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Decision that interest expenses incurred on loans for purposes of dividend payment deductible

The Hong Kong Court of Final Appeal issued its decision in Zeta Estates Limited v. Commissioner of Inland Revenue on 29 March 2007 and held that interest on shareholder's loans to fund the dividend payments was deductible for profit tax purposes.

(a) Facts. Zeta Estates Limited (ZEL) was a joint venture engaged in the development and trade of real estate in Hong Kong. ZEL declared HKD 400 million worth of dividends in 1998/99, and in order to pay this dividend while retaining its working capital, the dividends declared were converted into interest-bearing shareholder loans. It should be noted that from its date of incorporation until 1994, the shareholders had been providing ZEL interest-free loans. After 1994, ZEL was able to obtain bank loans.

ZEL claimed a deduction on the interest payable on the interest-bearing shareholder loans on the basis that the loans were to finance its working capital and thus, the interest expense was incurred in the production of taxable income. The tax authorities contended that the loans were for the purposes of paying dividends and not for the purposes of producing taxable income, and as such, the interest expense was not deductible.

On appeal to the Board of Review, the tax authorities' view was upheld. On further appeal to the Court of First Instance and the Court of Appeal, the Board of Review's decision was affirmed.

(b) Issue. The issue before the Court of Final Appeal was whether the Board of Review was correct in finding that the interest expenses incurred on the shareholder loans were deductible as expenses incurred in the production of taxable income.

(c) Decision. The Court of Final Appeal held that, in order to determine whether or not the interest expenses were deductible, the underlying purpose of the transactions had to be analysed. As ZEL had accumulated profits of up to HKD 408 million in the financial year ending 1998, it was acceptable that it would seek to return some of the profits to the shareholders, i.e. by declaring a dividend. Furthermore, with regard to ZEL's liquidity, the Court found that it was acceptable for ZEL to raise capital to meet its liability to pay the dividends and simultaneously, preserve it profit-earning capacity. As such, the interest expenses had been incurred in the production of taxable income and therefore, were deductible.

Court rules that commission income from trades carried out in a foreign stock exchange is sourced in Hong Kong

The Hong Kong Court of Final Appeal issued its decision in Kim Eng Securities Ltd. v. Commissioner of Inland Revenue (FACV No. 11 of 2006) on 29 March 2007 and upheld the decision of a lower court that the commission income derived from transactions executed on the Singaporean Stock Exchange is sourced in Hong Kong for tax purposes.

(a) Facts. The Taxpayer (i.e. Kim Heng Securities Ltd.) was a licensed stockbroker in Hong Kong and a group member of a Singapore corporate group listed on the Singapore stock market. The corporate group also had a licensed stockbroker in Singapore, i.e. Kim Eng Securities (Pte) Ltd. (KES Singapore). Under the Singapore Stock Exchange rules, KES Singapore was required to charge customers a minimum commission when carrying out trade orders. However, this minimum commission can be reduced by 50% if it must be shared with a foreign stockbroker who refers customers to the Singaporean stockbroker. The corporate group to which the Taxpayer belonged maintained a system which allowed customers to open an account with the Taxpayer in Hong Kong in order to buy/sell shares on the Singapore Stock Exchange. The Taxpayer would then issues statements to the client proving that it had referred stock transactions to KES Singapore. As a result, KES Singapore shared its commission with the Taxpayer and the Taxpayer in turn passed some of the savings from the reduction in KES Singapore's minimum commission to the customers in Hong Kong. It should be noted that the orders of customers were directly handled by employees of KES Singapore which was empowered to act on behalf of the Taxpayer in respect of receiving payments and operating the Taxpayer's bank account in Singapore.

The Hong Kong tax authorities argued that the interposing of the Taxpayer between the customers and KES Singapore was a crucial part of the structure whereby the corporate group reduced the customer commissions for Singapore transactions. Further, the tax authorities argued that the Taxpayer was properly compensated for its role in Hong Kong and the commission income was earned due to its presence and activities in Hong Kong.

The Taxpayer contended that the commission income derived from the transactions arose outside Hong Kong and, as a result, were not assessable to profits tax in Hong Kong. The Taxpayer's contention was that the transactions were carried out in Singapore by KES Singapore in its capacity as an agent for both the Taxpayer and customers, that KES Singapore's actions should be considered to be the actions of the Taxpayer outside Hong Kong.

(b) Issue. The issue before the Court was whether or not the actions of KES Singapore as an agent of the Taxpayer, could be viewed as the acts of the Taxpayer performed in Singapore, and thus not taxable in Hong Kong.

(c) Decision. The Court, although not providing a clear legal analysis of the facts, held that the Taxpayer could not depend on the agency relation to conclude that the commission income was earned outside Hong Kong. The Court further held that KES Singapore was not the Taxpayer's agent because KES Singapore had acted on customer's instructions, which had not been relayed via the Taxpayer. The parties had prepared the relevant paperwork after the transaction and interposed the Taxpayer in order to avoid the minimum commission requirement.

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