Question 2 (28 marks)

TT Toys Limited

TT Toys Limited (the Company) was founded in Hong Kong in the 1980s. The Company was involved in manufacturing and exporting toys, and trading listed shares. In 2016, the Company set up two wholly-owned subsidiaries, TT (Investments) Limited (TT Investments) and TT (Manufacturing) Limited (TT Manufacturing) in Country X and mainland China respectively. The above companies are collectively known as the TT group.

TT Investments

TT Investments commenced business on 1 October 2016 and closes its accounts on 31 December each year. TT Investments closed its first and second accounts on 31 December 2017 and 31 December 2018, respectively. The shares in Water Limited (Water) are listed on the Hong Kong Stock Exchange. In October 2015, the Company acquired 500,000 shares (the Shares) in Water as its trading stock for a consideration of HK$5 million. The Company had never owned or traded shares in Water prior to the acquisition. To streamline its business, the Company sold the Shares to TT Investments on 16 August 2017 at cost. The transaction price on the Hong Kong Stock Exchange on that date in respect of 500,000 shares in Water was HK$7 million.

TT Manufacturing

The manufacturing activities of the Company are conducted by the wholly-owned subsidiary, TT Manufacturing, in mainland China. TT Manufacturing will purchase all the required raw materials for manufacture locally in mainland China. Any required imported materials will be imported by the Company, and the materials will then be sold to TT Manufacturing. To facilitate the manufacturing process, machinery (acquired under hire purchase) and moulds owned by the Company were transferred to TT Manufacturing for its use, at no cost. Quality assurance engineers and production control staff from the Company visit TT Manufacturing to train and update its staff. In addition, a number of senior management staff employed by the Company are stationed in TT Manufacturing to monitor and manage its operations. However, the machinery and moulds are only used to manufacture finished goods supplied to the Company. After the production, the TT Manufacturing will first sell the products to the Company, which will then resell the products to the end customer, depending on the demand.

Required:

(a) Evaluate and suggest the most appropriate method of establishing an arms-length price in respect of the selling of the Shares by the Company to TT Investments, with reference to the transfer pricing methods recognised in the OECD Transfer Pricing Guidelines as discussed in Departmental Interpretation and Practice Notes No. 46 (DIPN No. 46). Elaborate on the reasons for your choice. (10 marks)

(b) Determine, with explanation in support, the basis periods of TT Investments for the years of assessment 2016/17, 2017/18 and 2018/19. (7 marks)

(c) The management of the Company raised the following tax question. As its tax advisor, please reply to this question with supporting references from tax authorities (e.g. DIPN, tax legislation or tax cases): The management of the Company has heard of the 50:50 offshore profits claim. Explain the qualifying conditions and evaluate whether any of their group companies could be entitled to such a claim. (11 marks)

(Total for Question 2: 28 marks)