Question 1 (27 marks)

Mr. White is a UK citizen living and working in Hong Kong. He owns an office building in Hong Kong, which has been leased out for rental for the past five years. Mr. White is now considering the following restructuring:

Mr. White intends to take over a beauty salon business through an acquisition of 100% shareholding in the salon business operating company, Best Ltd. Best Ltd. was incorporated in Hong Kong 4 years ago and carries on hair and nail salon business in Hong Kong. Due to the competitiveness in the industry, Best Ltd. started to incur operating and tax losses in recent years. After the acquisition, Mr. White will transfer his office building into Best Ltd. The office building will continue to be leased out for rental income which will then be received by Best Ltd.

Required:

You are the tax consultant engaged by Mr. White. Prepare a memorandum for Mr. White addressing each of the following issues from a Hong Kong tax perspective.

(a) Based on the Inland Revenue Ordinance (IRO), discuss the eligibility of Best Ltd. to carry forward the tax losses after the change in shareholding. (8 marks)

(b) During the acquisition negotiation, the senior beauty specialist employed by Best Ltd, Susan, proposed that, after the shareholding change, she will terminate her existing employment contract with Best Ltd., and incorporate a self-owned Hong Kong company (HK Co) which will enter into a service agreement with Best Ltd. Under the service agreement, she will provide beauty consultancy services to Best Ltd. in the capacity of HK Cos employee. An annual fee will be payable by Best Ltd. to HK Co at an amount equivalent to her annual salary under the existing employment contract with Best Ltd. The fee is payable on a quarterly basis through bank transfer. She asked to be entitled to the staff discount on the nail beauty services in the salon but will forgo all other staff benefits. As an employee of HK Co, Susan will receive a salary based on 60% of the service fee payable by Best Ltd., as HK Co will be responsible for most of her living expenses.

Based on the IRO, analyse and comment the arrangement proposed by the senior beauty specialist, Susan, as to:

(i) how the tax positions of Best Ltd. and Susan will change under the proposed arrangement and what are the potential tax benefits for Susan; and (5 marks)

(ii) whether the proposed arrangement will be challenged by the Inland Revenue Department, and if so, what the potential consequences are. (10 marks)

Professional marks will be awarded in Question 1 for the appropriateness of the format and presentation of the report and the effectiveness with which the advice is communicated. (4 marks)

(Total for Question 1: 27 marks)