Case Study: Rose Ltd

Background

Trading profits

Rose Ltd (RL) is incorporated in Hong Kong and has been carrying on a business of distribution of fruits, flowers and plants in Hong Kong for many years. It sources products from its wholly owned subsidiary, Dorathy Ltd (DL), which is also incorporated and based in Hong Kong. The ultimate suppliers of DL are located in Europe. DLs three procurement managers go to Europe at least once every season to attend the trade exhibitions of the suppliers. They sign memorandum of cooperation with the suppliers on behalf of DL during their visits to Europe. The memorandum set-out the trading terms between DL and the suppliers. The selling prices between RL and DL are fixed with reference to the trading terms between DL and the suppliers. DL sells goods to RL at 10% mark-up on the relevant costs. The management of RL and DL believe that the basis is reasonable and is at arms length.

During the year ended 31 December 2019, RL had started its business in the mainland China. It appointed sales agents in the mainland. In general, the agents solicited and accepted orders, based on the trading parameters provided by RL. The customers in China placed orders directly to the agents, which then fowarded the orders to RL if the orders could be accepted according to the trading parameters. If the orders were not within the trading parameters and hence could not be accepted immediately, RL and the agents would negoitate with the customers through e-mails or face-to-face discussion at the agents office. If agreement could be reached, the customers would place orders to the agents, which then relayed the orders to RL. Having received orders from the mainland agents, RL would place the orders to DL. The flowers and plants would be delivered directly from DLs Hong Kong warehhouse to the customers in the mainland.

During the year 2019, the marketing managers of RL has travelled to the mainland to solicite customers and promote RLs business. They has met with some of the customers at the mainland agents office because RL did not own or rent any office premises in the mainland. For promotion, RL displayed products at the mailand agents offices but the mainland agents did not charge any rental on using their offices in this regard.

The trademark

The Rose trademark is owned by Imagine Inc (II), which is the holding company of RL and principally carries on business in the USA. II had operated a branch in Hong Kong before setting up RL and DL in Hong Kong. IIs Hong Kong branch had been using Rose in carrying on its trading business here for many years. Since the establishment of RL, II had granted a license to use the trademark to RL in return for a royalty. In addition to using the trademark by itself, RL also sub-licensed the right to use such trademark to another subsidiary, Great Road Enterprise (GRE) at a royalty of 5% on GREs sales in the Mainland. GRE is incorporated in the Mainland of China and is engaged in trading of organic foods.

Financing arrangement

RL has a quite sizeable amount of retained earnings and a relatively low level of external borrowing. However, most of the companys current assets were trading stock and account receivable. At the request of II, RL has declared dividend of $10 million to II. As RL did not have sufficient cash on hand, such amount was still outstanding to II as at 31 December 2020. RL planned to borrow $20 million from a bank in Hong Kong to repay the dividend payable, rather than selling some trading stock to finance such payment. David Sung, a director of II and RL, said during the recent Board of Directors meeting that II could place any dividends received into a time deposit and use the time deposit to guarantee RLs borrowing from the bank.

Requirement:

You are required to prepare a comprehensive report to the Board of Directors of RL, addressing the following issues:

the recommendation on the financing arrangement of RL for dividend payment from a Hong Kong profits tax perspective, including appropriate adjustment to enhance tax efficiency if necessary.