Question
Cherry Ltd (CL) carried on a business of Internet service provision and trading of related products in Hong Kong. The draft income statement of CL
Cherry Ltd ("CL") carried on a business of Internet service provision and trading of related products in Hong Kong. The draft income statement of CL for the year ended 31 March 2020 shows a net profit before taxation of $22 million after crediting the following income and charging the following expenses, unless otherwise stated:
Income
$
Onshore service fee income and trading profits
55,000,000
Service fees from agreements concluded outside Hong Kong
1(NOTE)
3,000,000
Interest income
2
1,500,000
Gain on disposal of trademark
3
400,000
Expenditure
Product research expense
4
900,000
Depreciation
300,000
Bank interest
5
740,000
Repair and maintenance
6
300,000
Bad debts
7
360,000
Explanatory Notes
1 The service fees derived from agreements concluded outside Hong Kong of $3,000,000 representing gross income in total of 5,000,000 (after deduction of all related administration expenses) less a royalty fee of $2,000,000. CL appointed agents located in various cities in mainland China to promote its server maintenance services to companies in mainland China. These agents, which were fully authorized by CL, negotiated and concluded the relevant agreements with clients in mainland China. The agents prepared the initial maintenance plan under CL's instructions and presented the plans to clients for their approval. The total amount of $5,000,000 was received for maintenance services rendered in Hong Kong. The fee income was deposited in CL's bank account in mainland China. CL paid a royalty fee of $2,000,000 to Berry Ltd (BL), which is a resident company of the United States and unrelated to CL. The fee was paid for the right to use BL's trademark in promoting its server maintenance services in mainland China. BL did not carry on business in Hong Kong and it did not have any connected entity carrying on business in Hong Kong.
2 Interest income of $1,500,000 was derived from a fixed deposit placed with a bank in Hong Kong (the deposit has been used to secure a bank loan borrowed by CL, see note (5) below)
3 In the year 2009/10, CL bought a registered trademark from an unrelated company, Umbrella Ltd ("UL") for use in its trading business at a price of $1.4 million. During the year 2019/20, CL sold the trademark at a price of $1.8 million and hence made a profit of $400,000.
4 The product research expense of $900,000 consisted of $700,000 for research staff salary and $200,000 for purchase of consumables related to the research conducted by the staff.
5
$
Interest on bank loan (Loan 1), see note (2) above
540,000
Interest on bank loan (Loan 2)
200,000
Total per accounts
740,000
Loan 1 was secured by CL's fixed deposit (see note (2) above) and was applied for purchase of a computerised service provision system which was used by CL's business.
Loan 2, in the amount of $4,000,000 was borrowed on 1 April 2019, and was used to purchase trading stock of CL for its onshore trading operation. Holding Ltd (HL), which was CL's holding company, pledged its overseas listed shares and overseas listed debentures to secure the repayment of Loan 2. The market value of the overseas listed shares and the amount of the overseas listed debentures were both at $4,000,000. HL received dividend income of $80,000 from the shares and interest income of $150,000 from the debentures.
6 The repair and maintenance expense of $300,000 was incurred for redecoration of CL's showroom.
7 $
A loan to a manager written off 200,000
General provision for trade debts 160,000
Total per accounts 360,000
8 Depreciation allowance agreed by the Inland Revenue Department for the year was $200,000
9 CL bought an environmental protection installation at a price of $3,000,000, which has NOT been charged to the above income statement. The installation was used in its Hong Kong service provision business.
Required:
(a) Calculate the profits tax payable by CL for the year of assessment 2019/20. Ignore provisional tax.
(b) Explain your profits tax treatment for the items below:
1) Note (1) - Gross service fee from agreements concluded outside Hong Kong of $5,000,000 and royalty fee of $2,000,000 paid to BL
2) Note (5) - Interest on Loan 2, $200,000
Please cite and apply the relevant provisions in the Inland Revenue Ordinance, case law, and practice notes in supporting your analysis, where appropriate.
Tax Rates
Standard rate 15%
Corporate profits tax rate
First $2,000,000 8.25%
Remainder 16.5%
Progressive rates
First $50,000 2%
Next $50,000 6%
Next $50,000 10%
Next $50,000 14%
Remainder 17%
Tax Reduction (where applicable)
Percentage of reduction 100%
Maximum per case $20,000
Personal Allowances $
Basic 132,000
Married person's 264,000
Child - 1st to 9th (each) 120,000
Additional (for year of birth, each) 120,000
Dependent parent / grandparent (each)
Basic 50,000
(aged 55 or above but below 60: $25,000)
Additional 50,000
(aged 55 or above but below 60: $25,000)
Dependent brother / sister (each) 37,500
Single parent 132,000
Personal disability 75,000
Disabled dependant (each) 75,000
Deductions (maximum)
Self-education expenses 100,000
Home loan interest 100,000
Elderly residential care expenses 100,000
Contributions to recognised retirement schemes 18,000
VHIS policy premiums (for each insured person) 8,000
Annuity premiums and tax deductible MPF voluntary contributions 60,000
Depreciation Allowance
Plant and machinery
Initial - 60%
Annual - Air-conditioning plant: 10%
Furniture and fixtures, office equipment, room air-conditioning units,
domestic appliances: 20%
Motor vehicles, electronic data processing equipment (computer),
electric cookers, production machines: 30%
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