Taxes. London: LexisNexis, 2000.

Wong, P. and Wong, J. Taxation in Hong Kong, A Practical Guide 2020/21. Hong Kong:
Wolters Kluwer, 2020.

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 G l o s s a r y o f   T er m s

G L O S S A R Y OF   T ERMS

60-day exemption rule the maximum duration an factor, receiver, or manager of the non-resident
individual can visit or stay in Hong Kong under person in Hong Kong; and any person in Hong
s.8(1B) of the IRO to be disregarded as present in Kong through whom a non-resident person
Hong Kong for the purposes of ascertaining if the receives any profits or income arising in or derived
income of the person falls within the scope of from Hong Kong (s.2(1)). [Ch2, Ch8]
salaries tax. For the purposes of 60-day agreement for sale the sale and purchase
exemption rule, the day of arrival and the day of agreement governing the sale and purchase of
departure are counted as two days. immovable property in Hong Kong. In most cases,
ad valorem stamp duty (AVD) stamp duty on the ad valorem stamp duties payable with respect to
transfer of Hong Kong stock or immovable the acquisition of immovable property are paid on
property situated in Hong Kong computed as a the agreement for sale. [Ch7]
percentage of the higher of the value or transfer alternative bond scheme (ABS) a contractual
consideration. [Ch7] relationship that synthesises interest specifically
advance pricing arrangement an arrangement to comply with the restrictions of the Muslim
that determines in advance of controlled religion on the payment of interest. [Ch7]
transactions, an appropriate set of criteria (e.g. arm’s length principle the principle of transfer
method, comparables and appropriate pricing whereby transactions and arrangements
adjustments thereto, critical assumptions as to between associated persons or otherwise
future events) for the determination of the between a head office and its permanent
transfer pricing of those transactions over a fixed establishment must be carried on as though the
period of time. [Ch11] two entities in question were independent
additional stamp duty the additional AVD persons acting commercially in the ambit of the
payable on the sale and purchase of residential same or similar transactions or
property in Hong Kong to any person other than a arrangements. [Ch3]
HKPR acting on their own behalf and not owning arm’s length principle in the context of transfer
any other residential property in Hong Kong at pricing, this means a basis that two independent
the time of acquisition. [Ch7] parties acting commercially would agree as
adjudication process by which an interested party between themselves. [Ch10]
requests that the collector express their opinion assessable business profit also assessable
on whether an instrument is chargeable with any profits, profits assessable to tax computed in
stamp duty and, if so, the amount of duty payable accordance with Part 4 of the IRO. [Ch6]
thereon. [Ch7] assessable income the assessable income of a
advance pricing agreement (APA) a form of person in any year of assessment as ascertained
advance ruling relating to the allocation of profits in accordance with ss.11B, 11C and 11D of the
between associated parties or between a head IRO. [Ch2]
office and its PE. [Ch10] assessable profits the profits in respect of which a
advance ruling a form of revenue clearance under person is chargeable to tax for the basis period for
section 88A of the IRO. The applicant sets out a any year of assessment, calculated in accordance
proposed structure or transaction in detail and with the provisions of Part 4 of the IRO. [Ch2]
requests that the Commissioner opine on assessable profits profits that are assessable to
whether they agree with the taxpayer’s tax profits tax on the terms of the IRO. [Ch3]
analysis. A ruling, whether favourable or adverse
assessable value considerations received net of
from the perspective of the taxpayer, is binding
irrecoverable rent. [Ch5]
on the Commissioner. [Ch10]
assessment the Inland Revenue Department’s
agent in relation to a non-resident person includes
computation of tax which it considers due and
any person in Hong Kong through whom such
payable with respect to a given taxable
person is in receipt of any profits or income arising
person. [Ch3]
in or derived from Hong Kong. The agent, attorney,

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 TAXATION

assignment the deed transferring legal title of broad guiding principle one looks to what the
Hong Kong immovable property. If AVD has been taxpayer has done to earn its profits, and where it
paid on the agreement for sale, the assignment has done it, discounting antecedent or incidental
bears a nominal HK$100 duty. [Ch7] matters. See also the operations test. [Ch3]
associate a natural person in partnership with business defined (unhelpfully) in s.2, and
another person, officers, such as an entity, considered (more helpfully) in case law as any
partner or controller in a corporation, or partners gainful use to which a taxpayer puts its assets – the
in a partnership (s.21A). [Ch8] threshold for carrying on a business is low. [Ch3]
associate partnership any partner in the business profits in the context of DTAs, profits
partnership; a relative of any partner; a arising from the exercise of a trade or
corporation that is controlled by the partnership, business. [Ch10]
or by a partner or any relative of a partner; a buyer’s stamp duty (BSD) in additional to AVD,
director or principal officer of a controlled stamp duty charged at the flat rate of 15% on the
corporation; a corporation whose director or acquisition of residential property by persons
principal officer is a partner in the Hong Kong other than HKPR acting on their own behalf. [Ch7]
partnership. [Ch8] capital the means by which profits are generated,
associated corporation a corporation over which rather than the subject matter of the trade or
the Hong Kong entity has control, a corporation business itself. [Ch3]
that has control over the Hong Kong entity, or a capital gains gains derived on the disposal of
corporation under the same control as the Hong capital assets. [Ch1]
Kong entity; a person who controls the
capital gains a gain or profit arising from the
corporation, or a partner of the controller, or a
disposal of a capital asset. Capital gains are
relative of the controller or partner; a director or
expressly exempt from profits tax under s 14(1) of
principal officer of the corporation (or any
the IRO. [Ch3]
associated corporation), or a relative of the
director or officer; or a partner of the corporation, capital gains gains arising from the disposal of
or a relative of the partner. [Ch8] capital assets, as distinct from the profits of the
exercise of a trade or business. [Ch10]
authorised representative means a person
authorised in writing by any other person to act captive agent an insurance agent who only works
on their behalf for the purposes of the for or represents one insurance company. [Ch4]
ordinance. [Ch2] Chinese tax resident it refers to a Chinese-
balancing allowance or charge a balancing domiciled individual and a non-Chinese-domiciled
deduction or additional charge to tax which may individual but has stays in China for 183 or more
arise when a capital asset with respect to which days within a tax year. A Chinese tax resident
depreciation allowances have been allowed is shall be subject to IIT on their worldwide income,
sold or otherwise transferred. [Ch3] i.e. both onshore Chinese-sourced income and
the offshore non-Chinese-sourced one. [Ch9]
base erosion and profit shifting (BEPS) an
initiative of the OECD to combat cross-border tax combined reduced total income the sum of the
avoidance by, among other things, requiring taxpayer’s reduced total income and their
participating jurisdictions to enact legislation to spouse’s reduced total income. [Ch6]
prevent the abuse of double taxation treaties and commercial occasion or event includes any
harmonise transfer pricing laws. [Ch10] occasion or event for which an entertainer might
basis period the accounting period to which a receive cash or other form of property for their
person’s accounts are made up and which is performance, or any occasion or event designed
covered in a given assessment to tax. [Ch3] to promote commercial sales or activity. As
presently defined, it is considered that the phrase
bearer instrument dutiable instrument denoting
will cover all those occasions or events, whether
a debt, often with a coupon for interest payable
commercial or charitable, in respect of which an
with respect to the debt. It is transferable on
entertainer or sportsperson might receive profits
delivery. [Ch7]
assessable to tax. [Ch8]
branch a form of permanent establishment – a
common reporting standard (CRS) a system for
commercial presence of a non-resident person in
financial institutions to report financial
another jurisdiction. Not a separate legal person
information relating to account holders, and
from the head office. [Ch10]
periodically to report that information to the

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 G l o s s a r y o f   T er m s

revenue authority in which the financial institution certain sums that would not otherwise be
is resident. The revenue authority in question will chargeable to profits tax and deems these to be
then exchange such information with the chargeable to profits tax. [Ch3]
jurisdiction(s) of tax residence of the account deferred pay a portion of an employee’s income;
holders concerned. [Ch10] i.e. salary, wages or bonus which is paid out at a
comparable uncontrolled price method a deferred or later date. [Ch4]
transfer pricing methodology that compares the depreciation allowance a periodic or one-off
price for property or services transferred in a allowance for capital expenditure allowable in
related-party transaction to the price charged for certain circumstances for the construction of
a similar, comparable transaction between industrial or commercial buildings, or the
independent parties. [Ch11] acquisition of plant and machinery. [Ch3]
comprehensive income it refers to the aggregate direct tax the tax charged on an income stream or
of the first four (4) schedules of income a gain, generally on a receipts or accrual
chargeable to IIT, namely wages and salaries, basis. [Ch1]
remuneration for labour services, remuneration double taxation agreement an agreement
for manuscripts, and royalty income. [Ch9] concluded between jurisdictions to coordinate the
concessionary deductions these are deductions allocation of their taxing rights. [Ch1]
by concessions which are stipulated under Part double taxation agreement (DTA) instrument of
4A of the IRO. [Ch4] public international law that allocates taxing
consideration it includes any sum received in rights between two jurisdictions. [Ch10]
respect of the provision of any services or double taxation treaty (DTT) instrument of public
benefits connected with or related to the right of international law that allocates taxing rights
use of the property. [Chs 4, 5] between two jurisdictions. [Ch10]
controlled foreign companies (CFCs) an ­anti- effective tax rate the total tax payable divided by
avoidance principle of revenue law in a number of the total income subject to tax. [Ch6]
jurisdictions not currently including Hong Kong
entertainer or sportsman means a person, other
whereby passive income arising to a company
than a corporation, who gives performances in
resident in a low-tax jurisdiction which is
any kind of entertainment or sport, including any
beneficially owned or controlled by a resident
physical activity which the public is permitted to
person is taxed directly in the hands of that
see or hear. In terms of the definition it matters
person in their jurisdiction of tax
not whether the activity is in a live or recorded
residence. [Ch10]
form or whether the public is required to make
conveyance on sale an instrument whereby any payment to see or hear. [Ch8]
immovable property is transferred to or vested in
executor means any executor, administrator, or
any person upon the sale thereof. [Ch7]
other person administering the estate of a
corporation means any company which is either deceased person, and includes a trustee acting
incorporated or registered under any enactment under a trust created by the last will of the author
or charter in force in Hong Kong or elsewhere but of the trust. [Ch2]
does not include a co-operative society or a trade
Financial Accounts Tax Compliance Act (FATCA) 
union. [Ch2; Ch8 (in part)]
the United States equivalent of CRS. [Ch10]
cost plus method a transfer pricing methodology
general anti-avoidance provision a statutory
that uses the costs incurred by the supplier of
provision aimed at negating the effect of tax
property or services in a related-party
avoidance schemes generally – sections 61 and
transaction. [Ch11]
61A of the IRO are examples of this. [Ch10]
deductible expenditure expenditure that is
goods it refers to tangible moveable property, as
deductible under the IRO for the purposes of
well as electricity, heat and gas (‘VAT
ascertaining the assessable income or profits of a
Implementing Rules’, Article 2). [Ch9]
person. [Ch3]
Hong Kong employment an employment which
deeming provision in the context of a revenue
originates from Hong Kong or is Hong Kong
statute, a provision that deems an item of income
sourced. [Ch4]
or gain or loss as something other than what it
would otherwise be at law specifically in the indirect tax the tax charged on a transaction and
context of taxation. For example, s.15 enumerates usually collected through an intermediary and not
from the taxable person itself. [Ch1]

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 TAXATION

Inland Revenue Ordinance (IRO) the income tax corporation controlled by the person; or a
law of Hong Kong. [Ch1] director or principal officer of a controlled
intangible property it is defined as an asset that corporation. [Ch8]
does not have a physical form but could generate net assessable income means assessable income
economic benefits, including patented and as adjusted in accordance with s.12 of the
unpatented technology, trademarks, copyrights, IRO. [Ch2]
goodwill, rights to use land or other natural net assessable value net assessable value of
resources, and other intangible property (Circular government rates and 20% of statutory
[2016] 36, Article 2 of Appendix 1). [Ch9] deduction. [Ch5]
interest a payment in consideration for the net income net assessable income less
time-value of money. [Ch3] concessionary deductions under Part 4A. [Ch4]
joint assessment a joint assessment refers to the nomination direction for a person other than the
assessment upon an election by a married couple purchaser to take up an interest in the immovable
who is not living apart to have their income jointly property. Generally, nomination is treated as an
assessed under s.10(2) of the IRO. [Ch4] agreement for sale, unless specifically
joint venture a commercial and contractual exempted. [Ch7]
arrangement between persons wishing to non-resident person a person who is not a
undertake a course of business or transaction ‘resident person’ in relation to that year of
together, but generally falling short of a assessment (see s.20AB(3)). [Ch8]
partnership. Joint venturers are in the ordinary non-tax resident it is defined as a non-Chinese-
course treated as separate taxable persons. [Ch3] domiciled individual who does not habitually live in
lease the grant of a right to the exclusive China; or their stay in China do not exceed 183 days
possession of land for a determinate term. cumulatively in a tax year. A non-tax resident is
Distinguished from a licence, which is a personal chargeable to IIT only on their Chinese-sourced
and contractual right to use land. [Ch7] income. [Ch9]
local file a transfer pricing documentation that one country, two systems the principle ensures
reports some prescribed information at the entity that the HKSAR is to operate separately and
level. [Ch11] autonomously from the mainland of China. [Ch1]
loss the mirror image of a profit – essentially, operations test a corollary of the broad guiding
where a person in carrying on a trade, profession principle – one must identify the operations that
or business has revenue that is less than their in substance give rise to the profits of the
expenditure. [Ch3] taxpayer. [Ch3]
machinery a composite and complex system Organisation for Economic Co-operation and
composed of subordinate parts. [Ch3] Development (OECD) international organisation
master file a transfer pricing documentation that founded to promote economic development, but
reports some prescribed information at the group which has since become highly influential in
level. [Ch11] establishing principles of international
midnight rule midnight rule is a basis used to taxation. [Ch10]
count the presence of a person in a country; Hong other deductible items permitted by law this
Kong in this case. If the individual is in Hong Kong group of deductions covers recognised charitable
at midnight, they are present in Hong Kong on donation, contributions made to qualified
that day. Thus, the day of arrival is ignored and corporate annuity and/or qualified professional
only the departure day is included when annuity, premiums paid to qualified commercial
computing the total days spent Hong Kong. [Ch4] health insurance and tax deferrable commercial
mutual agreement procedure (MAP) a pension insurance, and other deductible items
procedure mandated in certain DTAs where the stipulated by the state council. [Ch9]
competent authorities of the two contracting partnership an unincorporated business
parties agree as between themselves on a dispute association that is not a separate legal person at
arising from the interpretation or application of a law, but is treated as a separate taxable unit for
DTA. [Ch10] the purposes of the IRO. [Ch3]
natural person a relative of the person; a partner permanent establishment (PE) a fixed place
of the person, or a relative of the partner; a through which the business of a non-resident
partnership in which the person is a partner; a enterprise is wholly or partially carried on. In

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effect, a PE amounts to a taxable presence of a property tax income tax charged on the owners
non-resident person in the jurisdiction where it is of land and/or building situated in Hong
established. [Chs 3, 10] Kong. [Ch1]
personal service companies (PSCs) companies purposive approach rule of statutory
through which the services of an individual, or an interpretation by which a statute must be
individual and their close associates, are rendered construed in light of its purpose and, insofar as it
– generally the PSC will be controlled by the is apparent, the intention of the legislature in
persons whose services it offers. [Ch10] enacting a given piece of legislation. Conceptually
place of effective management it is defined as equivalent to the Mischief Rule on interpreting tax
the place where the overall management and legislations in the common law system. [Chs 1, 7]
control of the production and business Ramsay principle legal principle stemming from
operations, personnel, accounting, properties, etc. the Ramsay case whereby the court was entitled
is located. [Ch9] to look at the effect or substance of all the
plant a fixture, or a piece of infrastructure, or relevant transactions instead of looking at each
other part of the productive apparatus other than individual transaction separately. It is the principle
machinery that is utilised in the exercise of a whereby one departs from the assumption that
trade or business. [Ch3] taxing statutes were meant to apply to real-world,
premium (lump sum payment) premium refers commercial situations. Consequently, in applying
to the consideration payable in respect of a a taxing statute, the court may under certain
period of the right of use that is not contained circumstances disregard steps in a transaction
within any one year of assessment. It can be that serve no apparent commercial purposes.
spread over the shorter of the lease term or for a [Chs 1, 7, 10]
maximum of three years (36 months). [Ch5] reasonable excuse is what one would expect an
processing it is defined as the business of ordinary person with reasonable knowledge and
contracting to process goods, where the attention of the subject matter would do in all of
contractor supplies the raw materials or major the circumstances. (See BIR Case No. D13/85
materials and the subcontractor manufactures – Page 3) [Ch2]
the goods in accordance with the requirements of reduced assessable value net assessable value
the contractor and receives a processing fee (‘VAT less mortgage interest deductions under
Implementing Rules’, Article 2). [Ch9] s42(1)(d). [Ch6]
profession any skilled pursuit carried on with a reduced total income total income reduced by
view to profit, such as the law, accountancy, the mortgage interest deductible, concessionary
journalism, consultancy, etc. [Ch3] deductions under Part 4A, current year business
profit a measure of economic gain, to be losses and loss brought forward from prior years
computed in accordance with the terms of the under personal assessment. [Ch6]
Ordinance, on which tax under s 14 is related party the parties are related when one
charged. [Ch3] party was participating in the management,
profit split method a transfer pricing control or capital of the other party or the same
methodology that identifies the aggregate profit person(s) was/were participating in the
of the related companies and then splits those management, control or capital of each of the
profits between the companies based on an related parties. [Ch11]
economically valid basis. [Ch11] repair and replacement it is defined as the
profits arising in or derived from Hong Kong for business of contracting to repair damaged or
the purposes of Part 4 shall, without in any way malfunctioning goods, and to restore the goods to
limiting the meaning of the term, include all their original condition and function (VAT
profits from business transacted in Hong Kong, Implementing Rules, Article 2). [Ch9]
whether directly or through an agent. [Ch2] resale price method a transfer pricing
profits tax income tax charged on person carrying methodology that is based on the price in which a
on a trade, profession or business in Hong Kong product that has been purchased from a related
in respect of the assessable profits arising in or party is then re-sold to an independent
derived from Hong Kong. [Ch1] company. [Ch11]

profits tax the general charge to tax in Hong Kong residence jurisdiction a principle of taxation
on business, trading or professional profits. [Ch3] under which taxing rights are allocated based on

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 TAXATION

the nexus between that jurisdiction and the six-year test it is the rule for assessing whether a
person subject to tax, such as the location of non-Chinese-domiciled individual should be
incorporation of a company or the location where chargeable to IIT on their worldwide income or
its effective central management function is not. Accordingly, a non-Chinese-domiciled
exercised. [Ch1] individual with their days of residence in China for
resident-day-count rule it refers to the rule for 183 days or more in a tax year but less than a
assessing the tax residency status of a non- consecutive period of 6 years may be exempt
Chinese-domiciled individual for IIT Purposes. from IIT on their non-Chinese-sourced income.
Accordingly, if a non-Chinese-domiciled individual Should the individual have any absence from
is physically present in China for 24 hours in a China for 30 days or more in one departure
given calendar day, that day will be counted as a during any time of a Chinese Year, the count of
day of residence in China. However, if a non- the 6-year test will be reset. [Ch9]
Chinese-domiciled individual’s presence in source jurisdiction a principle of taxation under
mainland China is less than 24 hours in a given which taxing rights are allocated based on the
calendar day, that day will not be counted as a nexus between that jurisdiction and the business
day of residence in China. [Ch9] activities that generated the chargeable income,
resident person an individual who (a) ordinarily i.e. the source of the income being situated within
resides in Hong Kong (has a permanent home in its territory. [Ch1]
Hong Kong where they or their family live in that source of profits the effective or proximate cause
year of assessment), or (b) stays in Hong Kong for of a profit to be understood as a commercial and
more than 180 days in the relevant year of not as a technical matter – the locality of the
assessment or more than 300 days in two source of profits is determined by applying the
consecutive years of assessment, one of which is broad guiding principle. [Ch3]
the relevant year of assessment (in counting the special stamp duty (SSD) in addition to AVD,
number of days, part of a day is treated as one stamp duty charged on the disposal of Hong Kong
day); or a company, partnership or trustee of a residential property within 36 months of
trust estate whose central management and acquisition. [Ch7]
control is exercised in Hong Kong in the relevant specific additional deductions this group of
year of assessment (s.20AB(2)). [Ch8] deductions is newly provided by the 2018 IIT Law
revenue otherwise known as income – the fruit to for covering a taxpayer’s expenditure incurred in
capital’s tree. [Ch3] six aspects, i.e. children education, continued
royalty a payment for the use or the right to use education, medication for critical illnesses,
intellectual property rights such as patent, mortgage loan interest, housing rental, and
trademarks, designs, know-how, scientific elderly care. [Ch9]
processes, etc. [Ch3] specific anti-avoidance provision a statutory
s.45 relief relief from all forms of stamp duty provision aimed at negating the effect of tax
under s.45 of SDO: available to bodies corporate avoidance within a specific context of the tax code
transferring Hong Kong stock or immovable – ss.61B and 9A of the IRO are examples of
property to an associated body corporate. [Ch7] this. [Ch10]
schedular income it refers to the remaining specific deductions this group of deductions
five (5) schedules of income chargeable to IIT, covers the contributions made or premiums paid
namely income generated from business by a taxpayer to their statutory pension fund,
operations, interest, dividend incomes and profit statutory medical insurance, unemployment
sharing, income generated from leasing of insurance and housing provident fund. [Ch9]
property, income generated from transfer of Stamp Duty Ordinance (SDO) the Hong Kong
property, and contingent receipts. [Ch9] tax law governing the imposition of stamp
salaries tax income tax charged on Hong Kong duty. [Ch1]
sourced employment, directors’ fees and standard personal deduction the basic deduction
pension. [Ch1] eligible to all taxpayer at RMB60,000 per person
services it include processing, repair and per annum. [Ch9]
replacement services; transportation services; statutory allowance a special allowance for
postal services; telecommunications services; repairs and outgoings calculated at 20% of the
construction services; financial services; modern assessable value of the property less government
services; and consumer services. [Ch9] rates paid by owner. [Ch5]

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statutory income statutory income refers income total income the sum of assessable profits, net
assessable to tax under the specific provisions of assessable income and net assessable
the IRO. [Ch4] value. [Ch6]
strike price strike price is the price at which the trading profit a profit that arises from trading
stock/share can be bought on exercise of the activities or otherwise in the ordinary course of
stock option. [Ch4] trade. [Ch3]
tax avoidance a solution aimed at minimising the trading stock the stock-in-trade of a trader, as
tax burden on one or more taxpayers by distinct from capital, which is turned over the
decreasing the amount of taxable income (or course of the trade. [Ch3]
otherwise eliminating this altogether) or transactional net margin method a transfer
generating an allowable loss. There is no clear line pricing methodology that examines the net profit
between tax avoidance and tax mitigation; margin relative to an appropriate base such as
generally, tax avoidance is perceived as being sales, cost or assets that an enterprise realises
consistent with the letter but contrary to the from a related-party transaction. [Ch11]
purposive intent of the statute. [Ch10] transfer pricing a set of rules that govern the
tax credit where a person is liable to tax in its ability of related parties within a multinational
jurisdiction of residence, but has already borne corporate group to set prices on the transfers of
foreign tax on the same income stream, if a tax goods and/or services that are different from the
credit is allowed with respect to such foreign tax same that would be set in similar transfers with
paid, the taxpayer’s liability to tax in its jurisdiction unrelated parties. [Chs 1, 3, 10, 11]
of residence will be adjusted to take into account type I service company type I service company is
and to give credit for the foreign tax paid. [Ch10] a company or a trust used to disguise an
tax evasion not to be confused with tax employer–employee relationship by changing the
avoidance, tax evasion is a serious criminal contract of services into a contract for
offence whereby a person wilfully and dishonestly service. [Ch4]
and in breach of the taxing statute, whether by voluntary disposition inter vivos a transfer
act or omission, seeks to procure a tax advantage otherwise than for market consideration, treated
for themself. [Ch10] as a transfer giving rise to ad valorem stamp duty
tax mitigation a strategy to save tax (or generate under s.27 of SDO, unless specifically exempted
an allowable loss) that is considered less under s.27(5). [Ch7]
aggressive than tax avoidance, and is perceived as workday rule it refers to the apportionment
being in line with both the letter and purposive method for ascertaining the monthly taxable
intent of the taxing statute. [Ch10] income of a non-Chinese-domiciled non-tax
time apportionment basis the method of resident individual. Accordingly, a workday in
allocating income including leave pay to services China is calendar day which is spent in China for
rendered in Hong Kong based on the days an business purposes. A stay in China for less than
individual is present in Hong Kong using the 24 hours on a calendar day should be counted as
midnight rule. [Ch4] half workday in this regard. [Ch9]
time-in-time-out basis same meaning as time
apportionment basis. [Ch4]

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 T a b l e o f Ca ses

T ABLE OF C ASES

Ahn Sang Gyun v CIR (2009) HCIA 4/2008 4.2.2

All Best Wishes Ltd v CIR (1992) 3 HKTC 750 at 771 3.6.1

American Leaf Blending Co Sdn Bhd v DGIR (1978) STC 561 3.2.3

Avco Financial Services Ltd v FCT (1982) 13 ATR 63 3.10.6.1

AXY & Ors v Comptroller of Income Tax (2017) SGHC 42 10.5.3.8

Ayerst v C & K (Construction) Ltd (1976) AC 167 7.6

Bangkok Capital Antique Co Ltd v CSR (1984) 2 HKTC 83 7.8.6

Banque Nationale de Paris Hong Kong Branch v CIR (1985) 3.5.1

Bank voor Handel en Scheepvaart NV v Administrator of Hungarian Property (1954) 35 TC 311 4.2.2

Barclays Bank v Naylor (1958–1961) 39 TC 256 4.4.4

Barclays Mercantile Business Finance Ltd v Mawson (2005) STC 1 1.4.2.2

Becke v Smith (1836) 2 M&W 195 1.4.1.1

BFC v CIT (Singapore) (2014) SGCA 39 3.5.3.7

Bohemian Club v FCT (1918) 24 CLR 334 3.10.6.7

Bombay Presidency and Aden v Chunilal B Mehta (1938) 1 ITR 521 3.3.2

British Insulated and Helsby Cables Ltd v Atherton (1926) AC 205 3.6.2.2

British Mexican Petroleum Co Ltd v Jackson (1932) 16 TC 570 3.6.1

Brown v Bullock (1959–1963) 40 TC 1 4.6.1.3

Bywater Investments Ltd v Commissioner of Taxation; Hua Wang Bank Berhad v

Commissioner of Taxation (2016) HCA 45 4.2.1

Calvert v Wainwright (1947) 27 TC 475 4.4

Cape Brandy Syndicate v IRC (1921) 1 KB 64 3.2.1, 7.1.1

Carreras Group Ltd v Jamaican Stamp commissioner (2004) STC 1377 10.2.6

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CEC v CIT (1971) MSTC 551 10.2.1.3

Cheung Wah Keung v CIR (2002) 5 HKTC 698 10.2.1

Church Body of the Hong Kong Sheng Kung Hui v CIR (2017) 1 HKC 3.6.1.1

CIR v Aberdeen Restaurant Enterprises Ltd (1989) 1 HKRC 90-009 3.7.1, 3.7.2

CIR v Asia Television Limited (1987) 2 HKTC 198 8.3.1

CIR v Bartica Investment Ltd (1996) 4 HKTC 129 3.2.3

CIR v Carlingford Life and General Assurance Co Ltd (1989) 3 HKTC 229 3.10.6.2

CIR v Chinachem Finance Co Ltd (1989) 3 HKTC 529 3.10.6.1, 3.10.6.4

CIR v Chow Hung-kong (1978) HKLR 475 4.4.2

CIR v Church Body of the Hong Kong Sheng Kung Hui (2016) 1 HKC 1 3.2.1

CIR v Cosmotron Manufacturing Co Ltd (1997) 2 HKC 417 3.5.2

CIR v County Shipping Co Ltd (1990) 3.5.3.8

CIR v Datatronic Limited (2009) 4 HKLRD 675 3.3.3

CIR v Dr Chang Liang-jen (1977) 1 HKTC 975 3.6.1

CIR v Emerson Radio Corporation (2000) HKRC 90-102 8.2.3.1

CIR v Franco Tong Sui Lun (2006) HCIA 2/2006 4.6.1.4

CIR v Fraser (1942) 24 TC 498 3.2.1

CIR v General Garment Manufactory (Hong Kong) Ltd (1997) 4 HKTC 532 3.10.3, 3.10.6.1

CIR v George Andrew Goepfert (1987) 2 HKTC 210 4.2.2

CIR v Hang Seng Bank Ltd (1972) 1 HKTC 583 3.10.3

CIR v Hang Seng Bank Ltd (1990) 1 HKRC 1.1.2.1, 3.3.1, 3.3.2, 3.3.11

CIR v HK-TVBI Case International Ltd (1992) 1 HKRC 3.3.1, 3.3.3, 3.3.11

CIR v Humphrey (1970) HKTC 451 4.6.1.4

CIR v Indosuez WI Carr Securities Ltd (2002) 1 HKLRD 308 3.3.4

CIR v Lever Brothers & Unilever Ltd (1946) 14 SATC 1 3.4.1.4

CIR v Li & Fung (1980)1 HKTC 1193 3.10.6.1

CIR v Li & Fung (Trading) Ltd (2012) HKCU 643 3.3.11

CIR v Livingston and Others (1926) 11 TC 538 3.2.1

CIR v Lo & Lo (1984) 3.5.1

CIR v Magna Industrial Co Ltd (1997) HKLRD 171 3.3.2

CIR v Malaysian Airline System Berhad (1994) 3 HKTC 775 3.10.6

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CIR v National Mutual Centre (HK) Ltd (1998) 3 HKC 397 3.5.3

CIR v N V Philips Gloeilampenfabrieken (1946) 10 ATD 435 3.4.1.4

CIR v Orion Caribbean Ltd (1997) 1 HKLRD 924 3.3.1, 3.3.5, 3.4.1.4, 3,5.3.1, 3.10.6.1

CIR v Perfekta Enterprises Ltd (2019) HKCFA 25 3.6.1.1

CIR v Peter Leslie Page (2002) 5 HKTC 683 4.4.2

CIR v Pang Fai (2017) 1 HKLRD 1275 2.4.4, 4.2.2.1

CIR v Sanford Yung-Tao Yung (1979) HKTC 959 3.8.1.5, 4.6.6.1

CIR v Sawhney, Subhash Chander (2005) HKRC 4.4.3.1

CIR v Scottish & Newcastle Breweries Ltd (1981) 1 WLR 322 3.7.1.1

CIR v Secan Ltd & Anor (2000) HKCFAR 411 3.8.1.1, 3.10.3

CIR v SIN Chun-wah (1988) 2 HKLR 496 at 498 4.6.1.4

CIR v Sincere Insurance and Investment Co Ltd (1973) 1 HKTC 602 3.6.1, 3.10.3

CIR v So Chak Kwong, Jack (1986) 2 HKTC 174 4.1.2.2

CIR v Swire Pacific Ltd (1979) 1 HKTC 1145 3.6.2.2

CIR v Tai Hing Cotton Mill (Development) Limited (2008) 2 HKLRD 40 10.2.1.3, 10.2.6

CIR v Tai On Machinery Works Ltd (1969) 1 HKTC 411 3.5.3.7

CIR v The Hong Kong & Whampoa Dock Co Ltd (1960) 1 HKTC 85 3.3.1

CIR v Willoughby (1997) STC 995 10.2.6

CIR v Yick Fung Estates Ltd (1999) 5 HKTC 52 3.9.4, 10.2.1.1

CIR v Yung Tse-Kwong (2003) HICA 5 4.4.8.4

CLP Power Hong Kong Ltd v Commissioner of Rating and Valuation (2017) 3 HKC 249 3.7.1

Collector of Stamp Revenue v Arrowtown Assets Ltd (2004) HKLRD 77 1.4.2.2, 7.9, 10.2.4

Consco Trading v CIR (2004) 1 HKRC 90-132 3.3.3

CoT v British Shoe Machinery (SA) (Pty) Limited (1964) 26 SATC 163 3.3.6

CoT v Cam & Sons Ltd (1936) 36 SR (NSW) 544 3.3.2

CoT v Kirk (1900) AC 588 3.3.1

Dairyfarm Establishment & The Dairy Farm Company Limited v CIR (2018) HKCFI 2245 2.6.3.2

Datatronic v CIR (2011) 2 HKLRD 763 3.3.3

David Hardy Glynn v CIR (1990) 3 HKTC 245 4.4.1

973

M14_b02.indd 973 1/25/2021 11:04:13 PM

 TAXATION

De Beers Consolidated Mines Ltd v Howe (1906) 5 TC 198 4.2.1, 10.5.3.1

Denver Chemical Manufacturing Co v FCT (1949) 4 AITR 216 10.6.2

Edwards v Bairstow (1956) AC 14 3.6.1

Edwards v Clinch (1981) STC 617 4.2.1

Ensign Tankers (Leasing) Ltd v Stokes (1992) 1 AC 655 10.2.6

Esquire Nominees Ltd v FCT (1971–1973) 129 CLR 177 3.3.1

Europa Oil (NZ) Ltd v IRC (1976) 1 WLR 646 10.2.1.3

Extramoney Ltd v CIR (1997) 2 HKC 38 2.4.5

Fall v Hitchen (1972) 49 TC 433 4.2.2

FCT v Spotless Services Limited (1997) 34 ATR 183 10.2.1.3

Federal Commissioner of Taxation (FCT) v Cooke and Sherden (1980) 80 ATC 4140 4.4

F.L. Smidth & Co v Greenwood (1921) 3 K.B. 593 3.3.1

Fuchs, Walter Alfred Heinz v CIR (2011) HKCFAR 74 4.4.8.1, 4.4.8.2

Furniss v Dawson (1984) 1 AII ER 530 1.4.2.2

G Deacon & Sons v CIR (1952) 33 TC 66 2.6.2.2

George Wimpey & Co Ltd v IRC (1975) 2 All ER 45 7.2

Glenboig Union Fireclay Co Ltd v IRC (1921) 12 TC 427 3.6.1

Graham v CIR (1995) 17 NZTC 12 3.5.2

Great Western Railway v Bater (1922) 8 TC 231 4.2.1

Grey v Pearson (1857) HL CAS 61 1.4.1.1

Guoji Transport Co Ltd v CSR (1997) HKLRD 1168 7.2.9

Hafal v Lane-Angell (2018) EAT 0107/17 4.2.2

Harrods (Buenos Aires) Ltd v Taylor-Gooby (1964) 41 TC 450 3.5.2

974

M14_b02.indd 974 1/25/2021 11:04:13 PM

 T a b l e o f Ca ses

Henriksen v Grafton Hotel Ltd (1942) 24 TC 453 3.6.2.3

Heydon’s Case (1584) 76 ER 637 1.4.1.1

Higgs v Olivier (1952) CH 311 3.6.1

HIT Finance Ltd & Another v CIR (2008) 2 HKLRD 52 10.2.1.3

HKSAR v Gammon (2003) 3 HKC 276 3.11.4

Ho Kwok Tai v CSR (2016) 5 HKLRD 713 7.2.4

Hochstrasser v Mayes (1960) AC 376 4.4

Hudson’s Bay Co v Stevens (1909) 5 TC 424 3.2.1

Income Tax Special Commissioners v Pemsel (1891) AC 531 4.6.6.1

India v Taylor (1955) AC 491 10.5.4

ING Baring Securities (Hong Kong) Ltd v CIR (2008) 1 HKLRD 412 3.3.1, 3.3.11

IRC v Duke of Westminster (1936) AC 1 (HL) 1.4.2.2, 10.1

IRC v John Lewis Properties plc (2003) STC 117 3.6.1

IRC v Lysaght (1928) AC 234 6.2.1

IRC v Maxse (1919) 1 KB 647 3.2.2

IRC v McGuckian (1997) STC 908 1.4.2.2

IRC v Reinhold (1953) 34 TC 389 3.6.1

IRC v Rennell (1964) AC 173 7.6

IRC v Scottish & Newcastle Breweries (1982) 2 All ER 230 3.7.1

Iswera v IRC (1965) 1 WLR 663 at 668 3.6.1

Kelsall Parsons & Co v IRC (1938) 21 TC 608 3.6.1, 3.8.1.5

Kim Eng Securities (Hong Kong) Ltd v CIR (2007) 2 HKLRD 117 3.3.11

Koo Ming Kown & Anor v CIR (2018) HKCFI 2593 10.2.5

Kowloon Stock Exchange Ltd v CIR (1984) STC 602 3.2.1, 3.10.6.7

Kwong Mile Services Ltd v CIR (2004) 3 HKLRD 168 3.3.11, 3.6.1

KWP Quarry Co Ltd v IRBR HCAL 102/2016 3.6.2.3

975

M14_b02.indd 975 1/25/2021 11:04:13 PM

 TAXATION

Lam Soon Trademark v CIR (2005) HKLRD 625 2.6.3.1, 3.3.8, 8.2.3.1

Lee Hung Kwong v CIR (2005) 4 HKLRD 80 4.2.2, 4.11.1

Lee Yee Shing Jacky & Anor v CIR (2008) 2 HKC 436 3.2.1, 3.2.3. 3.6.1, 3.10.3, 10.4.5.1

Leung Chun Kwong v Secretary for the Civil Service (2019) 22 HKCFAR 127 4.1

Limmer Asphalte Paving Co v IRC (1872) LR 7 Ex 211 7.1.2

Lincolnshire Sugar v Smart (1937) AC 697 3.6.1

Littlewoods Mail Order Stores Ltd v IRC (1963) AC 135 7.2.9, 7.7

Louis Kwan-nang Kwong and Carlos Kwok-nang Kwong v CIR (1982) 2 HKTC 541 5.1.2

MacNiven v Westmoreland Investments Ltd (2001) STC 237 7.9, 10.2.4

Mallalieu v Drummond (1983) 2 AC 861 3.5.3.4, 4.6.1.5

Magna Industrial v CIR (1997) 1 HKLRD 173 3.3.1, 3.3.11

Mamor Sdn Bhd v DGIR (1985) STC 801 3.6.1

Mangin v IRC (1971) AC 739 7.1.1

Market Investigations Ltd v Minister of Social Security (1969) 2 Q.B. 173 4.2.2, 4.4.1.1

Marson v Morton (1986) 1 WLR 1343 3.2.1

McMillan v Guest (1942) 24 TC 190 4.2.1

Medical Council of Hong Kong v Chow Siu Shek David (2000) 2 HKC 428 1.4.1.1

Millin v CIR (1928) AC 207 3.3.8

Miramar Hotel & Investment Co Ltd v CSR (1961) 1 HKTC 755 7.2.9

Mok Tsze Fung v CIR (1962) 1 HKTC 166 2.6.3.2

Moulin Global Eyecare Holdings Ltd (in Liquidation) v CIR (2014) 17 HKCFAR 218 2.4.5

Murad v CIR (2010) 1 HKLRD C6 4.4.8.2

New Zealand Commissioner of Inland Revenue v Challenge Corporation Ltd (1986) STC 548 10.2.6

Ngai Lik Electronics Co Ltd v CIR (2010) 2 HKC 1 10.2.1

Nice Cheer Investment Ltd v CIR (2014) 2 HKC 112 3.10.3

976

M14_b02.indd 976 1/25/2021 11:04:13 PM

 T a b l e o f Ca ses

Nina T. H. Wang v CIR (1991) 3 HKTC 483 2.6.3.2

Nomura Funds Ireland v CSR (2017) DCSA 4 7.11

Oakey Abattoir v FCT (1984) 55 ALR 291 1.4.2.2

Ogilvy and Mather Pty Ltd v FCT (1990) 90 ATC 4836 4.6.1.3

Overseas Textiles Ltd v CIR (1990) 3 HKTC 29 3.8.2

PA Holdings Ltd v Revenue and Customs Commissioners (2012) STC 582 4.4.1

Patcorp Investments Ltd v FCT (1976) 140 CLR 247 1.4.2.2

Payne v FCT (1996) 66 FCR 299 4.4

Pickford v Quirke (1927) 13 TC 251 3.2.1

Pitt v HMRC and Futter v HMRC (2013) UKSC 26 10.1

Poon Cho Ming, John v CIR CACV 94/2016 (2018) HKCA 297 4.4.8.1, 10.4.1

R v Ng Wing-keung (1996) 4 HKTC 264 10.6.2

Rangatira Ltd v CIR (1997) STC 47 3.2.1

RCC v Anson (2015) UKSC 44 10.5.1

Re Chia Tai Conti-Hong Kong Ltd 6 HKTC 688 2.6.3.2

Re Little Olympian Each Ways Ltd (1995) 1 WLR 560 4.2.2

Re Marseilles Imperial Land Co. L.R. 11 Eq. 478 7.4

Reg v Barnet London Borough Council ex parte Shah (1983) 2 AC 309 4.7.3, 6.2.1

Rhodesia Metals Ltd (Liquidator) v CoT (1940) AC 774 3.3.1, 3.3.6, 3.6.1

Ricketts v Colquhoun (1926) AC I 4.6.1.5

Roger Jesse Robertshaw v CIR (2006) HKRC 4.4.2

Rolls-Royce Motors Ltd v Bamford (1976) STC 162 3.12.1, 10.4.4

Royal Insurance Co v Watson (1897) AC 1 3.8.2

977

M14_b02.indd 977 1/25/2021 11:04:13 PM

 TAXATION

Seramco Ltd Superannuation Fund Trustees v ITC (Jamaica) (1977) AC 287 10.2.1

Sharkey v Wernher (1956) AC 58 3.8.3, 3.10.1

Shiu Wing Ltd v Commissioner of Estate Duty (2000) 3 HKLRD 76 1.4.2.2

Shop and Store Developments Ltd v IRC (1967) 1 AC 472 7.7

Shun Lee Investment Co Ltd v CIR (1967) HKLR 712 3.10.6.4

Simmons v IRC (1980) 2 All ER 798 3.2.1

Sit Kwok Keung v CIR (2002) 5 HKTC 647 4.7, 4.7.4

Stedeford v Beloe (1929–1932) 16 TC 505 4.2.3

Street v Mountford (1985) UKHL 4 7.2.9

Studebaker Corporation of Australia Limited v Commissioner of Taxation for New South Wales
(1921) 29 CLR 225 3.3.5

Sun Hing Co v Brilliant Investment Co Ltd (1966) HKLR 310 7.8.7

Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) HCA 73 3.6.2.3

Sun Yau Investment Co Ltd v CIR (1984) 2 HKTC 17 2.4.5

Tan Kay Thye v Commissioner of Stamp Duties (1991) 3 MLJ 150 7.6

Taylor v Good (1974) STC 148 3.2.1

Turner Entertainment Networks Asia, Inc v CIR (2015) HKC 33 3.4.1

United States v American Trucking Association (1940) 310 US 534 1.4.1.1

Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 3.6.2.1

Vallejos Evangeline B. v Commissioner of Registration and Another (2013) 2 HKLRD 533 4.7.3, 6.2.1

Van den Berghs Ltd v Clark (1935) AC 431 3.6.1

978

M14_b02.indd 978 1/25/2021 11:04:13 PM

 T a b l e o f Ca ses

Wharf Properties Ltd v CIR (1997) 4 HKTC 310 3.5.3.7, 3.6.2.3

William Cory & Son Ltd v IRC (1965) AC 1088 7.1.2

Wisdom v Chamberlain (1969) 1 WLR 275 3.2.1

Wood v Holden (Inspector of Taxes) (2006) EWCA Civ 26 4.2.1

W.T. Ramsay Ltd v IRC (1982) AC 300 1.4.1.1, 1.4.2.2, 7.9, 10.2.4

Yarmouth v France (1887) 19 QBD 647 3.7.1

Yau Wah Yau v CIR (2006) 3 HKLRD 586 4.4.2

Yewens v Noakes (1880) 6 QBD 530 4.2.2

Zeta Estates Limited v CIR (2007) 2 HKLRD 102 3.5.3.7

979

M14_b02.indd 979 1/25/2021 11:04:13 PM

M14_b02.indd 980 1/25/2021 11:04:13 PM
 T a b l e o f O r d in a nces

T ABLE OF ORDINANCES

A
Air Pollution Control Ordinance (Cap.311), 3.5.2

B
Banking Ordinance (Cap.155), 3.4.1.4, 3.5.3, 3.5.3.3, 3.5.3.7, 3.10.6.3, 10.4.6

Bankruptcy Ordinance (Cap.6), 7.7

Betting Duty Ordinance (Cap.108), 1.3.1, 2.1.1

Building Management Ordinance (Cap.344), 5.1.1.1, 7.2

Buildings Ordinance (Cap.123), 7.2

Business Registration Ordinance (Cap.310), 1.3.1, 2.1.1, 3.3.1, 3.8, 3.11.5, 7.2.3, 10.4.2, 10.5.3.3

C
Companies Ordinance (Cap.622), 7.3.1, 7.4, 7.11, 10.4.4

Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap.32), 7.7

Consular Relations Ordinance (Cap.557), 5.4.1

Conveyancing and Property Ordinance (Cap.219), 7.2.9

Co-operative Societies Ordinance (Cap.33), 5.1.1.1

Credit Unions Ordinance (Cap.119), 4.6.6.3

Criminal Procedure Ordinance (Schedule 8), 2.5, 10.6.2

E
Employment Ordinance (Cap.57), 2.6.3.3, 4.4.8.2, 4.4.8.3

Estate Duty Ordinance (Cap.111), 1.3.1, 2.1.1

G
Government Rent (Assessment and Collection) Ordinance (Cap.515), 5.3

H
Hong Kong Reunification Ordinance (Instrument A601), 1.2

Hotel Accommodation Tax Ordinance (Cap.348), 1.3.1, 2.1.1

I
Inland Revenue (Amendment) Ordinance 1989, 8.3.2

Inland Revenue (Amendment) Ordinance 2004, 8.3.2

Inland Revenue (Amendment) (No. 3) Ordinance 2018, 8.1

Inland Revenue (Amendment) (No. 6) Bill 2017 [Ch1], 8.1.1

Inland Revenue (Amendment) (No. 6) Ordinance 2018, 2.1.1.5, 2.2.4.4, 8.1.1, 11.2, 11.3, 11.3.2

981

M14_b03.indd 981 1/25/2021 11:04:23 PM

 TAXATION

Inland Revenue Ordinance (IRO) (Cap.112), 1.1.3.1, 1.3.1, 1.4, 1.4.2.2, 1.4.3, 2.1.1, 2.1.1.2, 2.1.1.3, 2.1.1.5,
2.1.2, 2.1.2.1, 2.1.2.4, 2.1.2.7, 2.2.1, 2.2.2.1, 2.2.3, 2.2.3.1, 2.2.4.1, 2.2.4.2, 2.2.4.3, 2.2.4.5, 2.3.1, 2.3.2, 2.4,
2.4.2, 2.5, 3.1.1, 3.1.2, 3.2.1, 3.2.2, 3.2.3, 3.2.4, 3.3, 3.3.5, 3.3.6, 3.3.10, 3.3.11, 3.3.12, 3.4.1, 3.4.1.1, 3.4.1.2,
3.4.1.3, 3.4.1.4, 3.4.3, 3.5, 3.5.1, 3.5.2, 3.5.3.1, 3.5.3.4, 3.5.3.7, 3.5.4, 3.6.1, 3.6.2.3, 3.7, 3.7.1, 3.7.1.1, 3.7.1.2,
3.7.2, 3.7.3, 3.8.1.5, 3.8.2, 3.8.3, 3.9.3, 3.9.4, 3.10.1, 3.10.2, 3.10.3, 3.10.4, 3.10.5, 3.10.6.1, 3.10.6.2, 3.10.6.3,
3.10.6.4, 3.10.6.4, 3.10.6.5, 3.10.6.6., 3.10.6.7, 3.10.6.8, 3.10.6.6, 3.11, 3.11.1, 3.11.2, 3.12.1, 3.12.2, 3.12.4,
3.12.4.1, 3.12.4.2, 4.1, 4.2, 4.3, 4.4, 4.4.1, 4.4.2, 4.4.3, 4.4.4, 4.4.5, 4.4.6, 4.4.7, 4.4.8, 4.5, 4.5.1, 4.5.2, 4.6, 4.6.1,
4.6.1.5, 4.6.1.8, 4.6.2, 4.6.3, 4.6.4, 4.6.5, 4.6.6, 4.6.6.1, 4.6.6.2, 4.6.6.3, 4.6.6.4, 4.6.6.5, 4.6.6.6, 4.7, 4.7.1, 4.7.2,
4.7.4, 4.7.5, 4.8, 4.8.1, 4.9, 4.9.1, 4.10.1, 5.1, 5.1.1.1, 5.1.1.4, 5.1.2, 5.1.3, 5.1.4.1, 5.1.4.2, 5.1.4.3, 5.2, 5.2.1,
5.4.2, 5.4.2.1, 5.5.1, 6.2.1, 6.2.2, 6.3.2, 6.4, 6.4.1, 6.4.1.1, 6.4.1.2, 6.4.1.3, 6.4.1.4, 6.4.2, 6.5.1, 7.2.7, 7.2.8, 7.3.1,
8.1.1, 8.2, 8.2.1, 8.2.2, 8.2.3, 8.3.1, 8.3.2, 8.3.3, 8.3.4, 10.1, 10.2, 10.2.1, 10.2.1.1, 10.2.1.2, 10.2.1.3, 10.2.2.1,
10.2.2.2, 10.2.2.3, 10.2.2.4, 10.2.3, 10.2.4, 10.2.5, 10.3, 10.4.1, 10.4.2, 10.4.3, 10.4.4, 10.4.5.1, 10.4.6, 10.5,
10.5.1, 10.5.3.2, 10.5.3.3, 10.5.3.4, 10.5.3.5, 10.5.3.6, 10.5.3.7, 10.5.3.8, 10.5.4, 10.5.4.1, 10.5.4.2, 10.5.5,
10.5.6, 10.6.1, 10.6.2, 11.2.1, 11.2.2, 11.4.1, 11.4.2.1, 11.5.1, 11.5.2

Inland Revenue Ordinance (Part 6), 10.4.5

Inland Revenue Ordinance (Part 8), 10.2.2, 10.2.3, 10.4.4, 10.4.6, Chapter 11

Inland Revenue Ordinance (Part 9), Chapter 11

Inland Revenue Ordinance (Schedule 1), 3.1.2, 4.1, 4.10

Inland Revenue Ordinance (Schedule 2), 4.1, 4.10

Inland Revenue Ordinance (Schedule 3), 3.5.3, 4.6.5, 4.6.5.1, 4.6.6, 4.6.6.2, 4.6.6.3, 4.6.6.4, 4.6.6.5, 4.6.6.6
Inland Revenue Ordinance (Schedule 4), 4.7, 4.7.2

Inland Revenue Ordinance (Schedule 5), 4.10.2

Inland Revenue Ordinance (Schedule 7F), 3.10.6.6

Inland Revenue Ordinance (Schedule 8), 3.1.2, 3.10.6.6

Inland Revenue Ordinance (Schedule 8A), 3.1.2

Inland Revenue Ordinance (Schedule 8B), 3.1.2

Inland Revenue Ordinance (Schedule 10), 10.3

Inland Revenue Ordinance (Schedule 13), 4.6.5.3

Inland Revenue Ordinance (Schedule 16), 3.10.6.3

Inland Revenue Ordinance (Schedule 16C), 3.10.6.3

Inland Revenue Ordinance (Schedule 17), 3.5.2

Inland Revenue Ordinance (Schedule 17A), 3.10.4

Inland Revenue Ordinance (Schedule 17B), 3.10.6.4

Inland Revenue Ordinance (Schedule 17F), 3.10.6.6

Inland Revenue Ordinance (Schedule 17G), 2.1.1.5, 2.1.2.7, 3.2.4, 3.3.2, 8.1.1, 10.5.3.2

Inland Revenue Ordinance (Schedule 17I), 11.3.1

Inland Revenue Ordinance (Schedule 45), 3.5.2, 3.5.3

Inland Revenue Rules (Cap.112A), 1.1.2, 8.1.1, 8.2.1

Insurance Ordinance (Cap.41), 3.10.6.24.6.6.6

Interpretation and General Clauses Ordinance (Cap.1), 1.2, 7.2, 10.5.1

982

M14_b03.indd 982 1/25/2021 11:04:23 PM

 T a b l e o f O r d in a nces

L
Land (Compulsory Sale for Redevelopment) Ordinance (Cap.545), 7.2.7, 7.2.8

Land Acquisition (Possessory Title) Ordinance (Cap.130), 7.2.8

Land Drainage Ordinance (Cap.446), 7.2.8

Lands Resumption Ordinance (Cap.124), 7.2.8

Loans Ordinance (Cap.61), 3.4.3, 7.3.1

Loans (Government Bonds) Ordinance (Cap.64), 3.4.3

M
Mandatory Provident Fund Schemes Ordinance (Cap.48S), 4.6.6.6

Mass Transit Railway (Land Resumption and Related Provisions) Ordinance (Cap.276), 7.2.8

Money Lenders Ordinance (Cap.163), 4.6.6.3

O
Occupational Retirement Schemes Ordinance (Cap.426), 4.4.1

P
Partnership Ordinance (Cap.38), 3.11.4

Personal Data (Privacy) Ordinance (Cap.486), 10.5.3.8

R
Railways Ordinance (Cap.519), 7.2.8

Rating Ordinance (Cap.116), 4.4.2, 5.1.1, 10.4.5.1

Roads (Works, Use and Compensation) Ordinance (Cap.370), 7.2.8

S
Securities and Futures Ordinance (Cap.571), 3.4.3, 3.5.3.5, 3.5.3.7, 3.10.6.3

Stamp Duty Ordinance (SDO) (Cap.117), 1.3.1, 2.1.1, 2.1.1.1, 3.10.2, 5.1.4.3, 7.1, 7.1.1, 7.1.3, 7.2.2, 7.2.3, 7.2.4,
7.2.5, 7.2.7, 7.2.8, 7.2.9, 7.3, 7.3.1, 7.4, 7.6, 7.7, 7.8.1, 7.8.3, 7.8.5, 7.8.6, 7.8.7, 10.4.4

Stamp Duty Ordinance (First Schedule), 7.1.1, 7.1.3, 7.2.2, 7.2.3, 7.2.5, 7.2.8, 7.2.9, 7.3.1, 7.4, 7.5, 7.8.2, 7.8.5,
7.9, 7.10, 10.4.3

T
Tax Reserve Certificates Ordinance (Cap.289), 1.3.1, 2.1.1

Transfer of Businesses (Protection of Creditors) Ordinance (Cap.49), 10.4.5.1

W
Waste Disposal Ordinance (Cap.354), 3.5.2

Water Pollution Control Ordinance (Cap.358), 3.5.2

983

M14_b03.indd 983 1/25/2021 11:04:23 PM

M14_b03.indd 984 1/25/2021 11:04:23 PM
 T a b l e o f   B o a r d o f  R ev iew Decisions

T A B L E OF   BOARD OF   REVIEW DECISIONS

D2/06 4.1.2.2 D29/89 4.1.2.2

D3/14 4.7.4 D29/95 4.1.2.3
D4/91 4.4.3.1 D30/03 4.1.2.3
D5/02 4.6.6.3 D30/07 4.7.1
D5/93 4.6.1.5 D31/05 4.6.6.2
D6/17 4.6.1.8 D31/87 2.4.4
D7/04 4.6.2 D33/97 4.4.2
D7/15 4.4.3.1 D36/90 4.6.1.8
D8/92 4.2.2 D36/95 4.4.2
D10/11 4.7.4 D37/92 4.6.1.8
D11/01 4.6.1.5 D38/04 4.4.2
D11/07 4.6.6.3 D40/0 4.1.2.2
D11/13 4.1.2.1 D40/11 4.4.8.2
D11/15 6.2.1 D40/12 4.6.6.3
D11/97 4.1.2.2 D41/92 4.6.1.5
D15/15 4.7.5 D43/00 4.6.1.8
D17/12 4.9.1.2 D43/99 4.4.3.1
D18/99 4.4.2 D46/87 4.4.2
D19/16 4.1.2.2 D49/94 4.3.1
D20/00 4.1.2.2 D52/04 3.7.1.1
D20/09 4.4.2 D52/86 1.4.2.2
D20/10 4.7.2 D53/04 4.4.2
D20/97 4.2.2, 4.11.1 D53/12 4.1.2.3
D21/13 4.2.1 D54/11 4.6.6.1
D21/16 4.4.1 D54/94 4.6.1.1
D22/01 4.6.6.3 D55/12 4.9.1.5
D22/11 4.7 D55/91 4.11.1
D23/14 4.6.1.7 D66/06 4.4.3.1
D24/87 4.6.1.7 D76/90 4.6.1.4, 4.6.1.5, 4.6.1.8
D25/87 4.6.1.5, 4.6.1.8 D78/06 4.4.1.1
D26/07 4.9.1.5 D79/05 4.1.2.2
D27/03 4.1.2.2 D80/92 or 02 5.1.4.1
D27/98 5.1.4.1 D82/06 4.6.5

985

M14_b04.indd 985 1/25/2021 11:04:32 PM

 TAXATION

D84/03 4.4.3.1 D106/89 4.3.1

D84/04 5.4.2.1 D121/97 4.6.1.8
D88/99 4.6.5.1 D123/01 4.6.6.3
D90/03 4.1.2.2 D140/01 4.7
D92/95 4.4.2 D149/00 4.4.2
D98/00 4.6.1.8

986

M14_b04.indd 986 1/25/2021 11:04:33 PM

 P r a c t ic e No t es a n d   C ir c ul a r s

P R A C T I C E N OTES A N D   CIRCULARS

D
DIPN 4 (Revised), 5.1
DIPN 5, 3.5.2
DIPN 6 (Revised), 2.1.1.5, 2.4, 2.4.4
DIPN 7 (Revised), 3.7.1, 4.6.2
DIPN 8, 3.12.4.1, 3.12.4.2
DIPN 9 (Revised), 4.6.1.3, 4.6.1.5, 4.6.1.8, 4.9.1.5
DIPN 10 (Revised), 1.1.2.1, 4.2.1, 4.2.2, 4.3.1, 4.6.6.6
DIPN 11 (Revised), 2.6.2.2, 10.6.2
DIPN 13 (Revised), 3.3.5, 3.3.10, 3.4.1.4, 3.5.3, 3.5.3.7
DIPN 14 (Revised): Property Tax, 5.1, 5.1.2, 5.1.4.1, 5.6
DIPN 15 (Revised), 1.4.2.2, 3.7.1.2, 10.2.1, 10.2.2, 10.2.5
DIPN 16 (Revised), 4.4.1, 4.4.4, 4.4.6, 4.11.2
DIPN 17 (Revised), 8.1, 8.3.1, 8.3.3
DIPN 18 (Revised), 6.2.2, 4.7, 4.7.3, 4.8.2
DIPN 21 (Revised), 2.1.1.4, 3.3.1, 3.3.10, 3.10.6.1
DIPN 22 (Revised), 8.2.3
DIPN 23 (Revised), 4.4.7
DIPN 24, 10.2.2
DIPN 25 (Revised), 4.2.2, 4.4.1.1, 10.2.2
DIPN 26, 3.10.2
DIPN 27, 3.10.2
DIPN 28 (Revised), 3.5.2, 3.10.6.1
DIPN 29, 1.2.2
DIPN 30 (Revised), 8.3.1
DIPN 31 (Revised), 10.3
DIPN 33 (Revised), 4.1.3
DIPN 35 (Revised), 4.6.6.3
DIPN 36, 4.6.6.2
DIPN 37 (Revised), 3.5.2, 4.6.6.1
DIPN 38 (Revised), 4.4.3, 4.4.3.1, 4.4.3.2
DIPN 39, 3.3.7
DIPN 40, 3.8.4
DIPN 41, 4.10.1
DIPN 42, 3.10.3
DIPN 44, 3.3.10, 10.5.4.2, 10.5.6
DIPN 45, 11.5.1, 11.5.2,
DIPN 46, 3.10.6.4, 11.6.1, 11.6.2
DIPN 47 (Revised), 2.1.1.2, 10.5.3.8

987

M14_b05.indd 987 1/25/2021 11:04:41 PM

 TAXATION

DIPN 48, 10.3, 11.4, 11.4.1.3, 11.4.1.5, 11.4.2, 11.4.2.1

DIPN 49, 3.3.8, 3.3.10
DIPN 50, 3.10.4, 5.1.4.3
DIPN 52, 3.5.3.7, 3.10.6.4
DIPN 53, 3.10.5
DIPN 54, 3.10.6.6
DIPN 56, 4.6.6.5
DIPN 60, 2.1.1.5, 3.2.4, 8.1.1, 10.5.3.3

G
Guofa (2018) No. 41, 9.4
Guoshuifa (1995) No. 192, 9.2.1.4
Guoshuifa (1997) No. 54, 9.4.5.1
Guoshuifa (2005) No. 9, 9.4.5.1
Guoshuifa (2009) No. 78, 9.4.3.1
Guoshuifa (2011) No. 70, 9.3.5.1
Guoshuifa (2012) No. 84, 9.2.1.4
Guoshuifa (2013) No. 5, 9.3.5.1
Guoshuifa (2013) No. 74, 9.2.1.4
Guoshuifa (2016) No. 36, 9.2.1
Guoshuifa (2018) No. 164, 9.4

M
MOF and STA Joint Announcement (2019) No. 34, 9.4
MOF and STA Joint Announcement (2019) No. 35, 9.4
MOF and STA Joint Announcement (2019) No. 74, 9.4

N
Notice of the State Administration of Taxation (2010) No. 18, Chapter 11
Notice of the State Administration of Taxation (2016) No. 28, Chapter 11

S
STA Announcement (2018) No. 56, 9.4
STA Announcement (2018) No. 59, 9.4
STA Announcement (2018) No. 60, 9.4
STA Announcement (2018) No. 61, 9.4
STA Announcement (2018) No. 62, 9.4
Stamp Office Interpretation and Practice Notes (SOIPN) No. 1, 7.2.3, 7.2.5, 7.2.7
Stamp Office Interpretation and Practice Notes No. 6, 5.1.4.3

988

M14_b05.indd 988 1/25/2021 11:04:41 PM

 Ind ex

I NDEX

NOTE: Key Terms and their page references are given in bold

A flat rate deductions for certain

employment, 409
Accommodation benefits payments to assistant, 408
chargeable to salaries tax, 361, 362 professional institution subscription, 408–409
rental value, 364–372 record-keeping and substantiation, 410–411
rent refund, 363–364 travelling expenses, 409
‘what transpired at the time of payment,’ 364 wholly, exclusively and necessarily incurred,
Accounting date, 246–249 405–406
Accounting policy, 238 Alternative bond schemes (ABS), 254–255,
Actual profits method, 51 516, 673–674
Ad valorem stamp duty, 625 Annual allowance (AA), 226
charge to, 638–642 for hire purchase, 214
rates of, 642–644 pooling system, 209–210
Advance pricing agreement (APA), 851 Annual bonus, 801
Advance pricing arrangements (APA), 937 Annual tax returns and final settlement, 772
application procedures Anti-avoidance provisions
analysis and evaluation, 942 general, 834–838
drafting, executing and monitoring, 943 penalty, 846–847
formal application, 941–942 Ramsay principle, application of, 845–846
negotiation and agreement, 942–943 specific, 839–844
pre-filing, 941 summary of, 844–845
assurance, 939 tax implications and development of, 847–848
benefits of, 943–944 Arm’s length principle (ALP), 12, 155–156, 851
content of, 938–939 Ascertainment of assessable income
mutual expectation, enhancement of, 940 income accrued and received
threshold, 939–940 deemed commencement and cessation
time frame, 939 of an employment, 444
Advance ruling, 851–853 income accrued but not received, 442–443
Agent, 66 income deemed accrued, 444
Agreement for sale, 626 income deemed received, 442–444
Aircraft leasing company, 282–283 income received but not accrued, 444–445
Aircraft owners, 279–282 lump sum payment on cessation of employment
Allowable deductions, 521, 795–797 or deferred pay, 446–447
concessionary deductions, 416–433 Assessable income, 71
depreciation allowances, 411–414 Assessable profits, 46, 127, 128
joint assessment, 415 Assessable value, 518
loss brought forward, 414–415 Assess first audit later (AFAL) approach, 63, 90
outgoings and expenses demand for payment, 71
assessable income production, 406–407 notice of assessment, 71
capital expenditure, 405 payment of taxes, 73–74
clothing, 407–408 time limit, 70–71
commission payment for services, 408 Assessment, 129
domestic and private expenses or Assets Betterment Statement (ABS) method, 92–93
outgoings, 405 Assignment, 633
entertainment expenses, 408 Associate, 705
expense allowances from employer, 409 Associated corporation, 706

989

M14_bindex.indd 989 1/27/2021 12:27:23 AM

 TAXATION

Authorised captive insurer, 265–266 fixed capital and circulating capital, 203–206
Authorised representative, 46 Capital gains, 22, 199, 855, 881–882, 887–888
Automatic exchange of information (AEOI), 848 Capital receipts, 199–201
Captive agent, 336
Case law, 26–28
B
Cash, seller’s perspective, 864
Bad debts, 257 Cessation of business, 242–245
Badges of trade, 131 Change of intention, 202–203
Balancing allowance, 216, 218 Charge, 218
Balancing charges, 216 Chargeable income, 787–789
profits tax computation, 231 Charitable donations, 767
Bank Deposits method, 93 Cheung Luck An (HK) Ltd (CLA), 733
Base erosion and profit shifting (BEPS), 11–12, China
848, 871–874 corporate income tax, 758
Basis period, 169 annual tax returns and final settlement, 772
accounting date, 246–249 calculation, 762–771
business foreign-invested enterprises, 772–777
cessation of, 242–245 incentives, 771–772
commencement, 240–242 liability, 760
normal/continuing, 240 non-tax resident enterprise, 759–760
Bearer instruments, 659 resident enterprise, 759
BEPS. See Base erosion and profit shifting (BEPS) withholding tax on non-tax resident
Board of Review (BOR), 514 enterprise, 760–762
decisions, 28–29, 56 individual income tax, 777–780
excuses rejected by, 82–83 filing and payment, 803–805
functions and procedures, 55–56 incentives, 800–803
notice of hearing, 56 non-tax resident, 780–786
primary functions of, 55 rates and computation, 790–800
Branch, 859 residence, 780
Broad guiding principle, 141 specific rules, 804–805
Business, 127 taxable income, 786–790
cessation of, 242–245 tax system, 734–735
commencement, 240–242 administration and collection, 735–736
normal/continuing, 240 attract investments, 740
special transactions and disputes and appeals, 737–739
aircraft leasing company, 282–283 foreign investments, 739
clubs and associations, 283–285 penalties and surcharges, 736–737
corporate treasury centres, 268–274 turnover taxes, 741
financial institutions, 256–259 consumption tax, 754–757
Hong Kong branch of an overseas company, value added tax, 741–754
285–286 Chinese-sourced income, 789
insurance companies, 259–266 Chinese tax resident, 780
privately offered funds, 266–268 Clubs associations, 283–285, 525–526
ship and aircraft owners, 275–282 Combined reduced total income, 598
and tax purposes, entity choice for, 293–294 Commencement of business, 240–242
Business Economics method, 93–94 Commercial building allowance, 226–229
Business profits, 880–881 Commercial occasion or event, 714
Commissioner of Inland Revenue (CIR), 509
Commissions and service fees, 149
C
Common law jurisdictions, 26
Capital, 129 Common reporting standard (CRS), 13,
Capital allowances, 231 848, 871–874
Capital expenditure Comparable uncontrolled price method, 950
all expenditure, 203 Comprehensive double taxation agreement
enduring benefit, 203 (CDTA), 50

990

M14_bindex.indd 990 1/27/2021 12:27:23 AM

 Ind ex

Comprehensive income, 777 Cost plus method, 950, 951

Concessionary deductions, 325, 571–572 Country-by-country reporting, 934–937
approved charitable donations, 417–419 Court of Appeal (COA), 79
contributions to recognised retirement schemes Court of First Instance (CFI), 79
s.26G, 425 Cross-border land transportation income, 152–154
elderly residential care expenses Cross set off, of unrelieved losses, 297
deduction operates, 419–420 CRS. See Common reporting standard (CRS)
eligibility, 419
expenses allowable, 419
D
home loan interest
deduction for married taxpayers, 424 Debentures, and debt instruments, 183
definition, 421 Debts, interest and, 164–165
dwelling wholly used as residence, 422–423 Deceased taxpayer, 560–562
eligibility, 421 Deduct depreciation, capital allowances, 231
home loan used partly for dwelling, 423–424 Deductible expenditure, 156
nomination for spouse to claim s.26E Deductible interest
deduction, 424 corporate treasury centre, 183–184
period of deduction, 424 debentures and debt instruments, 183
qualifying dwelling, 421–422 financial institutions, 182
shared ownership, 424 interest deduction rules, 185–188, 191–
of qualifying annuity premiums, 428–430 193, 195–196
qualifying premiums paid, 425–428 interest limitations, 184–185
tax-deductible mandatory provident fund specified purposes conditions, 182–183
voluntary contributions, 430–431 Deductible items, 169–181
Concessionary trading receipts, 297 Deductible items permitted by law, 791
Connected activities, 697 Deduct non-assessable profits, 230
Consideration, 369, 370, 518 Deeming provisions, 149
Consular Relations Ordinance, 524 Deferred revenue expenses, 239
Consumption tax (CT), 754 Departmental Interpretation and Practice Notes
rates and computations, 755–757 (DIPN), 29–30
rebate, 757 Depreciation allowances, 171, 411–414
taxable products, 754–755 capital nature, 206
Contingent receipts, 788 commercial building allowance, 226–229
Continuing business, 240 industrial building allowance
Controlled foreign companies (CFC), 294, 858 annual allowance, 214–218
Controlled foreign corporation (CFC), 767 assets acquired under hire purchase, 213–214
Conveyance on sale, 634 initial allowance, 214
Corporate income tax, 758, 762–763 machinery or plant
annual tax returns and final settlement, 772 non-pooling system, 212–218
calculation, 762–771 pooling system, 209–212
foreign-invested enterprises, 772–777 Designated zones to attract investments, 740
general deductions, 765 Director’s fees, 883
gross income, 764 Direct tax, 17
incentives, 771–772 examples of, 18
liability, 760 Dividends, 774–775
limited deductions, 765–771 Doctrine of Precedent, 26–27
net taxable income calculation, 763–764 Documentation requirements
non-taxable income, 765 country-by-country reporting, 934–937
non-tax resident enterprise, 759–760 local and master file, 930–934
tax resident enterprise, 759 Double taxation agreements (DTA), 6, 53–54, 137
withholding tax on non-tax resident business profits, 880–881
enterprise, 760–762 and capital gains, 881–882
Corporate treasury centre (CTC), 183–184, 268–274 director’s fees, 883
Corporate treasury profits, 272 dividends, 881–882
Corporations, 64, 706 exchange of information, 884–885

991

M14_bindex.indd 991 1/27/2021 12:27:23 AM

 TAXATION

Double taxation agreements (DTA) (cont’d) Executor, obligations of, 67–68

Hong Kong special administrative region Exemptions and reliefs, 662–665, 789–790
for, 893–900
income from employment, 883
F
and Inland Revenue Ordinance, 886–888
interest, 881–882 FATCA. See Financial Accounts Tax Compliance
jurisdictions, 876–877 Act (FATCA)
mutual agreement procedures, 883–884 Field audit, and investigations, 90–91
permanent establishment, 878–880 Filing procedure for withholding corporate income
residence, 877–878 tax, 761–762
royalties, 881–882 Financial Accounts Tax Compliance Act (FATCA),
scope and terminology, 875–876 871–873, 874
tax advantages of, 900 Financial assistance, 163–164
tax credits computations and application, 888 Financial institutions, 256–259
Double tax treaties (DTTs), 876 Financial instruments, 253–254
DTA. See Double taxation agreements (DTA) Fines, levels of, 83
Fixed capital expenditure, 203–206
Fixed place of business, 697
E
Foreign Account Tax Compliance Act
E-commerce, 151 (FATCA), 10, 12–13
Education benefits, 389–370 Foreign exchange, 253–254
Effective tax rate, 581 control, 775–777
Election, for personal assessment Foreign-invested enterprises, 772
married taxpayers, 564 dividends, 774–775
time limit for, 564 foreign exchange control, 775–777
Employee share-based benefits interest, 775
phantom share awards, 389 royalties, 774
stock awards, 380–389 service fees, 772–774
stock options, 368–379 Foreign investment enterprise (FIE), 215
Employees tax planning Foreign tax, 169, 257
structuring employment arrangements, Foreign tax credit (FTC), 767
462–465 Formal notice, 69
structuring remuneration packages, 465–469 Fringe benefits
Employer’s obligations, 59–63 benefits relating to the employee’s
Employer’s return, 65–66 residence, 392
Employment income, 883 club memberships, 392, 393
categories of, 340 credit cards used for private purposes, 392
control test, 341 interest-free loans or loans provided at reduced
economic reality test, 341 rates, 392
integration test, 341 private purposes, 391–392
mutuality of obligation test, 341–342
remuneration payment, 346
G
source of, 343–349
totality of facts, 342 General anti-avoidance provisions, 832
Entertainer, 704 sole or dominant purpose test, 836–838
Entertainment, advertising and promotional tax benefit, 836
expenses, 766 transaction, 836
Environmental protection installation (EPI), 180–181 General anti-avoidance rule (GAAR), 769
Environmental protection machinery (EPM), 179 General deduction
Environment-friendly vehicle (EFV), 180 deductible interest
Equity-based compensation, 801 corporate treasury centre, 183–184
Error claim, 80–81 debentures and debt instruments, 183
Estate Duty Office Interpretation and Practices financial institutions, 182
Notes (EDOIPN), 29, 30 interest deduction rules, 185–188, 191–193,
Exchange losses, 766 195–196

992

M14_bindex.indd 992 1/27/2021 12:27:23 AM

 Ind ex

interest limitations, 184–185 ascertainment of taxable income, 792–794

specified purposes conditions, 182–183 comprehensive income, 790–791
deductible items, 169–181 IIT computations, 797–800
not allowed, 196–198 income generated from business
rule, 168–169 operations, 791–792
German Bank AG (GBank), 323 schedular income, 792
Goepfert case, 343–346 residence, 780
Golden Rule, 25 taxable income, 786–787
Greater Bay Area (GBA), 802–803 chargeable income, 787–789
Gross income, 764 chinese-sourced income, 789
GSHM Limited (GSHM), 126 exemptions and reliefs, 789–790
Industrial and commercial buildings, seller’s
perspective, 865
H
Industrial building allowance
Hachiko Inc., 5 balancing charge/balancing allowance, 221–222
Hire purchase agreement, 213 building/structure sales, 222–224
Holdover industrial building/structure, 221
considerations, 76 qualifying building/structure, 220
of provisional tax payment, 76–77 qualifying expenditure, 220–221
of tax payment under an objection, 75–76 qualifying person, 220
Holiday journey benefits qualifying trade, 218–219
assessable value of, 390 unused industrial building, 224–225
business-cum-holiday journeys, 390–391 Information exchange, DATs, 884–885
organised holiday journeys for staff, 391 Initial allowance
Hong Kong employment, 332, 333–336, 380 hire purchase, 214
Hong Kong overseas company, 285–286 pooling system, 209–210
Hong Kong stock, vs. Non-Hong Kong Inland Revenue Department (IRD), 13, 46, 508, 558.
Stock, 656–658 See also Profits tax
Hong Kong tax system administration of, 48–54
Basic Law, 15–17 Board of Inland Revenue, 50
challenges in, 10–13 Board of Review, 55–56
Inland Revenue Department, 47–56 Inland Revenue Rules, 50–51
scope and purpose, 7 officers, duties and powers of, 49
sources and interpretation of, 24–30 organisational structure, 47, 48
territorial source principle, 7–9 permanent establishment definition
under double taxation agreements/
arrangements, 53–54
I
for fixed place of business, 54
IIT computations, 797–800 under Inland Revenue Ordinance, 52–53
Immovable property, seller’s perspective, 865 recovery actions taken by, 97
Income generated from business operations, 788 report remuneration paid to employees, 61–62
Indefeasible right of use (IRU), 515 secrecy provisions under Inland
Indirect tax, 17 Revenue Ordinance, 50
examples of, 18 Inland Revenue Ordinance (IRO), 6, 24, 127
Individual income tax, 777–780 employer obligations, 60
filing and payment important deeming provisions, 160–161
general rules, 803 permanent establishment definition
specific rules, 804–805 under, 52–53
incentives tax rate, 129
Greater Bay Area, 802–803 Inland Revenue Rules (IRR), 24
three-year transition period provided Insurance companies
by circular 168, 800–802 life insurance business, 260–263
non-tax resident, 780–786 mutual insurance, 266
rates and computation, 790 non-life insurance business, 263–265
allowable deductions/reliefs, 795–797 reinsurance, 265–266

993

M14_bindex.indd 993 1/27/2021 12:27:23 AM

 TAXATION

Intangibles, seller’s perspective, 865 grants, subsidies, financial assistance,

Intellectual property right (IPR), 173 163–164
Interest, 128, 775 interest and debts, 164–165
debentures and debt instruments, 183 rental income from movable property, 164
and debts, 164–165 royalties, 159–163
deductibility of, 184 sums specifically exempt, 166–168
deduction rules, 185–188, 191–193, 195–196 Mischief Rule, 25
Interest expenses, 766 Movable property, from rental income, 164
deduction of, 273–274 Mr. Wong, 126
Interest flow-back test, 185, 191–192 Mutual agreement procedures (MAP), 883–884
Interest income, 149–150 Mutual insurance, 266
Interpretation and General Clauses Ordinance
(IGCO), 24
N
Natural person, 706
J
Net assessable income, 80
Joint assessment, 326 Net assessable value, 509
Joint assessment election, 440–441 Net income, 325
Joint ventures, 286, 292–293 Net taxable income calculation, 757–758
Neutrality of treatment, 151
Nomination, 635
L
Non-Chinese-domiciled non-tax resident, 776–778
Lease, 626 Non-Chinese-domiciled senior management
Leasing arrangements, 215 executives, 779
Licence fees, 151–152 Non-Chinese-domiciled tax resident, 778
Life insurance business, 260–263 Non-deductible expenditure, 197, 230–231
Limited partnerships, 286–287 Non-Hong Kong employment
Literal Rule, 24–25 inbound employees, 382–385
Local and master file, 930–934 outbound employees, 385
Locality of profits, 152–153 Non-incorporated service providers, 62–63
Loss, 193 Non-life insurance business, 263–265
allocation of, 288–290 Non-pooling system, 212–218
corporation, 296–297 Non-residence tax implications, 696–700
incurred by an individual, 296 Non-residential property, 632
incurred by a partnership, 296 Non-resident persons
non-trading, 295 assessing liability of, 701–702
Lump sum receipts, 402–403 deemed trading receipts of, 704–710
selling goods, 702–703
Non-taxable income, 765
M
Non-tax resident, 780–781
Machinery, 179 non-Chinese-domiciled individuals, 781–786
Machinery/plant, depreciation allowances Non-tax resident enterprises, 759–760
non-pooling system, 212–218 Non-tax residents, 795
pooling system, 209–212 Non-trading losses, 295
Management fees, 766, 843 Normal business, 240
Manufacturing profits, 147–149 Normal loss, 299
MAP. See Mutual agreement procedures (MAP) Normal profits, 297–300
Married taxpayer, 559–560 Normal trading receipts, 297
Merger and acquisitions (M&A) transaction Notice of assessment (NOA), 63, 71
buyer and seller, tax issues to, 854–858
tax indemnity clause, 858–863
O
Midnight rule, 353
Miscellaneous income Objection process, 75
concessionary trading receipts chargeable Offences, 82
tax, 165–166 Office, 338–340
to profits tax Offshore reinsurance, 265–266

994

M14_bindex.indd 994 1/27/2021 12:27:23 AM

 Ind ex

Omission claim, 80–81 taxpayer with high property income, 592

One Country, Two Systems, principle of, 15–16 Personal service companies (PSCs), 833
‘183 days’ rule, 894 Phantom share awards, 389
Operations test, 142 Place of effective management, 759
Ordinarily resides, 558 Plant, 148
Ordinary resident, 559 Pooling system, depreciation allowances, 209–212
Organisation for Economic Co-operation and Post-cessation receipts, 237–238
Development (OECD), 843 Pre-commencement payments, 237–238
Ownership Premium, 519
change of, 510 Prepaid revenue expenses, 239
joint ownership, 511 Prescribed fixed assets (PFAs), 177–178
non-resident owner, 511 Privately offered funds, 266–268
Profession, 135–136
Professional reinsurer, 265–266
P
Profits, 50, 127
Partnership, 129, 706 allocation of, 288–290
vs. joint venture, 287 Hong Kong-sourced profit determining
limited, 286–287 methods, 51
loss incurred by, 296 Profit-split method, 952
specific rules for, 288 Profits tax, 19, 127, 336–337, 513, 525
Penalties for non-compliance, 58–59 business, 136–137
Penalty, on tax avoidance, 838–839 chargeable persons and tax rates, 129–130
Penalty provisions, 84–89 computation for partnership business, 287–288
Pension, 349–350 exemptions from, 166–168
Percentage Computation method, 93–94 miscellaneous income (See
Percentage of turnover method, 51 Miscellaneous income)
Permanent establishment (PE), 137–140, 878–880 permanent establishments, 137–140
non-residence, tax implications of, 696–700 profession, 135–136
residence, tax implications of, 696–700 scope of charge, 128–129
Personal allowances, 578–579 sources of profits
claims by more than one taxpayer, 437 commissions and service fees, 149
under Hong Kong salaries tax, 434–436 cross-border land transportation
maintained or treated as being maintained, 437 income, 152–154
ordinary resident in Hong Kong, 437 current developments, issues, 154–155
sole or predominant care, 437–438 defined, 140
Personal assessment income from e-commerce, 151
aggregation of income, 586 interest income, 149–152
benefits of, 550 manufacturing profits, 147–149
business losses set-off, 572–578 rental income, 150
calculation of total income, 594–595 royalties/licence fees, 151–152
concessionary deductions, 571–572 trading profits, 146–147
deceased taxpayer, 560–562 traditional tests of, 141–145
election for (See Election, for personal assessment) transfer pricing, 155–158
eligibility criteria, 557–559 underwriting income, 152
individual taxpayer, 595–597 trade, 131–134
married couple personal assessment, 597–606 Profits tax computation
married taxpayer, 559–560 accounting policies on, 238
one-time tax reduction, 586, 592 add balancing charges, 231
progressive tax rates and s.100 tax deduct depreciation/capital allowances, 231
reduction, 578–581 deduct non-assessable profits, 230
reduced total income, 566–567 non-deductible expenditure and
rental property mortgage interest outgoings, 230–231
deduction, 567–571 post-cessation receipts and payments, 237–238
resident taxpayer and/or spouse, 581 pre-commencement payments, 237–238
vs. schedular system, 557 prepaid/deferred revenue expenses, 239
taxpayer’s total income, 584 unrelieved losses carried forward, 231–232

995

M14_bindex.indd 995 1/27/2021 12:27:24 AM

 TAXATION

Profits test, 184 Residence jurisdiction, 6

Projection method, 94 Residence tax implications, 696–700
Property owners, 534–535 Residence tax systems, 6
Property tax, 19 vs. territorial tax systems, 9–10
allowable deductions, 521 Resident-day-count rule, 781
approved charitable bodies, 526 Residential property, 632
assessable value, 520 Restriction on foreign investors, 739
Chief Executive in Council, 526 Restrictive covenant, 400
computation, 528 Retirement benefits
corporations, 524–526 employers who are not chargeable to profits
government and consular properties, 524 tax, 396–397
letting and subletting, 511 mandatory provident fund schemes, 394–395
profits tax, deduction of, 512–513 provisions, 394
rental agreement, 518–519 recognised occupational retirement
scope of charge, 509–511 schemes, 395–396
special circumstances, 511–516 schemes, 393
Provisional tax payment, holdover of, 76–77 Revenue, 128
Purposive approach, 25, 26 Revenue expenditure
all expenditure, 203
enduring benefit, 203
Q
fixed capital and circulating capital, 203–206
Qualifying CTCs (QCTC), 269 Revenue receipts, 199–201
ROR schemes. See Recognised occupational
retirement (ROR) schemes
R
Royalty, 152, 774, 881–882, 887
Ramsay principle, 27–28, 672–673, 845–846 profits tax, 159–163
Reasonable excuse, 63 sources of profits, 151–152
Recognised occupational retirement (ROR) Royalty income, 788
schemes, 395–396
Reduced total income, 566–567
S
Refund of tax overpaid, 718
Regulatory capital security (RCS), 255–256 Safe harbour rule, 272–273
Reinsurance, 265–266 Salaries tax, 19
Related party, 925 allowable deductions
Relief and exemptions concessionary deductions, 416–433
approved charitable bodies, 526 depreciation allowances, 411–414
Chief Executive in Council, 526 joint assessment, 415
corporations, 524–526 loss brought forward, 414–415
government and consular properties, 524 outgoings and expenses, 404–411
Relief from double taxation self-education expenses, 415–416
economic double taxation, 945 ascertainment of assessable income, 442–445
juridical double taxation, 946–947 benefits specifically excluded from, 401–403
Remuneration for labour services, 788 computation
Remuneration for manuscripts, 788 joint assessment, 456–458
Rental agreement provisional salaries tax, 459–461
premium, 518–519 separate assessment, 451–455
rental deposit, 518 employees tax planning
rent-free period, 519 structuring employment arrangements,
Rental deposit, 518 462–465
Rental income, 150 structuring remuneration packages, 465–469
from movable property, 164 employment, 340–349
Rent-free period, 519 exemptions
Resale Price Method, 950, 951–952 60-day exemption rule, 330–32
Research and development expenses (R&D), 767 Hong Kong employment, 332–336
Residence Basis, 6 income of ship or aircraft crew, 329, 330

996

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 Ind ex

income chargeable to financial instruments and foreign exchange

accommodation benefits, 361–368 differences, 253–254
education benefits, 389–390 regulatory capital securities, 255–256
employee share-based benefits (see special classes of business
Employee share-based benefits) aircraft leasing company, 282–283
fringe benefits, 391–393 clubs and associations, 283–285
holiday journey benefits, 390–391 corporate treasury centres, 270–274
income specifically chargeable, 356–361 financial institutions, 256–259
principles, 355–356 Hong Kong branch of an overseas
retirement benefits, 393–397 company, 285–286
termination payments, 397–400 insurance companies, 259–266
joint assessment of spouses, 440–443 privately offered funds, 266–268
office, 338–340 ship and aircraft owners, 275–282
pension, 349–350 stock borrowing and lending transactions, 252
personal allowances, 433–439 trading stock, 250–251
profits tax, 336–337 Specific additional deduction, 778
scope of charge, 326–328 Specific anti-avoidance provisions, 833
time basis assessment, 352–355 in Inland Revenue Ordinance, 840–841
SBLT. See Stock borrowing and lending service company type I arrangements, 841–843
transaction (SBLT) service company type II arrangements, 843–844
Schedular income, 777, 795–796 utilisation of loss to avoid tax (S.61B), 839
Secured loan test, 185 Specific deductions, 791
Self-education expenses, 415–416 Sportsmen, 704
Service company Stamp duty
type I arrangements, 841–843 ad valorem stamp duty, 625
type II arrangements, 843–844 agreement for sale, 626, 634–638
Service fees, 772–774 alternative bond schemes, 673–674
Settlement methods, 91 appeal against stamp duty assessment,
direct method, 92 669–670
indirect method, 92–94 bearer instruments, 659
Severance payments, 802 chargeable instruments, 626–627
Shared accommodation, 366–370 charge to ad valorem stamp duty, 638–642
Shares, seller’s perspective, 865 conveyance, 634
Sharkey v Wernher, 250–251 duplicates and counterparts, 660
Shipowners, 275–279 exemptions and reliefs, 662–665
60-Day exemption rule, 327, 330–332 Hong Kong stock, 656–658
Six-year test, 781 lease, 652–655
Small corporations and business, concession for, 64 methods of stamping, 666–667
Source jurisdiction, 6 multiple properties and multiple
Sources of profits, 140 agreements, 644–646
commissions and service fees, 149 non-stamping, effect of, 670–671
cross-border land transportation penalty for failure to disclose relevant
income, 152–154 information, 668–669
current developments, issues, 154–155 penalty for late stamping, 668
income from e-commerce, 151 planning, 674–675
interest income, 149–150 property law in Hong Kong, 633–634
manufacturing profits, 147–149 Ramsay principle, 672–673
rental income, 150 rates of ad valorem stamp duty, 642–644
royalties/licence fees, 151–152 special stamp duty, 646–652
trading profits, 146–147 stampable consideration, 627–630
traditional tests of, 141–145 substance over form, 628
transfer pricing, 155–158 time limit and persons liable for, 667
underwriting income, 152 voluntary disposition inter vivos, 660–661
Special transactions and businesses Stamp duty (SD), 21
alternative bond schemes, 254–255 Stamp Duty Ordinance (SDO), 21, 24, 516

997

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 TAXATION

Stamp Office Interpretation and Practice Notes professional and ethical considerations
(SOIPN), 29–30 in, 902–904
Standard personal deduction, 778 Tax computation
Statutory allowance, 521 accounting policies on, 238
Statutory deduction, 521 add balancing charges, 231
Statutory incomes, 325 deduct depreciation/capital allowances, 231
Stock awards deduct non-assessable profits, 230
Hong Kong employment, 380 non-deductible expenditure and
non-Hong Kong employment outgoings, 230–231
inbound employees, 382–385 post-cessation receipts and payments, 237–238
outbound employees, 385 pre-commencement payments, 237–238
permanent departure from Hong Kong, 385–389 prepaid/deferred revenue expenses, 239
valuation, 385 unrelieved losses carried forward, 231–232
Stock borrowing and lending transaction Tax credit, 883
(SBLT), 252 Tax credit limit, 888
Stock options Tax deductions, 181
assignment or release, 371 Tax disputes and appeals
benefit, 368–369 administrative litigation, 737–739
exchange of rights, 371 administrative review, 737
exercise of, 369 Tax evasion, 832
gain from stock options chargeable to salaries Tax-exempt fringe benefits for foreign
tax, 371–378 nationals, 800–801
gain realised, 369–370 Tax incentives, 771–772
permanent departure from Hong Kong, Greater Bay Area, 802–803
378–379 three-year transition period provided by circular
time of exercise, 370–371 168, 800–802
Strike price, 368 Tax indemnities, 871
Tax liability, 760
business losses set-off, 572–576
T
concessionary deductions, 571–572
Tax progressive tax rates and s.100 tax
assessment and additional assessment, 95 reduction, 578–581
capital gains, 22 rental property mortgage interest
entities subject to, 18, 19 deduction, 567–571
levied under the ordinances, 19–20 Tax losses, 767
payment of, 73–74 Tax mitigation, 832
protective assessment, 95–96 Taxpayer
recovery of, 96–97 high-income taxpayers, 584–586
stamp duty, 21 with high property income, 592
types of, 17–23 individual taxpayer, 595–597, 605
Taxable income, 786–787 married couple taxpayers, 598–602, 606
chargeable income, 787–789 Taxpayer’s obligations, 58–59
chinese-sourced income, 789 Taxpayer’s return, 63–64
exemptions and reliefs, 789–790 Tax penalties and surcharges, 736–737
Taxable income per schedule of income, 792–794 Tax planning, 832–833
Tax administration and collection, 735–736 BEPS, implications in, 871–874
Tax administrative litigation, 737–739 business strategies, 949–950
Tax administrative review, 737 contractual terms, 949
Tax advisor, 68 CRS, implications in, 871–874
Tax appeal process, 78–79 determining organisational structure for, 857–858
Taxation, principle of, 6–14 economic and market circumstances, 949
Tax audit and investigation, 91 FATCA, implications in, 871–874
Tax avoidance, 832 functions performed, assets or resources
Tax compliance and tax advisory services contributed, risks assumed, 949
legal considerations in, 905–906 group of companies tax strategies, 859–862

998

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 Ind ex

merger and acquisitions (M&A) Rule 2, 928–929

transaction, 862–871 transactional net margin method, 953
property or services characteristics, 949 Transfer pricing adjustment, 156
services by individuals, 854–856 Transfer Pricing Documentation and Country-
subsidiary or forming branch, 858–859 by-Country Reports, 930
and transfer pricing (See Transfer pricing) Trustee, 66–67
Tax position, 136 Turnover taxes, 741
Tax rates and computation, 790 consumption tax, 754–757
allowable deductions/reliefs, 795–797 value added tax, 741–754
ascertainment of taxable income, 792–794 Type I service company, 325
comprehensive income, 790–791
IIT computations, 797–800
U
income generated from business
operations, 791–792 Underwriting income, 152
schedular income, 792
Tax rates, chargeable persons and, 129–130
V
Tax reserve certificates (TRC), 75, 76
Tax residence, 780 Value added tax (VAT), 741–742
Tax resident, 795 computation, 745–746
Tax resident enterprise (TRE), 759, 760 concurrent operation, 749
Tax symmetry test, 184 exemptions, 750–751
Tax systems, in Hong Kong. See Hong Kong filling, 753–754
tax system fraudulent invoices, 748
Termination payments general calculation method, 746–747
compensation for loss of office, 397–398 in-house invoice administration, 748
contract of employment, 398 internal control improvement, 748
long service payments and severance invoices, 747–748
payments, 399 mixed sales, 749
restrictive covenant, 400 mixed sales vs. concurrent operation, 748–749
Territorial Basis, 6 non-creditable input, 751–752
Territorial tax system, 6 payment, 752–753
Territorial vs. residence tax systems, 9–10 rates and computations, 745–753
Thin capitalisation rule, 768 reform, 742–743
Time apportionment, 352–353 scope of charge, 743
Time apportionment basis, 327 simplified calculation method, 747
Time basis assessment, 352–355 small-scale payers, 750
Time-in-time-out basis, 352 types of payer, 743–745
Total income, 560 Voluntary disposition inter vivos, 660–661
Trade, 131–134
Trade associations, 525–526
W
Trade debts, seller’s perspective, 864–865
Trading profits, 131 Wages and salaries, 787
source of, 146–147 Withdrawals from qualified annuity, 802
Trading receipts, 199 Withholding agent, 66
Trading stock, 131, 250–251 Withholding tax
Traditional tests, sources of profits, 141–145 amount of tax to be withheld, 714–716
Transactional net margin method, 950, 953 on Hong Kong agents, 712–713
Transfer pricing (TP), 6, 155–158, 835, 924. See refund of tax overpaid, 718
also Tax planning on resident persons paying to non-resident
comparable uncontrolled price method, 950 persons, 713–714
cost plus method, 951 Withholding tax on non-tax resident
profit-split method, 952 enterprise, 760–762
resale price method, 951–952 Workday rule, 783
Rule 1, 926–927 Worldwide profit margin method, 51

999

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M14_bindex.indd 1010 1/27/2021 12:27:24 AM
 QUALIFICATION PROGRAMME QU
PR

HKICPA Qualification: Pr
M
A Pathway to Success
The Qualification Programme (QP) of the Hong Kong Institute of CPAs (HKICPA)
provides a pathway for the development of world-class practicing accountants. The
HKICPA is the only body authorized by law to register and grant practising certificates
to certified public accountants in Hong Kong. Members of the Institute are entitled to
the description ‘certified public accountant’ and to the designation CPA.

Since 1973, the HKICPA (previously known as the Hong Kong Society of Accountants)
has worked to further the public interest by regulating and promoting efficient
accounting practices in Hong Kong. Through its efforts, the Institute has helped
secure Hong Kong’s position as an international financial centre.

The QP aims at providing accountants with the knowledge base they need to meet
future market needs. Successful participants develop skills by completing training
courses, passing examinations and acquiring practical experience.

The QP consists of three levels. At the Associate Level, participants develop a solid
technical foundation. The aim of the Professional Level is to deepen technical
capabilities. The Capstone integrates knowledge, skills and experiences and applies
them to business problems.

The QP provides accountants with relevant and portable skills that enhance their
employability and opens the door to opportunities in Hong Kong and around
the world!

The Hong Kong Institute of Certified Public Accountants

37th Floor, Wu Chung House, 213 Queen’s Road East, Wanchai, Hong Kong
Tel: (852) 2287 7228
Fax: (852) 2137 3293

www.hkicpa.org.hk

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