In this blog we will explore the principles of trading stock in Hong Kong tax law made under Inland Revenue Ordinance and their application on the daily affairs of taxpayer. We will go through the application of IRO on the different type of trading stock exploring the stock’s undervaluation, ongoing work, and contracts for the long term such as, engineering and building contracts, the chargeable profits concerning the long-term and incomplete contracts, property development, and property investment.
Undervaluation of the Stock
The undervaluation of stock has been disclosed by the field audit frequently. The practices of the Inland Revenue Department on the devaluation of stock are:
It is recommended by the HKAS 2 that, ongoing work should incur the direct expenses and a methodological allocation of variable and fixed generation overheads. The Inland Revenue department also accepts as well founded a reevaluation, if adopted consistently, depending only on the direct costs, i.e., cost of wages plus material. The reference for these statements is taken from the departmental interpretation and practice notes 1 (revised) and Duple Motor Bodies.
Contracts for Long Term
If the percentage of completion method in the financial statements is adopted by the taxpayer working for company incorporation Hong Kong, then this method must be chosen for the reasons of tax. Under this procedure, when the result of a contract of construction can be approximated reliably, revenue obtained from contract (including any remuneration retained under the contract) and the costs of contract affiliated with the contract of construction should be acknowledged as revenue and expenditures respectively in concerning with the stage of completion of the activity of contract at the balance sheet data. The method described previously is endorsed by the Hong Kong Accreditation Services 11 Construction contract. The Hong Kong Accreditation Services does not embrace the completion or realization of contract method (COCM) that acknowledges profits only when the contract is fulfilled.
If the POCM has been acquired and eventually the contract turned out to generate a loss, the Inland Revenue Department would refuse to accept a claim of Section 70A of Inland Revenue Ordinance to accurate the evaluation for earlier years. It is considered by the Inland Revenue Department that; the errors or omissions were the mere errors of retribution. The loss can only be set-off or carried forward against gains from other contracts. The only scenarios where Section 70A would be amused is where the contract consists of the pure contract of business that terminated after the contract’s completion.
But, the Inland Revenue department does not believe the commendation of Hong Kong Accreditation Services 11 that the approximated overreach of total contract costs over total contract revenue for the contract should be acknowledged immediately as an expenditure, i.e., a loss on contract as a complete acknowledged in the account as soon as it is anticipating. The Inland Revenue Department would only consider that part of the expected overall loss, computed either to expenses experienced or by reference to time (ordinarily up to the due accomplished date under the contract’s term), may be allowed for year-by-year during the residue of the period of contract. This is in this way as long as all contracts, gain able or otherwise are approached in the same way.
In the case D 19/07 it was observed that, a business of professional management was carried on by T, the installation and design in the fields of structural, mechanical, architectural, electrical contracting and engineering were done in this company who setting up a business in Hong Kong, for its new branch, T acknowledged the profits from deficient contracts on the foundation of the POCM concerning with the generally accepted practice of accounting. It was contended by the T that, for the reasons of taxation they were qualified to choose between completion of contract method and the percentage of completion method, and accented that they depended very heavily upon the 1976 departmental interpretation and practice notes 1 (Note: the departmental interpretation and practice notes was revised in July 2006). The appeal of T was dismissed by the Board of Review and he held that:
For a trade and start up company Hong Kong, the purpose of developing property for sale, given that the contracts of sale may have been dropped into and part payment obtained before the accomplishment of the development, it is general practice to take the gain on sale as arising when the agreement is competent of accomplishment by performance and the possession can be given to purchaser. The sale is considered as being taken place when the allowance of occupation is issued by the building authority in respect of the relevant unit.
For the property originated for long-term holding in the form of capital asset, all the overheads, including the expenditures of administration, attributable correctly to the accession of site and the establishment of the property, are capitalized properly. These will incur the expenditures of finance up to the date when the belongings are capable of being utilized in the generation of profits. This will most probably be the date of the permitted occupation or the date from which rent if receivable first. The interest is a revenue charge correctly, after that date.
Valuation of Stock on Termination under Section 15C of Inland Revenue Ordinance
Upon the termination of business, where the stock of trading is sold to a person who will utilize the stock in a business achieved in Hong Kong and will assert the purchase cost as a withdrawable expenditure, the sale in actual proceeds shall be used in the calculation of tax.
In the situation other than that, the free enterprise value of the stock at the termination date would be taken as its value for reasons of tax. In the case of Southtime Ltd it was observed that, the units in Kwai Chung Plaza was accessed by the taxpayer rendering services for company incorporation Hong Kong, some of these for the purpose of resale as stock of trading and the rest as properties of investment for the purposes of rental income. Subsequently, the taxpayer determined to transfer the untold stock of trading to fixed assets. It was detained that; two business was carried on by the taxpayer --- trading in properties and belonging properties for the investment of long-term, and that the ‘trading in properties’ had terminated. The trading stock that remained unsold was transferred to fixed assets was to be evaluated on an open market value foundation at the date of termination.
Case Study: Sharkey
Whether a trader has lived it up of his stock for his own utilization, consumption or enjoyment instead of being vended, that stock’s market value at the time of such arrangement is served as a receipt in his account of trading for the reasons of tax. The reference for this statement is taken from the case of Sharkey.
The case of Sharkey principle was extended in the case of Petrotim Securities Ltd. where investments were sold by a share-dealing company that was providing Hong Kong company setup service, these investments were its trading stock to its primary company, below the value of market. It was considered that the value in market should be exchanged for the agreed sale price. The decision of Petrotim Securities is applied by the Inland Revenue Department in order to extend the Sharkey principles to cases where the stock is inclined other than in ordinary route of trade. Due to the reason, it is feasible to apply this rule to the cases where sale was made by a trader at a very low price to a member of his family or a transaction of trading between affiliated companies not at discount.
Sharkey and Services
The key point to note here is that, the decision in the case of Sharkey was worried with the disposal or transfer of trading stock. An effort made by the United Kingdom Revenue to apply an author’s principle of copyright failed. In the case of Mason it was observed that, rights in a novel was given by the author to his father. The Inland Revenue Department sought to bring the vend value of the rights at time of gifts into gains for the reasons of tax, but was not successful. The case of Sharkey principle cannot be overreached to the services. An electrician fixing own electric appliance may not be evaluate able to tax on the vend value of the services rendered to himself.
Application to the Hong Kong
The applicability of the principle of Sharkey in Hong Kong was questioned in two cases of Board of Review. These cases were D 41 / 91 and D 47 / 91 respectively. It was considered by the Board of Review that, CIR had no power to ignore the actual price of sale unless the Section 61 was instanced. Section 14 did not charge estimated profit, but the actual profit obtained by Hong Kong company setup service.
It was pointed out by the Board of Review in case of Chinachem Investment Co Ltd that, great care should be exercised while applying the principle that should not be overreached. The reference for these statements is taken from the case D 26 / 84.
In the case of Quitsubdue it was observed that, old buildings were accessed by the Q Ltd. and developed the commercial building for the reasons of rental income. During this route of development and after that, the shares were sold by the actual shareholders of Q Ltd. to a second group of shareholders that as a result sold their shares to another group of shareholders. It was found by the Court of First Instance that; real properties were not a stock for trading. It would not be right to correspond the intention of shareholder for shareholdings with intention of Q Ltd for the actual properties. The reference for this statement is taken from the case of Beautiland Co Ltd. It was the opinion of judge that, principle of Sharkey did not apply to the Hong Kong.
It was considered by the court of first instance in case of the Nice Cheer Investment Ltd. that, case of UK Sharkey was resolved on the foundation of a very different tax arrangement and it was not applicable to Hong Kong and should terminate to be estimated as authority for the proposition that a man can commerce with himself.