Money Matter

Service companies under scrutiny

Article exclusively contributed by Asia Progress (Tax Division)

Our previous articles have explained steps taken by the Inland Revenue Department (IRD) in investigating the tax affairs of a Hong Kong company run by Mr Chan. Having established whether certain staff working predominantly on the mainland were or were not liable for Hong Kong income tax, the assessor next decided to examine the company's most recent profit and loss statements.

These showed that over the past five years a consultancy fee of HK$1 million had been paid to three different companies. The registered office address for each of them was the same as for Mr Chan's company and the named shareholders were his wife and secretary. To clarify things, the IRD arranged separate meetings with the various parties.

It was found that Mrs Chan was the major shareholder of the three entities and sole signatory for bank accounts. Mr Chan controlled the funding and instructed his secretary what to do as a nominated director. When questioned further, he said that the companies had originally been set up to source fabrics in China. However, the records revealed that Mrs Chan had never travelled to China, the consultancy fee was paid on an annual rather than a monthly basis and, in some years, was treated as an account receivable by Mr Chan's company, though never settled. Furthermore, no formal consultancy agreement had been signed. The Chans had claimed personal expenses against the companies, including salary payments for their domestic servant, and returns filed with the IRD showed a loss.

In view of this, the assessor made it clear that, according to the Departmental Interpretation and Practice Notes (DIPN) 24 and 25, two arrangements involving service companies may be queried by the IRD if they seem designed to reduce overall tax liabilities. Type I cases refer to the setting up of such companies as a way of disguising employer/ employee relationships. Instead of remuneration being paid as a salary to the individual concerned, it is paid as a consultancy fee to a service company that he or an associate controls. Type II cases involve the payment of inflated management fees.

Any payment made to a service company in a Type I case for the services of a controlling individual is deemed to be salary income and is subject to salaries tax. Therefore, in determining if the companies had a legitimate non-employment arrangement, the assessor told Mr Chan he would consider the following points about the service companies:

1) Whether provision had been made in line with Section 9A(3)(a) of the Inland Revenue Ordinance for key employment benefits such as annual leave, MPF contributions and sick leave, or if any payment was promised in lieu.
2) If any services were performed personally by a particular individual for anyone other than the person who was party to the agreement (i.e. was there any other client?)
3) If the individual performing the services was subject to any supervision of a kind usual in an employment relationship.
4) Whether remuneration was paid or credited and on what basis. For a contractor, payments are generally an agreed sum for specific work. For an employee, payment is usually on a regular basis for time worked or position occupied.
5) If there was a clear termination arrangement between the parties. With an independent contractor, the contract will be discharged by completion. With an employee, termination will be by providing the relevant notice.
6) If the individual was known to be an officer or employee of the person paying remuneration. This could be through having a relevant name card, being listed in company publications etc.

After careful review, the assessor decided the case fell under a Type II arrangement because he felt inflated consultancy fees were being paid. Under DIPN 24, which aims to prevent taxpayers making such payments to service companies in order to increase their deductibles, the IRD will closely examine the basis of the transaction. Where any such arrangement is entered into, the service company has to function as a separate business operating at arm's length from the company which appoints them. To verify if this was so, Mrs Chan was asked to provide the following documents for the IRD's inspection:

1. The agreement under which the services were provided
2. Minutes of the board meeting at which the service agreement was approved and adopted
3. All invoices and receipts regarding the services rendered
4. Bank transactions relating to the services actually provided
5. Employment contracts for persons employed by the service company.
Two weeks were allowed for the submission of these documents, after which the assessor was to decide on the deductible allowed for the consultancy fees. In the next article we will discuss what was found in the documents and how the investigation unfolded.

Q&A on service companies
Q1 What types of arrangement for service companies may be queried under IRD Departmental Interpretation and Practice Notes 24 and 25?
A1 Type I arrangements refer to possible attempts to disguise employer/employee relationships and typically involve services rendered by a person under employment-like conditions. Type II arrangements concern cases where the IRD has reason to suspect that inflated management or consultancy fees have been paid to the service company as a way of increasing deductibles.

Q2 What guidelines can the IRD assessor use when investigating a Type I case?
A2 The assessor can refer to Section 9A(3) of the Inland Revenue Ordinance and its various subsections which help in determining if companies have a legitimate non-employment arrangement.

Taken from Career Times 10 December 2004

(Last review date: 23 August 2013)

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Disclaimer: The opinions expressed in this article are those of the contributor

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