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:

Note

Income $

Onshore service fee income

and trading profits 55,000,000

Service fees from agreements

concluded outside Hong Kong 1 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 CLs 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 CLs 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 BLs 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. 8

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 CLs fixed deposit (see note (2) above) and was applied for purchase of a computerised service provision system which was used by CLs 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 CLs 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 CLs 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. Use the table in the Answer Book to write your answer.

(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.