Case 4
CS Limited (“CSL”) is a company incorporated in Hong Kong which owns and operates several jewellery stores located in major shopping centres. CSL specialises in fashion jewellery which are custom-designed in Hong Kong, produced in Shenzhen, and sold in retail stores in Hong Kong.
Customers would select the design of the jewellery when they visit the retail stores in Hong Kong. Designers in Hong Kong would produce a computer image of the design for the approval from customers. The image and the specifications are then sent to sub-contractors in Shenzhen for production.
Dow Ltd (“DL”) is one of the sub-contractors in Shenzhen. Although there is no formal agreement with DL, CSL will send staff from Hong Kong to train DL’s staff in Shenzhen. CSL would provide the technical know-how for the production of the custom-designed jewellery. DL would purchase half of the raw materials from local suppliers and half from CSL, and sell all its products back to CSL after production.
As the production process requires the use of a patented technology owned by CSL, a fee is deducted each month from the processing fee charged by DL. During the year ended 31 December 2011, DL earned a processing fee of RMB800,000.
DL receives many orders from other customers, as such, the quality of the products has been poor and the goods are usually not produced and delivered on time.
In order to control the production process, CSL is now in talks with authorities in overseas countries on whether it can setup and operate its own workshops in those countries.
During the year, CSL entered into a joint venture agreement with LF Limited (“LFL”), a PRC corporation, to open new fashion jewellery stores in the Mainland China. Under the agreement, LFL, which own several shopping centres in Shenzhen, will renovate and provide ten shop spaces at a competitive market rent with the first 3 months rent free. CSL will launch a marketing campaign in Hong Kong to solicit potential investors to sign franchise agreements with the CSL-LFL joint venture in order to open fashion jewellery stores in their shopping centres in Shenzhen.
CSL and LFL have agreed the target price for the franchise agreements. If CSL sells all 10 franchises above the target price, CSL will be entitled to receive all the excess amount above the target price as a bonus. However, if all 10 franchises are not sold or at below the target price, any losses will be borne by CSL.
Other than the above-said activities, LFL is also a leading business consultancy company, and its headquarter is located in Shenzhen. Many of its customers are based in Hong Kong. It does not have an office in Hong Kong. But for the purposes of performing its services in its customer’s office, it sends its employees to Hong Kong on a regular basis. The employees’ visits are typically for only a few days but, in the case of a major consulting project, it is possible that many employees will travel to Hong Kong over an extended period of some months in order to complete the project. LFL is subject to PRC enterprise income tax on its profits, at the rate of 25%.
Required:
(a)Advise CSL on whether it would be able to claim 50:50 apportionment of profits in respect of the processing arrangement with DL.
(b)Comment on whether your answer would be different if CSL was able to setup and operate its own workshops in overseas.
(c)Advise CSL on whether the income it would receive under the CSL-LFL joint venture is chargeable to tax in Hong Kong.
(d)LFL is interested in the patented technology developed by CSL and have offered to purchase the patent from CSL at a highly attractive price in order to develop it further for use in the Mainland China market. LFL will in turn charge CSL a royalty fee for future use of the patented technology.
Required:
(i)Advise CSL on the Hong Kong Profits Tax implication to CSL for selling the patented technology to LFL.
(ii)Advise CSL on whether the proposed royalty fee to be paid by CSL to LFL is deductible under Hong Kong Profits Tax in current situation and proposed workshops operate in overseas countries.
(e)Explain whether or not LFL will have any exposure to Hong Kong profits tax as a result of its consultancy business activities.
(f)Assuming that LFL has a “permanent establishment” in Hong Kong and is therefore subject to Hong Kong tax, describe the legal mechanisms that exist to ensure that LFL will not be subjected to double taxation of its profits in both Hong Kong and the Mainland China.
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