Chapter 14 Profits Tax Computation

 

LEARNING OBJECTIVES 1.      Understand the correct format of a profits tax computation. 2.      Understand how to prepare a profits tax computation. 3.      Understand what items commonly appear in a profits tax computation. 4.      Understand the sequence of claiming expenses for repairs and depreciation allowances. 5.      Understand the deduction of donation under profits tax. 6.      Understand the treatment of post-cessation receipts and payments. 7.      Understand the stock valuation on cessation of trade or business. 8.      Understand the treatment of pre-commencement expenditure.

 

 

List of Important IRO Sections and Cases

Section	Description
s. 15C	Stock valuation on cessation of trade or business (a)   If trading stock is sold to a person who will use the stock in a business carried on in HK and will claim the purchase cost as a deductible expense, the actual sale proceeds shall be used in the tax computation. (b)   Any other cases, the open market value will be used.
s. 15D(1)	Sums received after cessation are deemed to be taxable if such sums are taxable and received before cessation.
s. 15D(2)	Sums after cessation are deemed to be expenditure if such payments are deductible and paid before cessation.
s. 40(2)	Capital expenditure on acquisition of capital assets subject to tax depreciation allowances is treated as incurred on the day on which business commenced.

Taxpayer	Subject Matter
Overseas Textiles Ltd v CIR (1990) 3 HKTC 29	If the expense is not deductible under s. 16 or s. 17, s. 15D will not permit a deduction
Tai Shun Investment Co Ltd v CIR (1968) HKTC 370	If the action of the liquidator merely consisted of “tidying-up”, it was held that the liquidator did not carry on trade or business.
Southtime Ltd v CIR (2002) HKRC 90-119	The IRD sought to value the unsold shops at open market value and tax are deemed profit on disposal because the taxpayer ceased its property trading business.
Birmingham & District Castle By-Products Co Ltd v IRC (12 TC 92)	The activities of research, construction of buildings, etc were only preparatory nature and the trade or business did not commence until the company commenced to acquire raw materials for processing.

Reference	Issues Considered
D3/86	Preparatory acts are not considered as commencement of business.

 

1.       Ascertainment of Assessable Profit
(May 10, Jun 12, Jun 16)
1.1       The IRO does not lay down a complete code on how assessable profits are to be computed. Statutory rules are laid down in ss 15, 16 and 17 on what items are assessable, what items deductible and valuation of trading stock in certain circumstances.
1.2       Subject to the statute and case law, assessable profits are normally ascertained by reference to generally accepted accounting principles.

1.3

Key Points

(a)       The purpose of preparing a profits tax computation is to convert a company’s net profit figure shown in the income statement to the assessable profit figure. (b)       Unallowable items (expenses) are added to the net profit figure while non-assessable items (income) are deducted from the net profit figure. (c)       Then the resultant figure is reduced by depreciation allowance, industrial building allowance and commercial building allowance, and charitable donation.

1.4       A common error made by students is not to convert the net profit figure to assessable profit. Instead, they find out the gross profit, and then add to the gross profit with assessable income such as rental income, and deduct from the gross profit with allowable expenses. This method is not a proper approach to calculate the assessable profit, and students using this method usually omit many items in their calculations. Thus, students are reminded NOT to use the following gross profit method:
Wrong gross profit method:

ABC Ltd Profits Tax Computation Year of Assessment 2015/16     $ Gross profit   X Add: Assessable profit   X     X Less: Allowable expenses shown in income statement   (X)     X Less: Depreciation allowances   (X)     X Less: Charitable donation   (X) Assessable profit   X

 

Correct profits tax computation format:

ABC Ltd Profits Tax Computation Year of Assessment 2015/16   $ $ Profit/(loss) per account   X Add: Non-allowable expenses:     Charitable donation X   Depreciation X   Expenses attributable to offshore profits X   Fine/penalty X   General provision for doubtful debts X   Improvement X   Initial purchase of carpet, curtain, etc. X   Interest failed to satisfy Section 16(2), (2A), (2B), (2C) X   Legal fee X   Profits tax and property tax X   Salaries paid to proprietor/partners X   Share of joint venture loss as shown in accounts X   Unallowable proportion of retirement scheme X X     X Less: Non-assessable income/Deductible expenses not in the profit and loss account:     Computer software and hardware X   Dividend X   Interest income exempt from payment of profits tax   X   Offshore interest X   Offshore profit X   Prescribed fixed assets X   Recovery of bad debts previously not allowed X   Share of joint venture profit as shown in accounts X X     X Less: Depreciation allowance X   Industrial building allowance X   Commercial building allowance X X     Y Less: Charitable donation (restricted to 35% of Y for 2015/16)   Z Assessable profit   P Less: Loss brought forward from previous period X   Loss set off under Section 19C(5) X L Net assessable profit   N       Profits tax payable (16.5% on N for 2015/16)   T Less: Provisional profits tax paid X   Property tax set off under Section 25 X S Profits tax liability   R

 

1.5       Items of income often appeared in examination papers:
(a)        interest income – onshore and offshore
(b)        dividend
(c)        sale of patent
(d)        refund from retirement scheme
(e)        recovery of bad debts
(f)        release of debts
(g)        interest income exempt from payment of profits tax
1.6       Items of expenses often appeared in examination papers
(a)        interest expenses under Section 16(2), (2A), (2B), (2C)
(b)        legal fee
(c)        severance payment
(d)        property tax, salaries tax, profits tax, overseas tax
(e)        trade compensation
(f)        bad debts – general and specific provision
(g)        removal expenses
(h)        payment made for covenant against competition
(i)         payment made for getting rid of unsatisfactory director
(j)         initial contribution to retirement scheme – initial and special contribution
(k)        scientific research expenses – plant and industrial building
(l)         tax surcharge and fine
(m)       prescribed fixed asset
(n)        computer software and hardware

 

2.      Post-cessation Receipts and Payments

2.1       Sums received after cessation of business are deemed to be profits for the year of assessment in which the cessation occurs; and are taxable in that year if such sums are taxable if received before cessation (s. 15D(1)).
2.2       Such sums after cessation of business are deemed to be expenditure for the year of assessment in which the cessation occurs, and are deductible in that year if such payments are deductible if paid before cessation (s. 15D(2)).
2.3       If the expense is not deductible under s. 16 or s. 17, s. 15D will not permit a deduction (Overseas Textiles Ltd v CIR (1990) 3 HKTC 29).
2.4       Deduction is allowed for actual payment made. Thus, provisions or write off (e.g. bad debts written off) after cessation is not deductible. By concession, recovery of previously allowed bad debts after cessation will not be assessed.
2.5       Determining the date of cessation is a question of fact. “Cessation” is to be distinguished from “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 to protect the assets, the date of appointment of liquidator continues the business may not be the same as the date of cessation.
2.6       If the liquidator is merely realizing assets to wind up the company, it cannot be considered as continuing the business; and the date of appointment of liquidator is the same as the date of cessation.

Tai Shun Investment Co Ltd v CIR (1968) HKTC 370

In this case, a liquidator was appointed to wind up a property development company. The liquidator: (a)     collected arrears of rent; (b)     collected arrears of instalments and instalments which subsequently fell due; and (c)     conveyed legal title to flats which was paid in full. As the action of the liquidator merely consisted of “tidying-up”, it was held that there was no evidence upon which it could reasonably be found that the liquidator did carry on any trade or business.

3.      Stock Valuation on Cessation of Trade or Business
(Dec 13)
3.1       Pursuant to s. 15C, where trading stock is sold to a person who will use the stock in a business carried on in HK and will claim the purchase cost as a deductible expense, the actual sale proceeds shall be used in the tax computation.
3.2       In any other situations, the open market value of the stock at the date of cessation would be taken as its value for tax purposes.
3.3       In Southtime Ltd v CIR (2002) HKRC 90-119, the taxpayer transferred a number of unsold shops to its shareholders and director at cost. The IRD sought to value the unsold shops at open market value pursuant to s. 15C and tax the deemed profit on disposal on the ground that the taxpayer ceased its property trading business.

4.      Pre-commencement Expenditure

4.1       Expenses incurred before business commenced is not incurred in the production of assessable profits.
4.2       However, by concession, the IRD allows pre-commencement expenditure of a revenue nature, which would be allowed if incurred after commencement, in the first accounting period.
4.3       Capital expenditure on acquisition of capital assets subject to tax depreciation allowances is treated as incurred on the day on which business commenced (s. 40(2)).
4.4       Again, determining the date of cessation is a question of fact. “Commencement” is to be distinguished from “preparatory work”.
4.5       “Formation activities” such as recruiting staff and leasing office, are irrelevant.

Birmingham & District Castle By-Products Co Ltd v IRC (12 TC 92)

It was held that acts such as research, construction of buildings, acquisition of machinery and plant and entering into agreements with suppliers were of a preparatory nature only and the trade or business did not commence until the company commenced to acquire raw materials for processing. This approach of disregarding preparatory acts was followed by the BOR in D3/86. In this case, land originally acquired for non-trading purposes was subsequently redeveloped for sale. The BOR held that the property development business only commenced when an architect was employed to draw up redevelopment plans.

 

4.6       The date of commencement is the date upon which the taxpayer’s intentions begin to translate into an activity which can be characterized as trading. This normally follows the date when the income is first derived, or when profit seeking acts start, e.g. soliciting customers, negotiating sales terms and acquiring raw materials.

 

Examination Style Questions

Question 1
ABC Ltd is a HK company carrying on a trading business in HK, and all its profits are derived from HK. The income statement of the company for the year ended 31 March 2016 is as follows:

	$	$
Income from trading		26,900,000
Dividend received from listed shares		104,000
		27,004,000
Less: Expenses
Audit fee	120,000
Commission (Note 1)	350,000
Compensation (Note 2)	140,000
Depreciation	450,000
Donation made to Community Chest	250,000
Interest (Note 3)	155,000
Legal and professional fee (Note 4)	70,000
Rent	2,500,000
Salaries and allowances	20,000,000
Staff welfare (Note 5)	250,000
Sundries (Note 6)	190,000
Tax (Note 7)	360,000
Travelling (Note 8)	350,000	25,185,000
Net profit		1,819,000

Notes:

(1)	Commission paid to: Overseas agents whose addresses were known	250,000
	Agents whose identities were not disclosed	100,000
		350,000
(2)	Compensation paid for early termination of lease of the old office	80,000
	Penalty paid to clients for late delivery of goods	60,000
		140,000
(3)	Interest paid to:
	An individual director	35,000
	A bank in HK where the loan was secured by a deposit maintained in the name of an individual director	120,000
		155,000
(4)	Legal fee paid for lease of new office	30,000
	Professional fee paid for the preparation of profits tax return	40,000
		70,000
(5)	Annual dinner	100,000
	Trip to Ocean Park for staff	150,000
		250,000
(6)	All sundry expenses were allowable.
(7)	This was the company’s profits tax liability.
(8)	Overseas business trips for directors attending conferences	170,000
	Overseas private trips for directors and their families	180,000
		350,000
(9)	The assessor agreed with the company that depreciation allowances for the year of assessment 2015/16 is $1,300,000

Required:

Calculate the profits tax payable, if any, by ABC Ltd for the year of assessment 2015/16. (Ignore provisional tax)

Question 2
KWK Ltd was incorporated in Hong Kong in 1972 and carries on the business of wholesale and retail of sports equipment. It was two directors – Mr Chan and his wife. Its accounts are made up to 31 March annually. Its profit and loss account for the year ended 31 March 2016 is as follows:

	$	$
Gross trading profit		7,321,000
Profit on sale of fixed assets		100,000
Compensation (Note 1)		140,000
Dividends received from unquoted shares		110,000
Interest received (Note 2)		80,000
		7,751,000
Less: Salaries and allowances	3,100,000
Directors’ remuneration	1,300,000
Rent and rates (Note 3)	320,000
Telephone, water and electricity	66,000
Interest (Note 4)	168,000
Bad debts (Note 5)	230,000
Legal and professional fees (Note 6)	138,000
Advertising	150,000
Repairs and maintenance (Note 7)	640,000
Discounts allowed	25,000
Contributions to recognized retirement scheme (Note 8)	900,000
Donations (Note 9)	700,000
Insurance	40,000
Travel and transportation (Note 10)	220,000
Motor vehicles expenses (Note 11)	181,000
Depreciation	262,000
Sundry expenses (Note 12)	410,000	8,850,000
Loss for the year		(1,099,000)

Notes:

		$
(1)	Compensation received from a customer for the cancellation of one of the sales contracts	80,000
	Compensation received for loss of trading stock	10,000
	Compensation received for loss of a motor vehicle	50,000
		140,000
(2)	Interest on loan to customers	30,000
	Interest on a fixed deposit placed with a bank in Hong Kong	50,000
		80,000
(3)	Rent for office premises	84,000
	Rent for director’s quarters	220,000
	Rates for office premises	16,000
		320,000
(4)	Interest paid to a director of the company	50,000
	Interest paid on a loan from a local bank. The loan was secured by a director’s deposit, which was smaller than the loan. The director received interest of $25,000 from the deposit	118,000
		168,000

(5)	Bad debts
	Trade debts written off	110,000	General allowance c/f	40,000
	Loan to a customer written off	90,000	Profit and loss account	230,000

(6)	Audit fee	50,000
	Collection of trade debts	8,000
	Handling of investigation by IRD	80,000
		138,000
(7)	Renovation of office premises	500,000
	General repairs of fixed assets	140,000
		640,000
(8)	Special contribution	400,000
	Provision for special contribution	300,000
	Annual contributions	200,000
		900,000
(9)	Cash donations to approved charitable organization	560,000
	Donation of prizes for lucky draw for staff at the company’s annual dinner	60,000
	Donation of beds to elderly residential care homes	80,000
		700,000
(10)	Overseas business trips	90,000
	2-day Macau tour for company’s employees	50,000
	Transportation of goods to customers	80,000
		220,000
(11)	Petrol	64,000
	Repairs	20,000
	Parking charges	90,000
	Traffic fines	7,000
		181,000
(12)	Profits tax paid	23,000
	Property tax paid for director	50,000
	Other allowable expenses for tax purposes	337,000
		410,000

Other information:
(13)     The assessor agreed that the company was entitled to total depreciation allowances for plant and machinery of $141,000 for the year of assessment 2015/16.

Required:

(a)       Compute KWK Ltd’s profits tax liability, if any, for the year of assessment 2015/16. Ignore provisional profits tax. Show all your workings.                                                                 (16 marks)
(b)       Briefly explain your tax treatment of the following items in your profits tax computation:
(i)         interest expenses (Note 4)
(ii)        contributions to recognized retirement scheme (Note 8)
(10 marks)
(Total 26 marks)

Question 3
Emma Wong is a famous pianist in the Mainland. She has immigrated to Hong Kong and would like to set up her music studio providing music lessons to young talents in Hong Kong. She rented 2 apartments in Kowloon: one as her family accommodation and the other one as her studio. As she is a famous pianist, many students have signed up for her classes.

For the year of assessment 2015/16, her records revealed the following:

	$
Tuition fees	1,000,000
Rent for apartment	360,000
Rent for studio	600,000
Utilities – studio	10,000
Utilities – apartment	8,000
Travelling – personal	8,000
Domestic helper	3,000
Other personal expenses	200,000
Office expenses – studio	200,000

Required:

(a)     Explain whether Emma is liable to pay salaries tax or profits tax.               (3 marks)
(b)     Assuming Emma is liable in part (a), compute her assessable income / profits for the year of assessment 2015/16.                                                                                            (3 marks)
(c)     State which of the items (if any) are not deductible and explain.                  (2 marks)
(d)     Give suggestions, if any, for Emma to reduce her tax payable (assume Emma needs to pay tax in part (a)).                                                                                                              (2 marks)
(e)     If Emma was invited to perform in London’s Albert Hall and received a gratuity for her performance, explain whether such a gratuity would be taxable. Advise whether the cost of travel to the UK, hotel accommodation and miscellaneous expenses would be deductible.

What would be the tax position if Emma recorded her performance in her studio in Hong Kong and the recording was then broadcast in London?                                              (10 marks)
(Adapted HKICPA MD Taxation May 2010 Q6)

 

Question 4
Manchester Knitting Limited (“MKL”) is a company established in Hong Kong carrying on a garment trading business. The accounts and information for the year ended 31 March 2016 are provided below.

	Notes	HK$	HK$
Income
Sales		35,900,000
Less: Cost of sales		(21,300,000)
Gross profit	1	14,600,000
Exchange gain (net)	2	115,000
Gain on disposal of fixed assets	3	14,000
Interest income	4	18,000	14,747,000
Expenses
Consultancy fee	5	300,000
Depreciation	6	84,000
Interest expense	7	98,000
Office rental		1,480,000
Other deductible expenses		5,090,000
Rental allowance	8	240,000
Salaries		3,586,000	(10,878,000)
Profit before taxation			3,869,000
Less: Taxation			(500,000)
Profit for the year			3,369,000

Notes:
1.       The goods sold by MKL were mainly purchased from its PRC wholly owned subsidiary and were manufactured in mainland China. MKL reported all its trading profits as onshore in prior years and will continue to maintain this filing basis for the year 2015/16.
2.       Details of net exchange gain were as follows:

	HK$
Exchange gain on trade debts	125,000
Exchange loss on foreign currency bank deposit	(10,000)
	115,000

 

3.       Details of the gain on disposal of fixed assets were as follows:

	HK$	HK$
Sales proceeds of office furniture (ranked into respective pool claiming for depreciation allowance in prior years)		30,000
Original cost	150,000
Accumulated depreciation	(134,000)	(16,000)
Gain on disposal		14,000

4.       Details of interest income were as follows:

	HK$
Interest from local bank deposit as loan security (per Note 7 below)	8,800
Interest from local bank deposit denominated in Euro Dollar	5,500
Interest from overseas overdue trade debts	3,700
	18,000

5.       MKL paid a fee of HK$300,000 to an individual to provide consultancy work regarding the company’s daily business activities.

6.       Depreciation and additional information on fixed assets:

Accounting depreciation of HK$84,000 was calculated on the straight-line basis.

MKL acquired a motor vehicle on 1 August 2015 under a hire purchase scheme with a local bank and used it for business purposes. The cash price of the vehicle was HK$300,000. An initial payment of HK$120,000 was made upon acquisition, and the balance was repaid over 20 monthly installments of HK$10,000 each which commenced on 1 September 2015. The hire purchase interest was evenly allocated into each installment.

MKL did not have any tax written down value brought forward from the prior year in any pool claiming depreciation allowances.

7.       Details of interest expenses were as follows:

	HK$
Interest on bank loan secured by deposit (per Note 4 above) placed in the same bank, and on hire purchase of the motor vehicle (per Note 6 above)	16,800
Interest to overseas unrelated suppliers on overdue trade debts	66,000
Interest on loan from individual director	15,200
	98,000

8.       The amount was a cash allowance paid to a director of MKL. During the year the director leased a residential flat with an unrelated landlord and paid the rental of HK$240,000. MKL fully subsidised the rental expenses of the director by paying a rental allowance to him without setting any restriction on the usage of the amount.

Question 1 (19 marks – approximately 34 minutes)

(a)     Calculate the depreciation allowance that MKL was entitled to claim for the year of assessment 2015/16.                                                                                                                (3 marks)
(b)     Calculate the profits tax liabilities of MKL for the year of assessment 2015/16 (ignore provisional tax).                                                                                                                      (8 marks)
(c)     Explain the tax treatment on the following items:
(i)      interest income                                                                                          (4 marks)
(ii)     interest expenses                                                                                        (4 marks)

Question 2 (6 marks – approximately 11 minutes)

Evaluate the PRC Business Tax and Value Added Tax implications on the sales income derived by MKL’s PRC subsidiary from goods sold to MKL.                                                                (6 marks)

Question 3 (17 marks – approximately 31 minutes)

(a)     Suggest an efficient planning scheme from a salaries tax perspective for the director of MKL to replace the cash allowance in Note 8 of the Case, and analyse how the proposed planning scheme for the director will be assessed under salaries tax.                                        (8 marks)
(b)     Under what circumstance would the proposed planning scheme be tax efficient for the director from a salaries tax perspective?                                                                                 (2 marks)
(c)     Explain how the proposed planning scheme should be arranged in order to be accepted as a valid scheme by the Inland Revenue Department ("IRD").
                                                                                                                                       (7 marks)

 

Question 4 (8 marks – approximately 14 minutes)

(a)     What is the basic principle to determine whether the income derived by the consultant from MKL, as per Note 5 of the Case, is subject to either profits tax or salaries tax? Cite a court case to illustrate your answer.                                                                                                        (2 marks)
(b)     Outline the information that needs to be further obtained in order to ascertain the nature of the income derived by the consultant. Provide examples to illustrate your answer. (6 marks)
(Adapted HKICPA QP MD Taxation June 2012 Case)