sub-contract fee payable to Smart-PRC is agreed at 80% of the gross service fee under the PRC Contracts. For
each training session, experienced trainers are sent from Smart-HK to assist Smart-PRC, but no cost is charged
for this by Smart-HK. Other support provided in Hong Kong for the PRC Contracts include liaison with customers,
arranging itinerary etc. None of the customers are related to the Smart-Group, and all the service contracts (both
HK and PRC Contracts) are negotiated and signed in Hong Kong.
(2) Smart-PRC is responsible for preparing the relevant training materials for use in the training sessions. It has been
agreed that the copyright for these materials will remain with Smart-PRC. By virtue of the licence agreement
between Smart-PRC and Smart-HK, Smart-HK is granted the right to use the training materials in Hong Kong
and Singapore. The royalty payable is based on 3% of the training revenue received. Smart-HK has entered into
a sub-licence agreement with Smart-Singapore under which Smart-Singapore is allowed to use the training
materials for a royalty at 10% of the training revenue received.
(3) Smart-PRC is the wholly-owned subsidiary of Smart-HK. Each year, Smart-HK has recorded a considerable
amount of dividend income from Smart-PRC. Based on the management representation, Smart-PRC has been
making a very good return from its investment activities in the PRC, and these investments are mainly funded
by the large amount of cash received from Smart-HK by way of sub-contract fees.
Required:
As the tax advisor of Acquirer Group in charge of the tax due diligence review, prepare a report for the directors
of Acquirer Group, addressing the Hong Kong tax issues set out below relating to Smart-HK, including supporting
calculations where appropriate.
(i) The Hong Kong profits tax implications of the training fee revenue from the PRC Contracts and the
sub-contract fee payable to Smart-PRC. Your report should cover the contemporary principles/rules
determining the taxability of the net income of $200,000 from the PRC training service, the arguments both
for and against the offshore claim made by Smart-HK, the role played by Smart-PRC and whether you agree
with the current profits tax treatments by Smart-HK;
Note: For the purpose of this part only, you should assume that all amounts are charged on an arm’s length
basis. (14 marks)
(ii) Assuming that the training fees from the PRC Contracts are taxable in Hong Kong, the Hong Kong profits tax
implications, if any, to Smart-HK of the sub-contract fee paid to Smart-PRC, taking into account the current
transfer pricing rules and practices in Hong Kong. Your report should cover the current views of the Inland
Revenue Department on charges made between associated enterprises, as set out in Departmental
Interpretation and Practice Note (DIPN) 46 ‘Transfer pricing guidelines – Methodologies and related issues’;
Note: You are NOT required to make detailed references to the Double Taxation Arrangement between
Hong Kong and the PRC. (10 marks)
(iii) Assuming that Smart-PRC is not carrying on business in Hong Kong, the Hong Kong profits tax implications
to Smart-PRC in respect of the royalty received and the Hong Kong tax compliance obligations of Smart-HK
in this context; (6 marks)
(iv) Other than the potential technical risks as discussed above, any other information that you would request
from Smart-HK in order for you to assess its level of tax compliance in the context of the Hong Kong tax
regime, giving brief explanations as to why the information is required. (6 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 its advice is communicated. (4 marks)
(40 marks)
