Question

Evaluate the deductibility of expenditure/loss incurred in each of the following cases:

1. Company A placed the sale proceeds it received from a local customer into a three-months’ time deposit with a bank in Hong Kong. The account was in Japanese Yen. However, owing to fluctuation in the exchange rate, it suffered an exchange loss when converting the deposit back to Hong Kong dollars.

2. Company B is an international medicine manufacturer. One of its chief researchers retired and the company paid him a substantial sum of money for entering into an agreement whereby he agreed not to become involved in any activities which might compete directly or indirectly with the company’s business for two years.

3. In order to maintain a constant source of supply of raw materials, Company C made a loan to one of its major suppliers which had a serious financial problem. However, the supplier later went into liquidation. The company could not recover this loan and it was written off as bad in its accounts.

(d)       Company D, a local television company, paid royalty to a foreign film production company for allowing it to show in Hong Kong certain designated films which were produced offshore. The film production company has no representative office or agent in Hong Kong.

(e)        Company E, a manufacturing company, earns profits from the sale of its products in Hong Kong. The products were partly manufactured in Hong Kong and partly in mainland China. The manufacturing activities conducted in the mainland under contract processing arrangement were greatly involved by Company E in terms of expertise, machinery, raw materials and quality control. The following costs were incurred:

(i)   cost of machinery used in the mainland factory;

(ii) cost of staff who regularly visited the mainland factory; and

(iii) cost of raw materials used in the manufacturing.

Answer 1

Ans. A. As per Inland Revenue Department (IRD), Hong Kong, whether currency exchange gain is to be assessed or loss to be deducted depends on the nature of transaction – revenue or capital nature. Revenue nature activities are trading activities,i.e., that relate to sale of goods and services. Capital nature activities, on the other hand, would be those involving investment in fixed assets or long-term loans,etc.

In case of amount kept with banks, the IRD considers exchange gains/losses from amount kept in current accounts for trading purposes as tax assessable/deductible, but any exchange loss on amounts parked in term deposits as capital nature and therefore, not deductible.

Ans. B. Compensation to a leaving employee in return of a promise to not compete also depends on the nature of benefit that will arise from the given expenditure. If the expenditure gives rise to a benefit which is enduring in nature and lasts longer than normal revenue expenditure, it is likely to be capital in nature. Here, the benefits from the amount paid will be received for a span of two years, hence capital in nature. So, same will be non-deductible.

Ans. C. A bad debt is considered as a tax-deductible bad debt if it was a trading receipt (i.e., had the debt been good the revenue from the debt would have formed part of the assessable profits) or debts in respect of money lent in the course of normal money-lending business, and proved to the satisfaction of HKIRD to have become bad during the basis period for assessment. In this case, the bad debt written off was not directly a trading receipt, i.e., had it been good, it was not directly yielding assessable profits. Hence, not deductible.

Ans. D. Same is deductible tax expense since royalties and other such fees paid by Corporations in Hong Kong to foreign affiliates are tax deductible, provided they are incurred for the production of profits subject to tax in Hong Kong. This condition is fulfilled in the above case, so same is tax-deductible.

Ans. E. Under contract processing arrangement, the Hong Kong entity is responsible for supplying all the necessary raw materials, production equipment and technical know-how without consideration while the mainland China processing entity is responsible for the provision of factory premises, utilities and labour force. Based on territorial source principle, the profits to be apportioned on a 50:50 basis between the Hong Kong and the Mainland entity. Accordingly, the expenses incurred by the Hong Kong entity for production of above assessable profits are 50% deductible.