HK Profits Tax - Change of intention, Revenue vs Captial in nature

Captial asset to trading stock:
When a company reclassifies the fixed asset to current asset in the balance sheet, it is a change of intention on the use of the asset;

At the date of change of intention, the fixed asset is no more captial asset, but a trading stock, and the market value of the asset would be at the date of change of intention;

The business is deemed to have sold a capital asset and purchases a trading stock on the date of change of intention;

The asssible profit on the sale of the asset is the excess of the sales proceed of the trading stock over the market value on the date of change of intention;


Trading stock to capital asset:
The business is deemed to have sold that particular trading stock and purchase a capital asset on the date of change of intention, although there has not been any receipt of sales proceed;

The taxable amount is the excess of the market value on the date of change of intention over its historical cost according to the rule of Sharkey v. Wernher;

HK Profits Tax - Consititute to a "Trade"

Six badgets of trade:
- Subject matter of realization;
- Length of ownership;
- Frequency of simiar transactions;
- Supplementary work done on the asset disposed;
- Circumstance leading to the sale;
- Profit-seeking motive;
None of the above factors is by itself conclusive, all the relevant factors have to be considered.

Methoid of acquisition of the asset is important to IRD to determine the existence of a trade;

If the asset is not acquired through purchase, but an involuntary acquisition such as inheritance from family member, it's like that the profit made from such transction is exempt from profit tax.

HK Profits Tax - Source of trading profits

DIPN 21 applies to determine the source of profit;

Contract effected test applies to determine the source of trading profit;

Both purchase and sales contracts effected outside Hong Kong would be exempted from Hong Kong Profits Tax;

There is no apportionment exemptions under contract effected test of DIPN 21. Either purchase or sales contract effected in Hong Kong, the profit arising from that that trade is fully taxable in Profits Tax;

"Effected" is interpreted as not just executing or signing a contract, it includes the process of negotiation to conclude the contract. Any activity occured in Hong Kong to conclude the contract is regarded as partly effected in Hong Kong. Thus, the profit from that trade transaction is fully taxable in Hong Kong.

HK Profits Tax - Source of manufacturing profit

DIPN 21 applies to determine the source of profit;

Hang Seng Bank case: the Lordship said that the source of gross profit resulting from a transaction is a question of fact depending on the nature of the transaction, It is impossible to lay down precise rules of law by which the answer to the questof source of profit is to be determined. The Broad Guiding Principle is that "one looks to see what the taxpayer has done to earn the profit in question".

DIPN 21 - Contract operation test applies to manufacturing business;

DIPN 21 - Source manufacturing profit is divided into four types
- Wholly manufactured in HK: Taxable in HK;
- Contract processing: substantial involvement, including technical know-how, material etc, 50% exempt or fully taxable;
- Subcontracting process: A subsidiary (separate legal entity) carries out processing works. Little involvement from the HK entity who only delivery raw material to the subsidiary with a subcontracting fee. It's treated as trading transaction. Thus, governed by contract effected test, 100% taxable or exempt;
- Import processing: Sell raw material to PRC entity, buy-back finished goods when completed. Treated as trading transaction. Thus, governed by contract effected test. 100% taxable or exempt;

Takeover & Underleveraged Firm

Underleveraged Firm:

"Describing a company with too little debt. "

http://financial-dictionary.thefreedictionary.com/Underleveraged

"Of, relating to, or being a firm that has insufficient debt in its capital structure. Because bond interest is deductible for tax purposes and is generally fixed in amount for a long period of time, some use of debt can often result in a larger return on the owners' investment. Whether a company is underleveraged is usually a matter of opinion. "

http://business.yourdictionary.com/underleveraged

Financial Leverage:

Before discussing about "underleveraged", I have to familiar with what's financial leverage:

1. Financial leverage ratios measure the funds supplied by owners (equity) as compared with the financing provided by the firm‘s creditors (debt).
- i.e. Equity vs. Debt = Financial Leverage Ratios

2. Financial leverage is the use of debt to magnify return on equity (ROE) to shareholders.
3. Equity, or owner-supplied funds, provide a margin of safety for creditors. Thus, the less equity, the more the risks of the enterprise to the creditors.

4. To understand financial leverage, I need to understand ratios between Debt to Total Assets and Debt to Equity

Debt Ratio - Debt to Total Assets: Indicates the level of reliance of debt to finance its assets. To determine whether the ratio indicating of its good performance, we have to compare to the industrial average and the historical trend of the company. If the debt ratio is closing to the average, the performance of the company is improving, otherwise is worsening.

Debt to Equity Ratio - Total Debt to Total Equity: Indicates the level of financial leverage. It compares the amount of money borrowed from creditors to the amount of shareholder’s investment made within a firm.


Illustration of overleveraged and underleveraged:


Overleveraged:
- The problem of overleverage occurs when a firm has overborrowed debt from a bank (or other sources) on a consistent basis;
- As a result, firm has a higher Debt to Equity Ratio;
- Using debt to run a firm is a common practice, however, sometimes there is an over-reliance on debt;
- Over-reliance on debt can be a factor in hurting the company’s bottom line;


Underleveraged:
- The problem of underleverage arises when a firm has raised majority of its capital through stocks;
-As a result, firm has a very low Debt to Equity Ratio;
-With higher equity the firm has to improve its performance to keep the shareholders happy;
-If firm pays dividends, it has to constantly allocate a portion of its profits towards dividends payable to shareholders;

World Digital Library

I found this one brilliant!
http://www.wdl.org/en/

Enjoy!

What is business risk?

"Business risks include concerns about the probable effects of an uncertain event on achieving established business objectives. The nature of these risks may be financial, regulatory or operational, and may also include risks derived from specific technology. "

[CISA Review Manual 2008 - The IS Audit Process]