SECTION A – CASE QUESTIONS (Total: 75 marks)

Answer 1(a)

Since MPHZ accounts for 35% and 40% of the Group’s revenue and profit, respectively, for
the current year, it is of individual financial significance to the Group, per Hong Kong Standard
on Auditing 600, that we shall perform an audit of the financial information of MPHZ using
component materiality.

The Group’s auditor should evaluate whether the local auditor understands and complies with
the ethical requirements that are relevant to the group audit, and in particular, is independent.

Involve in the risk assessment of the local auditor to identify significant risks of misstatement
of the group financial statements. For example, inquire as to the business activities that are
significant to the group, susceptibility of the component to material misstatement of the
financial information due to fraud or error, and review their documentation of identified
significant risks of material misstatements of the group financials statements.

Communicate with the local auditor on a timely basis throughout the audit, such as the ethical
requirements, financial reporting framework and auditing framework expected of the
component auditor, component materiality and the threshold above which misstatements
cannot be regarded as clearly trivial to the group financial statements, a list of related parties.

Obtain confirmation from the local auditor of their compliance with the ethical requirement
relevant to our group audit, financial reporting framework and auditing framework.

Request the local auditor to report to the Group’s auditor if there is any instances of non-
compliance with laws and regulations during the year that could give rise to a material
misstatement of the group financial statements, indicators of a possible management bias,
description of any identified significant deficiencies in internal control at MPHZ level.

Obtain overall findings, conclusions or opinion from the local auditor.

The reason that the audit approach is different from the Group’s predecessor auditor is due
to the significance of MPHZ’s financial information to the Group this year as compared with
that of last year.

Final Examination (December 2019 Session) – Paper I 1 of 16

Answer 1(b)

Requirement under HKFRS 12 Disclosure made for the Group

Since non-controlling interest of MPHZ is material to the

Group, the following information shall be disclosed in
accordance with HKFRS 12:

(a) the name of the subsidiary MPHZ

(b) the principal place of business (and country of PRC

incorporation if different from the principal place of
business) of the subsidiary

(c) the proportion of ownership interests held by non- 45%

controlling interests

(d) the proportion of voting rights held by non- Not mentioned in the case
controlling interests, if different from the
proportion of ownership interests held

(e) the profit or loss allocated to non-controlling HK$2,657K = HK$14,763K x 40%

interests of the subsidiary during the reporting x 45%
period
(f) accumulated non-controlling interests of the Not mentioned in the case
subsidiary at the end of the reporting period

(g) summarised financial information about the

subsidiary, including

 dividends paid to non-controlling interests Not mentioned in the case

(not mentioned in the case).

 summarised financial information about the Revenue of MPHZ = HK$43,750K

assets, liabilities, profit or loss and cash flows (HK$125,000 x 35%) and profit of
of the subsidiary that enables users to MPHZ = HK$5,905K (HK$14,763K
understand the interest that non-controlling x 40%); other information not
interests have in the group’s activities and mentioned in the case
cash flows. That information might include,
but is not limited to, current assets, non-
current assets, current liabilities, non-current
liabilities, revenue, profit or loss and total
comprehensive income.

Final Examination (December 2019 Session) – Paper I 2 of 16

Answer 1(c)

For the incident of unauthorised use of customers’ images:

Impact on the overall audit plan

Understand, evaluate, and test management’s process and control in place to obtain consent
and use of customers’ image.

Enquire Management for a list of customer complaints received and handled during the year
and subsequent to the year end; obtain Management’s explanation and evaluation of the
impact to the financial statements.

Obtain the list of legal and professional fee recorded by the Group during the year, test the
expenses by checking to the supporting documents and match the fees recorded to the list
of customer complaints received and handled by the Group, in order to ensure completeness
of cases identified by the Group.

Obtain a list of litigations and claims and Management’s assessment of the outcome and
estimates of the financial implications of each of the litigations and claims.

Request the Group’s external legal counsel to confirm the reasonableness of Management’s
assessments and provide us with further information if the list is considered by the Group’s
external legal counsel to be incomplete or incorrect.

Perform a search for any other identified/pending litigation and claims involving the Group.

Accounting treatment in connection with the compensation made to Gigi

In accordance with HKAS 10, the compensation made to Gigi of HK$200,000 is an adjusting
event, as the evidence of conditions that existed at the end of the reporting period.

The settlement confirms that the Group had a present obligation at the end of the reporting
period and the agreed compensation amount provides additional evidence that would be
considered when determining whether a present obligation existed as at the end of the
reporting period in accordance with HKAS 37.

Considering MPHK has the present obligation for the compensation as a result of the past
event (unauthorised use of the images of Gigi), it is probable that the outflow of resources
embodying economic benefits will be required to settle the obligation (compensation payment
to Gigi) and a reliable estimate can be made of the amount of obligation (HK$200,000),
the provision of HK$200,000 should be recorded at 31 December 2018.

Final Examination (December 2019 Session) – Paper I 3 of 16

Answer 2

(a) For the non-reply confirmation from the two banks located in Taiwan, the audit team
should:

 Request Management to contact the banks to follow-up on the confirmation

request.

 Enquire Management about the purpose of the bank accounts and facility
arrangement in Taiwan, given the Group currently has no business operation in
Taiwan.

 Perform alternative procedures:

- Agree the bank balances per the reconciliation to the bank statement.

- Obtain an understanding of, and test the controls relating to, the Group’s
treasury function, such as the authorisation levels, access to online banking
facilities, approval of new facilities, capturing all facilities and arrangements
and monitoring of compliance with terms and arrangements.

- Observe authorised personnel access online banking and compare recorded

bank balances and arrangements with details shown online.

- Request individuals responsible for banking relationships to identify changes

in banking arrangements during the year and to assist with assessment of
completeness of facilities and arrangements.

- Trace the facility granted by the bank in Taiwan to the bank facility letter,
correspondence letter, board minutes etc.

(b) For Management’s request that the audit team do not arrange confirmation with CPL:

 The audit team should first inquire Management for the reason that confirmation
should not be requested from CPL, and obtain evidence as to the validity and
reasonableness of Management’s response.

 Evaluate the implications of Management’s refusal on audit team’s assessment of

the relevant risks of material misstatement, including the risk of fraud, and on the
nature, timing and extent of other audit procedures.

 Perform alternative procedures designed to obtain relevant and reliable audit

evidence, such as interviewing CPL management , performing site visit of CPL,
inspecting the agreement signed between MPHK and CPL, examining the
correspondence or monthly statement between MPHK and CPL, testing the
supporting documents such as sales invoices comprising the receivable balances
and testing subsequent settlement made by CPL, if any.

Final Examination (December 2019 Session) – Paper I 4 of 16

  If the audit team concludes that Management’s refusal for the confirmation request
is unreasonable, or the audit team are unable to obtain relevant and reliable audit
evidence from alternative audit procedures, the audit team shall communicate with
those charged with governance in accordance with HKSA 260 (Revised)
Communication with Those Charged with Governance. The audit team shall also
determine the implications for the audit and the audit opinion in accordance with
HKSA 705 (Revised) Modifications to the Opinion in the Independent Auditor’s
Report.

Answer 3

Yes, MOL could be exempted from the preparation of consolidated financial statements
if they can meet the requirements under the Hong Kong Companies Ordinance.

As further explained below, there may appear to be a difference in the criteria between the
s379 of the Hong Kong Companies Ordinance and HKFRS 10 whether MOL should prepare
consolidated financial statements. MOL, as a company incorporated in Hong Kong which
falls within the requirement of s.379 of the Hong Kong Companies Ordinance to prepare the
company level financial statements, can take precedence over the requirement of HKFRS 10
and a statement of compliance included in the financial statements of MOL should clearly
state that the financial statements comply with the accounting standards applicable to the
company level financial statements only.

Requirement under the Hong Kong Companies Ordinance

As MOL is a partially-owned subsidiary of another body corporate during the year, per the
Hong Kong Companies Ordinance s.379(3)(b), in order for MOL to claim the exemption for
not preparing consolidated financial statements as its statutory financial statements,

 at least 6 months before the year end, the directors should notify the members in
writing of the directors’ intention not to prepare consolidated financial statements for
the financial year, and the notification does not relate to any other financial year; and

 at a date falling 3 months before the end of the financial year, no member has
responded to the notification by giving the directors a written request for the
preparation of consolidated financial statements for the financial year.

Alternatively, MOL can claim exemption for not preparing consolidated financial statements
under s.379(3)(c) of the Hong Kong Companies Ordinance, as included in the Companies
(Amendment) (No.2) Ordinance 2018 that came into effect on 1 February 2019:

If all members agree in writing before the end of the financial year that consolidated financial
statements will not be prepared for the financial year, and the agreement does not relate to
any other financial year, then MOL (as a partially-owned subsidiary of another body
corporate) will be able to claim the exemption for not preparing consolidated financial
statements as its statutory financial statements, MOL can apply this exemption if they can
fulfil the requirement.

Final Examination (December 2019 Session) – Paper I 5 of 16

Requirement under HKFRS 10 Whether MOL meets the conditions

A parent need not present consolidated financial MOL may be exempt from preparing the
statements if it meets all the following conditions: consolidated financial statements under
HKFRS 10 depending whether conditions
below are fulfilled.

(i) it is a wholly-owned subsidiary or is a Not certain – MOL is a 70%-owned

partially-owned subsidiary of another
entity and all its other owners, including
those not otherwise entitled to vote, have
been informed about, and do not object to,
the parent not presenting consolidated
financial statements;
subsidiary. In order to fulfill this condition,
MOL is required to inform Lawrence
Fung, the non-controlling shareholder
and Lawrence did not object MOL for not
presenting the consolidated financial
statements.

(ii) its debt or equity instruments are not Not certain – depending on whether MOL
traded in a public market (a domestic or has any debt or equity instruments traded
foreign stock exchange or an over-the- in any public market.
counter market, including local and
regional markets);

(iii) it did not file, nor is it in the process of Not certain – depending on whether MOL
filing, its financial statements with a filed or in the process of filing its financial
securities commission or other regulatory statements with any securities
organisation for the purpose of issuing any commission or other regulatory
class of instruments in a public market; organisation for the purpose of issuing
and any class of instruments in a public
market

(iv) its ultimate or any intermediate parent Not certain – Moments Photography
produces consolidated financial Company Limited (“Moments”) produces
statements that are available for public consolidated financial statements under
use and comply with HKFRSs or HKFRS. However, it is not certain
International Financial Reporting whether the consolidated financial
Standards, in which subsidiaries are statements of Moments is available for
consolidated or are measured at fair value public use, e.g. available on the
through profit or loss in accordance with company’s website or contact information
this HKFRS or IFRS 10. is available so that the users of the
financial statements are informed of how
they can obtain a copy of the consolidated
financial statements of Moments. It is
also not certain whether PHKL produces
any consolidated financial statements
that are available for public use or comply
with HKFRS or IFRS.

Final Examination (December 2019 Session) – Paper I 6 of 16

 Answer 4(a)

The Group can consider the following ways to obtain funding:

I. Issue shares or right issue

Advantage of issuing shares or right issue:

The Company is not obligated to make any dividend payments to shareholders.

Disadvantage of issuing shares or right issue:

The ownership of the Company will be diluted.

II. Issue bonds

Advantage of issuing bond:

The Company incurs interest expense periodically, and the interest expense is tax
deductible; therefore, it offers a tax benefit and reduces the amount of taxes.

Disadvantage of issuing bond:

The Company is obligated to make the interest payments to the bondholders periodically.
Therefore, it is a burden to the Company.

III. Request for bank loan

Advantage of obtaining loan from bank:

The Company can enjoy a tax saving benefit as the interest expense incurred is tax
deductible, therefore, it offers a tax benefit to the company.

The low interest rate in Hong Kong offers a cheaper option to the Company for fund raising.

Disadvantage of bank loan:

Banks have strict requirements to approve the loan request. For example, banks will require
collaterals from the Company. If there is no collateral, then the Company will subject to a
higher interest rate for an unsecured loan.

Currently, there is still a substantial amount of outstanding loan (short term and long term);
therefore, it will be difficult for the Company to obtain another bank loan or the bank will
charge for a higher interest.

Final Examination (December 2019 Session) – Paper I 7 of 16

IV. Factor the trade and other receivables

Advantage of factoring the trade and other receivables:

It requires less paperwork compare with requesting for a bank loan.

It is easy to get the funds immediately.

Disadvantage of factoring the trade and other receivables:

It is expensive for the Company to factor the receivables as the Company usually pays more
or sells at discount to get the funds.

It is a red flag or signal to the investors that the Company is short of cash.

V. Sale of unused, old and obsolete property, plant and equipment; or sale of assets

Advantage of selling unused, old and obsolete property, plant and equipment; or selling
assets:

The proceeds or cash realised can be used to pay off the liabilities owe to creditors and
reduce the bank loans or debts that improves the financial position of the company.

Disadvantage of selling unused, old and obsolete property, plant and equipment; or selling
assets:

Selling unused, old and obsolete property, plant and equipment or selling assets don’t always
bring in large amounts of fund. The replacement of those unused, old and obsolete property,
plant and equipment or replacement of disposed assets may even cost more to the Group.

Among all of the alternatives, sales of unused, old and obsolete property, plant and
equipment or selling assets is the best method to obtain funding because:

The ownership and control of the Group will be diluted by issuing shares or right issue.

The finance cost of the Group has increased from HK$1.8 million to HK$2.9 million in the
past year. If the Group issues bonds, the interest payments will be a substantial burden to
the Group.

The bank loan has increased from HK$8 million to HK$10 million in the past year.
It is not easy for the Group to obtain another loan from the bank or the Group will be subjected
to higher interest rate for the additional loan.

The Group will suffer a loss for selling the trade and other receivables at discounts.

The sales of unused, old, and obsolete property, plant and equipment; or sale of assets can
increase the cash amount without causing additional burden to the Group. The fund can be
used for reinvestment or expansion.

Final Examination (December 2019 Session) – Paper I 8 of 16

 Answer 4(b)

From the Group’s perspective, managing exchange rate risk is necessary because the cost
involved in hedging the exchange rate movement is not very substantial compare with
its benefits. Also, in the short run, it can mitigate the risk of financial distress and bankruptcy.
In the medium and long run, it can enhance the sustainability of the business and maintain a
relative stable cash flow. Given the high volatility of the HKD/SGD exchange in the past year,
it is necessary for the Group to manage the exchange rate risk from the uncertainty of the
exchange rate movement and reduce the risk to the Group.

(i) The gain on the one-year forward contract

= SGD5 million / 0.1628 – SGD5 million / 0.1933

= HKD30.7125 million – HKD25.8665 million
= HKD4.846 million

Answer 5

Ms Fung can consider the following exit plans:

I. Divestment or Sell off:

Divestment is the partial or complete sales or disposal of physical and organisational assets,
shut down of facilities and reduction in workforce in order to free funds for investment in other
areas.

Sell off is the sale of part of a Company to a third party.

Ms Fung can consider selling one of the subsidiaries company (e.g. MPSH) to get back the
capital for future investment opportunities that may arise.

Ms Fung can sell part of a Company for cash.

Advantage of disposal part of the business:

Ms Fung can retain the existing corporate form for the remainder, ownership, and control of
the business.

Selling under-performing business can stop incurring the loss in future.

Disadvantage of disposal part of the business:

Ms Fung will lose existing customers and contacts in Shanghai which takes time to establish
the relationship.

The staff will be made redundant and affect the morale of staff in other region; for example,
Hangzhou.

Final Examination (December 2019 Session) – Paper I 9 of 16

II. Management buy-outs or Management buy-ins or Look for other investors to purchase
Ms Fung’s ownership:

Selling all the ownership of Ms Fung is one of the ways for Ms Fung to exit the Company.

Ms Fung can consider looking for existing managers or outside managers or other investors
who are interested in the business as the scale of operation is expanding that can attract
existing managers or outside managers or other investors to join in.

Advantage of looking for existing managers or outside managers or other investors to

purchase Ms Fung’s ownership :

The Group plans to execute and launch the investment as the financial position and financial
performance of the Company is not bad; therefore, it is not difficult to find outside managers
or other investors to join and implement the expansion plan in Singapore.

It is easier and quicker to find existing managers for Ms Fung to exit the Company.

Ms Fung can receive cash immediately.

Disadvantage of looking for existing managers or outside managers or other investors to

purchase Ms Fung’s ownership :

Ms Fung will no longer own the Company.

Ms Fung may sell her ownership at a discounted price.

III. Initial public offer (“IPO”):

An IPO is an invitation to apply for shares in a company based on the information contained
in a prospectus. When companies go public for the first time, a large issue will probably take
the form of an IPO.

The financial performance and financial position look attractive to public, especially when the
profit has been increasing from HK$13.8 million to HK$14.7 million. Also, it is a prestige to
list on a regulated stock exchange and it improves the public image and awareness of the
Company

Advantage of IPO:

It is one way to access to capital as it reaches a large number of shareholders. After the
IPO, it can raise capital easily and Ms Fung can obtain cash quickly.

It attracts more potential individuals to invest in the Company; thus, Ms Fung may maintain
control of the Company.

Final Examination (December 2019 Session) – Paper I 10 of 16

Disadvantage of IPO:

It incurs significant legal, accounting and marketing costs, effort, and time, usually six to
nine months or longer, for an IPO to go public. Ms Fung cannot obtain cash very quickly.

There is a risk that the required funding will not be raised; therefore, Ms Fung cannot obtain
the required capital.

There is a loss of control due to new shareholders; thus, Ms Fung may face difficulties in
executing the exit plan.

Answer 6

Acquisition of 30% interest in MPSH from Raymond Yuan.

In accordance with HKFRS 10, changes in a parent’s (MPHK’s) ownership interest in a

subsidiary (MPSH) that do not result in the parent (MPHK) losing control of the subsidiary
(MPSH) are equity transactions (i.e. transactions with owners in their capacity as owners).

When the proportion of the equity held by non-controlling interests changes, an entity
(MPHK) shall adjust the carrying amounts of the controlling and non-controlling interests to
reflect the changes in their relative interests in the subsidiary (MPSH). The entity (MPHK)
shall recognise directly in equity any difference (RMB6 million) between the amount by which
the non-controlling interests are adjusted (RMB1.5 million) and the fair value of the
consideration paid (RMB7.5 million = RMB7 million + RMB500,000), and attribute it to the
owners of the parent directly in equity.

The difference (RMB300,000) between the fair value of the vehicle (RMB500,000) and the
then carrying value (RMB800,000) would be recorded as a loss in the profit or loss.

Answer 7

Year ended 31 December 2018

The loan drawn down subsequent to the year end date on 1 January 2019 is a non-adjusting
event in accordance with HKAS 10. Considering the amount is material, disclosure of the
nature of the event and an estimate of its financial effect shall be made in the financial
statements for the year ended 31 December 2018.

Final Examination (December 2019 Session) – Paper I 11 of 16

Year ending 31 December 2019

In accordance with HKFRS 9, the loan shall be initially stated at fair value and subsequently
measured at amortised cost using the effective interest rate method, as the Group intends to
hold the loan to maturity (i.e. held within a business model whose objective is to hold financial
assets in order to collect contractual cash flows) and the contractual terms of the loan give
rise on specified dates to cash flows that are solely payments of principal and interest.

Principal is the fair value of the financial asset at initial recognition. The principal (fair value)
of the loan is HK$3,969,161 (HK$5,000,000 / (1.08)3), which is estimated by discounting
HK$5 million cash flows to be received at the end of a three-year period applying 8%,
representing the market interest rate charged for a similar loan.

Given PHKL is the shareholder of the Company, and there is no other business relationship
between PHKL and the Company, the difference of HK$1,030,839 (HK$5,000,000 –
HK$3,969,161) between the face value and the fair value of the interest-free loan may be
considered as a deemed distribution from the Company to PHKL.

Deemed interest income of HK$317,533 (HK$3,969,161 x 8%) would be recorded with the
corresponding debit to the loan to PHKL for the year ending 31 December 2019.

* * * END OF SECTION A * * *

Final Examination (December 2019 Session) – Paper I 12 of 16

SECTION B – ESSAY QUESTIONS (Total: 25 marks)

Answer 8

To: Ms Rose Cheng

From: Tax advisor

Date: Exam date

Subject: Hong Kong tax implications and reporting obligations in respect of the lease
agreement with PII

We refer to your enquiry in relation to the rental payments made to PII with respect to the
3D scanning and 3D printing machines. As requested, we provide below our comments on
the respective issues.

Taxability of rental income received by PII

While PII has no other business presence in Hong Kong, and thus not chargeable to
Hong Kong profits tax under s.14, it is deemed to be chargeable to tax under s.15(1)(d),
as it received rental income in respect of the 3D scanning and 3D printing machines used by
MPHK in Hong Kong.

S.21A does not apply in fixing the assessable profit in respect of a sum deemed chargeable
under s.15(1)(d). As such, the normal rules apply and the assessable profit is the
gross amount of rental receipt, less allowable expenses and depreciation allowances.
The applicable tax rate is 16.5%.

Article 12 Royalties of the DTA between mainland China and Hong Kong provides that the
term “royalties” is defined to include payment received as a consideration for the use of
industrial or commercial equipment. The tax so charged is 7% of the gross amount of rental
receipt.

Under DIPN 44, the IRD states that Hong Kong adopts the “preferential treatment” principle.
Where the DTA and IRO contain different provisions relating to the same matter, preference
will be given to the provisions that are most beneficial to the taxpayers.

That means the tax payable on the rental receipt would be the lower of the sum computed
under s.15(1)(d) and the DTA.

Final Examination (December 2019 Session) – Paper I 13 of 16

Reporting obligations

MPHK has no obligations to withhold the tax from the rental payments it made to PII as
it was not an agent of PII. MPHK and PII deal with each other on a principal-to-principal
basis. Furthermore, sums deemed chargeable under s.15(1)(d) are not covered in s.20B,
under which a Hong Kong payer is required to withhold the tax payable in respect of certain
sums for a non-resident person.

MPHK did not have any obligation to report to the IRD in the year of assessment 2017/18
because the rental payments were made during MPHK’s financial year ended
31 December 2018. MPHK is only required to report the rental payments made to PII in the
relevant box in its 2018/19 profits tax return.

Please feel free to let us know if you have any questions regarding the above.

Best regards,
[Tax advisor]

Answer 9

S.16 permits the deduction of expenses incurred by a business in the production of its
assessable profits. But s.17(1)(c) of the IRO disallows the deduction of capital expenditure.

It is not always easy to decide whether an expense is capital or revenue in nature.

There are, however, guiding principles which can be drawn from precedent cases:

The “enduring benefit” test. This considers whether an item of expenditure has been incurred
to bring into existence an identifiable asset, tangible or intangible, for the enduring benefit of
a trade. An expenditure item falling within such category is likely to be of a capital nature.

The “once and for all expenditure” test. This suggests that capital expenditure is typically
something spent once and for all, while revenue expenditure is typically something that
recurs annually.

The “fixed or circulating capital” test. Expenses relating to fixed capital, which, once acquired,
generate income by the owner keeping them in possession and use, are treated as being
capital in nature. Expenses relating to circulating capital such as things traded or otherwise
circulated over and over again during the conduct of a business so as to generate profit for
the business owner are treated as being revenue in nature.

The “profit-yielding structure” test. That distinguishes between (i) expenditure to set up,
replace or enlarge a business structure or organisation for the purpose of generating profit
and (ii) regular expenditure to maintain an income-generating process of a business.
The former expenditure is likely to be capital in nature; the latter revenue.

Final Examination (December 2019 Session) – Paper I 14 of 16

These tests are, however, only indicative and not necessarily conclusive. In many borderline
cases, the characterisation of an item will ultimately depend on the sum total of the relevant
features and the application of each of the above tests to the same.

(i) Compensation paid to Gigi Cheung

The compensation paid to Gigi was made as a result of MPHK’s breach of its pledge to
respect the privacy of its customers. The claim made by Gigi was closely connected to
MPHK’s business of providing photography services. As such, the compensation was
incurred in the production of assessable profits and deductible under s.16(1).

The case The Herald and Weekly Times Ltd v The Federal Commissioner of Taxation (1932)
48 CLR 113 supports the above observation. The taxpayer in this case was the proprietor
and publisher of an evening newspaper. In deciding that the compensation payment for
damages in respect of defamatory matter published in that paper was allowable,
the Australian court considered that the liability to damages was incurred in the production
of assessable profits because of the very act of publishing the newspaper.

The compensation did not create any assets or enduring benefits to MPHK. While it had the
effect of safeguarding the goodwill of MPHK, not all such payments can be said to be of a
capital nature, e.g., payments for advertisements, which enhances goodwill, is a revenue
expenditure allowable for tax deduction (see CIR v Swire Pacific Limited [1979] 1 HKTC
1145). Therefore, the compensation paid to Gigi was not a capital expenditure disallowed
under s.17(1)(c).

The compensation was made as a result of MPHK’s breach of its pledge to respect the
privacy of its customers. It was not a fine or penalty that is not tax deductible.

(ii) Restrictive covenant paid to Gary Lau

It was held in the case Associated Portland Cement Manufacturers Ltd v Kerr (1945) 27 TC
103 that payments made to retiring directors for agreeing not to compete with the company
had the effect of enhancing the taxpayer’s goodwill by buying off competition. Thus, the
payments were considered as capital expenditure.

In the present case, Gary Lau would become a potential competitor of MPHK and the goodwill
of MPHK would become vulnerable after he left MPHK. The risk of competition was great.
The payment made by MPHK to secure a covenant from Gary Lau not to compete after he
has left for a long time-span of five years gives rise to an enduring benefit lasting longer than
normal revenue expenditure. The payments were referable to the income earning structure
of MPHK, rather than to its income earning process. As such, the payment would be
regarded as a capital expenditure and not deductible for profits tax purposes.

Final Examination (December 2019 Session) – Paper I 15 of 16

Answer 10

S.14 provides that only profits arising in or derived from Hong Kong is chargeable to profits
tax. The IRD’s position as regards the tax treatment of electronic commerce is detailed in
DIPN 39.

The IRD further states that DIPN 21 is equally applicable in deciding the locality of profits in
the context of electronic commerce. In general, the proper approach to be taken in
determining the locality of profits is to ascertain what were the taxpayer’s operations that
produced the relevant profits and where those operations took place.

In the context of electronic commerce, the IRD considers that it is generally the location of
the physical business operations, rather than the location of the server alone, that determines
the locality of profits. It states that the server (even an intelligent one) cannot function by
itself; and human control remains important in carrying out the overall business operations.

Under the contemplated expansion plan, apart from having a webserver located in
Singapore, the business activities that give rise to the commission income in question,
such as the verification of photographers, the answering of customers’ enquiries and the day-
to-day maintenance of the webserver and website, will be conducted in Hong Kong.

As such, the IRD would likely reject the claim that the commission income that will be derived
under the contemplated expansion plan in Singapore is offshore sourced and not chargeable
to profits tax.

* * * END OF EXAMINATION PAPER * * *

Final Examination (December 2019 Session) – Paper I 16 of 16