Chapter 9 Profits Tax: Receipts

1.       Learning Objectives

1.1       Explain the types of income deemed to be trading receipts arising in HK from a trade, profession or business carried on in HK.
1.2       Explain how to determine the source of interest income for persons other than a financial institution.
1.3       Identify the types of income that are exempt from profits tax.
1.4       Distinguish between capital and revenue receipts.
1.5       Explain the treatment of exchange gains/losses
1.6       Explain the treatment of stock borrowing and lending.
1.7       Explain the treatment of qualifying debt instruments.

2.       General Principle

2.1

KEY POINT

The general principles governing the assessability of income under profits tax may be summarized as follows: (a)        Before an income is assessable under profits tax, there must be a trade, profession or a business carried on in HK unless the income falls within the deeming trading receipts under Section 15 of the IRO; (b)        The source of the income must be arising in or derived from HK; (c)        Unless the income has been specifically exempted by the statutes, all types of income are assessable; (d)        The gain from the sale of capital assets is exempt from profits tax under Section 14 of the IRO.

 

 

3.       Deemed Trading Receipts

3.1       Section 15(1) provides that certain income received by a person (even though that person does not carry on any trade, profession or business in HK) are deemed trading receipts and they are chargeable to HK profits tax.

3.2

KEY POINT

Deemed trading receipts chargeable under Section 15(1) include the following: (a)       Royalty received by or accrued to a person for the exhibition or use in HK of cinematography (電影術) or television film – Section 15(1)(a). (b)       Royalty received by or accrued to a person for the use of or right to use in HK a patent, design, trademark, copyright material or secret process or formula or other property of a similar nature – Section 15(1)(b). (c)       Royalty, received by or accrued to a person for the use of or right to use outside HK a patent, design, trademark, copyright material or secret process or formula or other properties of a similar nature, which is deductible in ascertaining the assessable profits of a person in HK – Section 15(1)(ba). (d)       Financial assistance received by a person in connection with the carrying on of a trade, a profession or a business in HK, excluding financial assistance provided for capital expenditure – Section 15(1)(c). (e)       Income by way of hire, rental or similar charges for the use of movable property in HK or the right to use movable property in HK – Section 15(1)(d). (f)        Refund of contribution made to an employer in respect of a recognized occupational retirement scheme, and the taxable amount is restricted to the amount that was previously allowed as deductions in the ascertainment of the profits tax of the employer – Section 15(1)(h).

 

 

 

4.       Interest Income

4.1       Since the abolition of interest tax, interest income is only subject to profits tax. Section 14 is the charging section for profits tax. Interest income may therefore be subject to tax under Section 14. Further, interest income is deemed to be chargeable income under Section 15(1)(f) (for corporations), Section 15(1)(g) (for persons other than corporations) and Section 15(1)(i) (for financial institutions).

4.2	KEY POINT
	The source of interest is determined by the provision of credit test. It means where the money is made available to the borrower. If the money is made available to the borrower in HK, the source of income is in HK and the lender (i.e. the taxpayer) is liable to HK profits tax if it carries on business in HK.

4.3       The source of interest may be demonstrated by the three different situations shown in the following table. In all the three situations, the lenders are situated in HK while the borrowers are situated in USA.

Situation	Provision of Credit	Source of Income	Taxability
a.   The lender remits the money from his own bank account in HK to the borrower’s bank account in HK	The money is available to the borrower in HK	Hong Kong	Taxable
b.   The lender remits the money from his own bank account in HK to the borrower’s bank account in USA	The money is available to the borrower in USA	USA	Exempt
c.   The lender remits the money from his own bank account in USA to the borrower’s bank account in USA	The money is available to the borrower in USA	USA	Exempt

4.4

EXAMPLE 1

The first court case on the source of interest income is CIR v Orion Caribbean Ltd (in voluntary liquidation) (1997) 4 HKTC 432. The taxpayer was a Cayman Islands company, and it was a wholly owned subsidiary of a HK company, called Orion Royal Pacific Ltd. The taxpayer’s main business was to consider and approve the loan participations recommended by its parent company. The taxpayer borrowed money in foreign currencies from the parent company and on-lent the money to borrowers outside HK. The parent company negotiated, and serviced the loan for the taxpayer’s approval, and raised funds for the loans approved by the taxpayers. The parent company also provided management, administrative and accounting services for the loans approved by the taxpayer. The BoR found that based on “provision of credit test” the source of interest income was derived outside HK. However, the Board also found that the taxpayer was a financial institution, thus all its interest income was subject to HK profits tax. The taxpayer appealed directly to the Court of Appeal and the Court overruled the decision of the Board. The taxpayer did not carry on a business of a financial institution. As the interest income was sourced outside HK, the interest income was not subject to HK profits tax. The Commissioner appealed to the Privy Council which decided the case on the basis of operation test, not on the provision of credit test. The Privy Council considered that Lord Bridge’s comment in Hang Seng Bank as regards interest income only covered simple situations, for example, where the taxpayer lent money from its own resources. If the taxpayer has to borrow to finance its lending, it is not sufficient only to look at the place where the money was lent, it was also necessary to look at the place where the money was borrowed by the taxpayer. Ultimately, the Privy Council reaffirmed that the source of interest income, like other types of profit, is a practical hard matter of facts and is to be determined by the totality of facts.

 

 

(A)       Corporation (Section 15(1)(f))

4.5	KEY POINT
	Section 15(1)(f) provides that, where (a)        a corporation carries on a trade or business in HK; and (b)        derives interest income from HK. the interest income is taxable.

4.6       Thus, if a non-resident corporation which does not carry on business in HK derives interest with a HK source, the interest received is not taxable.

(B)       Persons other than a corporation (Section 15(1)(g))

4.7       The conditions which render interest interested by a person other than a corporation taxable are the same as for a corporation but there is one further condition: the fund must be a fund of the business. Thus, if a partner lends his own funds to another person, the interest is not taxable income of the partnership. In other words, the money has to be withdrawn from the business in the form of drawings, and the money is deposited with a bank in the name of the sole proprietor or partners.

(C)       Financial institutions (Section 15(1)(i)

4.8       The interest income received by a financial institution is taxed on a worldwide basis under Section 15(1)(i).

4.9

KEY POINT

In order to relieve the harsh treatment on the banking industry, the Commissioner has an agreement with the banking industry that the interest income from a loan is not taxed on a worldwide basis. However, two other factors are taken into consideration in the determination of source of interest income (received from a loan) as follows: (a)       where the loan is initiated, negotiated, approved and documented; and (b)       where the loan is funded (i.e. where funds are raised and loaned directly to the borrower). If both factors take place in HK, the interest income is fully taxed. If either one takes place in HK, half of the income is taxable. If both take place outside HK, all the interest income is exempt from HK profits tax.

4.10     Summary of taxation of interest income earned from a loan

Nature of Business of the Recipient	Source Rule
Received not by a money lender	Provision of credit test
Received by a money lender (not a financial institution)	Provision of credit test
	Operations test
Received by a financial institution	Worldwide taxable – s 15(1)(i)
	Compromise package – 2 factors

(D)       Exemption of interest income from bank deposits

4.11     By virtue of the Exemption from Profit Tax (Interest Income) Order 1998, any interest income received by or accrued to:
(a)        a corporation carrying on a trade, profession or business in HK; or
(b)        a person, other than a corporation, carrying on a trade, profession or business in HK, in respect of funds of that trade, profession or business
on or after 22 June 1998 from any deposit (regardless of the currency) placed in HK with an authorized institution (i.e. a bank, a restricted licence bank or a deposit taking company recognized by the Banking Ordinance), that person (including a corporation) will be exempt from the payments of profits tax on that interest income, after deduction of all allowable outgoings and expenses incurred in producing such interest income (DIPN 34). The exemption was granted by the Chief Executive in Council under Section 87.
4.12     The exemption of interest income granted under Section 87 does not apply to:
(a)        interest on deposits used to secure a loan, and
(b)        interest received by or accrued to a financial institution.
4.13     In case the interest income on the deposit is greater than the interest expense on the borrowing, the taxpayer cannot choose to give up the interest expense claim so as to be exempt from the interest income (DIPN 34 (Revised December 2004)).
4.14     Summary of taxation of interest income earned from a deposit

 

Recipient	Place of Deposit and Use of Deposit		Chargeability
Not a financial institution	In HK	Deposit pledged for a loan	100% taxable
		Deposit not pledged for a loan	100% exempt from profits tax
	Outside HK		100% exempt from profits tax
Financial institution	In HK		100% taxable
	Outside HK		100% taxable

4.15

EXERCISE 1

Printup Co Ltd commenced business in HK in 1983 as a magazine publisher. As a result of declining profits, in May 2007 it stopped publishing, gave up its office lease and terminated the employment of all its staff. The company has not, however, been liquidated. For the year ended 31 May 2008, the only income derived by the company was interest amounting to $20,000 on US dollar deposits and $10,000 on HK dollar deposits with a HK branch of Hang Seng Bank. Required: Discuss whether the interest income derived by Printup Co Ltd in the year ended 31 May 2008 is subject to profits tax.

(E)       Client’s trust accounts

4.15     Interest income received by a solicitors firm on the deposit held on clients’ accounts was held assessable in CIR v Messrs. Lau, Wong & Chan Solicitors 2 HKTC 470. Although the funds on deposit did not at the material time belong to the solicitors firm, the interest was retained by the firm in consideration for its services to the clients, and was therefore derived from the profession. Thus, the interest income is subject to profits tax.

5.       Gains on Certificates of Deposit or Bills of Exchange

5.1       Gains or profits arising in or derived from HK from the sale or other disposal or on the redemption on maturity or presentment of a certificate of deposit or a bill of exchange received by or accrued to a corporation or an unincorporated business carrying on business in HK are chargeable to profits tax under Sections 15(1)(j) and (k) respectively.
5.2       The location of the source of profits from the sale of the certificate of deposit or bill of exchange is the place where the contract for the sale is effected (as determined in the CIR v Hang Send Bank (1990)).
5.3       If the gain or profits arisen or derived from the sale or other disposal or on the redemption on maturity or presentment of a certificate of deposit or a bill of exchange are received by or accrued to a financial institution carrying on business in HK, the gain or profits are subject to HK profits tax even though the moneys for the acquisition of the certificate of deposit or bill of exchange, or the sale, disposal or redemption is effected outside HK under Section 15(1)(l).

6.       Change of Intention of Holding Assets

6.1       An asset which has been acquired for long-term investment purposes may change its nature to that of a revenue asset such as trading stock; or vice versa. A previously acquired trading stock may be changed to a capital/fixed asset, e.g. the property is subsequently occupied by the business as its office.

(A)       Capital asset being transferred to trading stock

6.2       The business is deemed to have sold a capital asset and purchased a trading stock on the date of change of intention although there is no movement of money involved in connection with such sale and purchase. Usually the only entry in the accounting records as a result of such transfer is to debit the trading stock account and credit the fixed asset account with the historical cost of the asset.
6.3       The market value of the capital asset is taken as the deemed cost of the trading stock for the purpose of computation of assessable profit when that particular asset is disposed in future.
6.4       The assessable profit on the sale of the asset is the excess of the sales proceeds over the market value of the asset at the date of change in intention.
6.5       The difference between the original cost of the asset and its deemed cost of trading stock is a capital gain and not subject to profits tax.

(B)       Trading stock being transferred to capital asset

6.6       The market value of the trading stock is taken as the deemed sales proceeds of the deemed disposal of the trading stock although no money is received by the company for such a transfer of asset.
6.7       The notional profit on such deemed disposal is assessable in the year of assessment when the change of intention takes place. The taxable amount is the excess of the market value of the asset (i.e. the deemed sales proceeds) over its historical cost according to the rule of Sharkey v Wernher. Any gain on subsequent disposal of the asset is not taxable because the company sells a capital asset and capital gain is exempt from profits tax.

7.       Capital Receipts

7.1       Receipts from the sale, disposal, loss or destruction of a fixed asset are capital in nature and not subject to profits tax. The nature of capital receipts is a question of fact to be determined from the circumstances of each particular case. There is no hard and fast rule. Very often it is a matter of degree. The IRO does not lay down any definition of capital receipts or fixed assets. Reference must be made to the large body of case law.

(A)       Permanent or temporary loss of fixed asset

7.2

KEY POINT

(a)       Receipts for a permanent loss of a fixed asset are capital receipts. In Glenboig Union Fireclay Co Ltd v CIR (1922) 12 TC 427, a railway was to be built over fireclay (耐火泥) mines operated by the taxpayer so that the mines could no longer be operated. Compensation paid to the taxpayer was held to be capital in nature as the loss was permanent. This was so even though the compensation was computed on the basis of profits lost due to the destruction. (b)       Receipts for temporary loss of fixed assets are revenue. In Burmah Steamship Co v CIR (1930) 16 TC 67, a shipping company placed a ship with a repairer to be overhauled (檢查). The delay by the repairer resulted in a claim for damages by the shipping company which was calculated by reference to the estimated loss of profit due to the delay. The compensation was held to be a taxable receipt. (c)       Compensation for the loss of trading stock including insurance compensation is a revenue receipt (Green v J Gliksten & Son Ltd (1929) 14 TC 364).

7.3

EXERCISE 2

As a result of Mass Transit Railway (MTR) construction work, a factory owned by Mr Leung was damaged and production ceased for six months while extensive repairs were carried out. The MTR Corporation has offered to pay compensation for the damage and losses suffered by Mr Leung. Required: Advise Mr Leung whether the compensation will be subject to profits tax. If so, specifically state whether the compensation agreement can be drafted so as to maximize its chances of being tax-free in Mr Leung’s hands.

(B)       Compensation for loss of contract

7.4       The governing factors are the nature of the contracts and the effect of the cancellation on termination of the contracts on the organizational structure of the company.

7.5

KEY POINT

The principle is that if the amount is received in connection with a trading or commercial contract (not including those in connection with the purchase of fixed assets) in the course of carrying on a business, the receipt is generally a revenue nature. However, if the termination of the contract affects the fundamental operation structure of the company, a compensation for its cancellation is capital. In other words, the contract is the taxpayer’s dominant contract and the cancellation of the contract may lead to the loss of the whole business or the winding up of the company.

7.6

EXAMPLE 2

(a)       In the case, Barr, Crombie & Co Ltd v CIR (1945) 26 TC 406, the taxpayer’s business was mainly the management of ships for one shipping company, and the loss of the management agreement represented a loss of the company’s total operation. It was held that the compensation paid to the taxpayer for the termination of the management agreement was capital in nature, and the sum was not taxable. (b)       In the case, Kelsall Parsons & Co v CIR (1938) 21 TC 608, the taxpayer was a company on the business of acting as sales agent for various manufacturers, and received a compensation from one manufacturer as a result of termination of an agency agreement. It was held that the compensation was revenue in nature and taxable.

(C)       Restrictive covenant or restraint of trade

7.7       Compensation received for agreeing not to compete with other people had been held in a number of cases to be capital. An analogy (類似) can be drawn with permanent loss of a capital asset.

(D)       Termination of tenancy agreement

7.8       A property investment company received a compensation from a tenant upon the premature termination of the tenancy. In addition, the taxpayer also forfeited the rental deposit. The BoR held that the compensation and the rental deposit forfeited were assessable to profits tax.

(E)       Lease premiums

7.9       Lease premiums are received for allowing the other for the use of a company’s capital asset, and they are assessable under profits tax. The profits tax treatments of income received from the use of a capital asset and the income/profit received from the sale of a capital asset are different. Section 14 exempts from the sale of capital asset from profits tax, but the exemption does not apply to income received for the use of capital asset.
7.10     In DIPN 4 (Revised February 2006), the IRD states that it will follow the requirement of generally accepted accounting practice that premium receipts be spread over the term of the lease for the purpose of recognizing them as income.

7.11

EXAMPLE 3

Company X carries on a property letting business and closes its accounts to 31 March each year. While retaining substantially all the risks and rewards incidental to its ownership, it leased one of its properties for a team of four years commencing from 1 April 2006 at a premium of $1,200,000. Company X follows the HKAS 17 Lease Income in preparing its accounts. According to HKAS 17, the lease will be an operating lease and hence the lease premium shall be recognized in income on a straight line basis over the lease term, i.e. over the 4-year period. Therefore, one quarter of the premium will be assessed to profit tax in each of the years of assessment 2006/07, 2007/08, 2008/09 and 2009/10.

8.       Exchange Profits

8.1       Profits tax is assessed on profits expressed in HK dollars (CIR v Malaysian Airline Systems Berhad (1993) HKTC 175). Accounts prepared in foreign currencies must be converted to HK dollars for the purpose of ascertaining the assessable profit.

8.2

KEY POINT

(a)       Exchange receipts which are capital in nature are not taxable, while receipts which are revenue in nature are taxable. (b)       An exchange profit has the same character as the asset or liability from which it arises. Therefore: (i)        exchange profits arising from trading transaction are revenue (e.g. settlement of trade debts, acquisition of trading stock, etc). Thus, the exchange profit in Imperial Tobacco Co Ltd v Kelly (1943) 25 TC 292, was held to be assessable. In that case, a tobacco company accumulated US dollars to finance its purchase of US tobacco leaf. The exchange profit arose from sale of US dollars. (ii)       exchange profits arising from acquisition or disposal of fixed asset are capital in nature. (iii)      exchange profits arising from raising capital or repayment of long-term loans are capital in nature.

(A)       Unrealised exchange profit/loss

8.3       Unrealised exchange profits arise from the conversion of the balance sheet items at the end of the accounting period. Unrealised exchange profits/losses can be assessable/deductible provided that the taxpayer consistently brings such profits/losses into account. However, the accounting treatment must be consistent.
8.4       The IRD issued DIPN 42 (Part 2) Taxation of Foreign Exchange Differences, to set out its new policy. The IRD’s new policy is that if profit or loss is recognized in the profits or losses account, it cannot be excluded in the tax computation on the ground that it is unrealized.

(B)       Exchange profits on repayment of loans

8.5       It is incorrect merely to look at the use of the loan. If the loan is long term in nature, it is capital even though it may be used for acquisition of current assets (Beauchamp v FW Wooloworth plc (1989) 61 TC 542).
8.6       Whether the exchange profit is capital or revenue in nature depends on whether the loan forms part of the fixed capital of the taxpayer. This depends on the purpose of the taxpayer: whether the loan is intended to augment (增加) the fixed capital or is merely a temporary accommodation. Relevant factors for determining the purpose of the loan are the terms of the loan and the use of the loan. It depends on the facts of each case.
8.7       If, however, the borrowing formed an integral part of the profit-making activities, the exchange profit/loss will be revenue (e.g. the borrowing is an integral part in the process of purchasing trading stock). This is illustrated in Thiess Toyota Pty Ltd v FCT (1978) 78 ATC 4463. In that case, letters of credit were obtained from a bank for the purpose of acquiring trading stock. The role of a trade creditor was therefore taken over by the bank.

(C)       Temporary credit facilities

8.8       Temporary credit facilities may be regarded as increasing the capital base of a taxpayer if the facilities keep being extended. In D 77/88, a trading company borrowed a US dollar loan from a bank. The borrowing was by means of the taxpayer accepting short-term bills. The bills were rolled over on a monthly basis for three-and-a-half years. The fund derived from the borrowing was placed with its parent company, partly to discharge the cost of goods purchased from the parent company and partly for other purposes. The exchange loss arising on the borrowing was held to be capital in nature.

(D)       Finance company

8.9       Exchange profits/losses on borrowings by a finance company are more likely to be revenue in nature than in other businesses. Money, to a money lender, is analogous to stock in trade of a trader. In CIR v Chinachem Finance Co Ltd (1992) 1 HKRC 90-066, the taxpayer company borrowed loans repayable on demand, but in fact for various periods up to nine-and-a-half years. The exchange loss was held to be allowable.

(E)       Trader in foreign currencies

8.10     Exchange profits/losses of a forex trader are revenue in nature as the foreign currencies are trading stock.

(F)       Cash at bank

8.11     Cash at bank of a trading company has been held to be a capital asset. Thus, exchange gains or losses arising from the translation of bank balances are capital in nature, even though the cash may have been derived from trading receipts (CIR v Li & Fung (1980) HKTC 1193).
8.12     However, the cash of a bank is analogous to the trading stock of a trading business, and exchange profits or losses arising therefrom are revenue in nature (CIR v Hang Seng Bank (1972) HKTC 583).

8.13

EXERCISE 3

Your client, Universe Trading Ltd, supplies you with the following information in relation to its foreign exchange gains or losses: (a)       It sold trading stock to a Japanese customer. Payment was made in Japanese yen and Universe recorded in its accounts an exchange gain of HK$10,000. Universe did not in fact convert the yen into HK dollars, but immediately placed it on a 10-day time deposit with a Japanese bank. (b)       The time deposit was converted into HK dollars on maturity. On this occasion, Universe suffered an exchange loss of HK$6,000. (c)       Universe then took out a temporary overdraft with its Japanese bank to finance working capital. The overdraft was denominated in yen. The overdraft was later extinguished and Universe incurred an exchange loss of HK$1,000. (d)       Universe then took out a long-term loan, again denominated in yen, from its Japanese bank to invest in current assets. At the end of the relevant basis period, Universe had suffered an unrealized exchange loss of HK$30,000. Required: Advise Universe whether its foreign exchange gains and losses should be taken into account for the purpose of computing its assessable profits under Part IV of the Inland Revenue Ordinance. State the reasons for your conclusions.

 

9.       Miscellaneous Income

(A)       Transfer of rights for receiving income

9.1       Sections 15(1)(m) and 15A provide that any sum received or receivable by a person as consideration in respect of the transfer of a right to receive income is subject to profits tax although the income is of a capital nature. The income means any profits, rent, interest or royalty chargeable to profits tax in HK.

(B)       Stock borrowing and lending

9.2       Section 15E was passed on 8 July 1994 to exempt certain receipts and income derived as a result of stock borrowing and lending from profits tax. When there is a stock borrowing and lending arrangement, the legal title and beneficial interest of the shares involved are transferred from the lender to the borrower. In return, the borrower gives a fee and a deposit to the lender as a security.
9.3       When the borrower holds the shares, the borrower would receive bonus shares, dividend, etc., for such shares, and the borrower is liable to pay these back to the lender. Such distributions received by the lender under a stock borrowing and lending arrangement are exempted from profits tax.
9.4       As the market values of the shares involved at the time of borrowing and at the time of return are unlikely to be the same, any profit or loss derived from such arrangement is exempted from profits tax.
9.5       For a stock borrowing and lending arrangement, the usual taxable income is the borrowing fee received by the lender from the borrower. The fee payable by the borrower is in the nature of a service fee and it is an allowable expense under profits tax.

(C)       Sale of patent

9.6       The assessability depends on whether the whole or part of the cost on the purchase of the patent has been previously allowed under Section 16E(1). The whole sales proceeds received on the disposal of the previously allowed patent is treated as a trading receipt, notwithstanding that it is the receipt from the sale of a capital asset. If only part of the cost of the patent was allowed previously, the sales proceeds will be apportioned and such apportionment depends on the facts of each case.

(D)       Exempted income under Sections 26 and 26A

9.7       Section 26(a) exempts dividend from profits tax.
(i)         Dividends received from corporations which are chargeable to profits tax are exempt from profits tax.
(ii)        Dividends received from a corporation which is not subject to HK profits are not specifically exempt. For example, dividends from a foreign company which is not subject to HK profits tax are not specifically exempt. However, such dividends are in practice not taxed. It is possible that such dividends are offshore in nature.
9.8       Section 26(b) provides that no income or profit from the same source shall be taxed twice.
9.9       Section 26A(1) exempts interest on Tax Reserve Certificates, interest on HK Government Bonds, interest on Exchange Fund debt instruments, interest on HK dollar denominated multilateral agency debt instruments from profits tax.
9.10     Section 26A(1) also exempts the profit on the sale or other disposal or on the redemption on HK Government Bonds, Exchange Fund debt instruments and HK dollar denominated multilateral agency debt instruments from profits tax.
9.11     Section 26A(1) also exempts the income (including interest, gain on disposal, redemption on maturity or presentment of the debt instrument) received in respect of long term debt instrument (maturity period not less than 7 years) issued on or after 5 March 2003.

9.12

EXERCISE 4

Film Ltd, incorporated in HK, makes movies in HK for distribution inside and outside HK. The company grants licences to various distributors outside HK to show its film exclusively outside HK. The company’s employees always negotiate and sign these licences on behalf of the company outside HK. Apart from: (a)       dividends received from a subsidiary company in HK, (b)       interest income received on maturity of a bill of exchange purchased from the Hang Seng Bank and denominated in US dollars, (c)       compensation from a HK distributor for early cancellation of a film distribution agreement, and (d)       royalties received from HK distributors for films screened in HK, the whole of the company’s gross income consists of the fees it receives under the licences granted to its overseas distributors. Required: Explain whether, and if so, to what extent, the company’s profits are subject to tax in HK.