Tax cost, one of the major factors that has an impact on the bottom-line of a company, has attracted more attention from business communities recently. The question of how to reduce tax cost in order to enhance a company's overall competitiveness and profits has become the most pressing issue for many businesses in recent years. Restructuring an organization and its operations may be the best approach for achieving tax optimization for some companies.

Legitimate tax planning may help companies structure their investment holdings, streamline their operations, and design their operational flows to achieve the best tax environment. In general, a good tax planning strategy involves the following procedures:

1. Performing passive-income-generated activities (such as certain types of e-businesses or established trading support) in countries that provide tax benefits or financial subsidies or by setting up companies that enjoy preferential tax treatment.

2. Allocating profits derived from active-income-generated activities to companies that enjoy preferential tax treatment through reasonable and consistently applied transfer pricing methodologies.

3. Applying for tax refunds or entitlements to preferential tax treatments in a timely manner in order to fully utilize all the tax benefits or exemptions, financial subsidies and the like, offered by the relevant countries or granted to specified industries.

4. Arranging the filing of tax returns, making tax payments and applying for tax credits within the time period granted and planning the correct booking of income and expenses in advance.

5. Distributing profits to shareholders in the most tax-efficient manner or by re-investing profits in order to enjoy tax refunds or tax deferral on re-investments.

6. Investing through intermediate holding companies to reduce capital gains tax from the transfer of shares or equity under the preferential provisions granted by relevant tax dispensations or arranging to speed up the timing for executing such transfers.

7. Designing a plan to achieve business objectives, improving modes of operation and reducing costs of operations (including tax costs). Tax savings should not be the sole or dominant purpose of the plan. Moreover, the planned or restructured organization and operation of the business should be supported by proper legal documentation and correct operational flow in order to achieve tax optimization.

Many multinational companies now operate businesses in both Hong Kong and on the Chinese mainland.

Mainland-based companies are engaged in the manufacture of goods for export to Hong Kong while Hong Kong-based companies are mainly responsible for sourcing raw materials from overseas suppliers and selling finished goods to overseas customers as well as performing administrative and general management functions. In these situations, mainland-based companies are subject to corporate income tax on profits generated from their mainland manufacturing activities, while Hong Kong-based companies are subject to Hong Kong profits tax at a rate of 17.5 per cent on their profits from business activities in Hong Kong.

Starting from January 1, 2004, the Value-Added Tax (VAT) refund rates have been reduced for certain types of export goods. Mainland companies exporting goods currently have VAT costs placed on exported goods to which reduced VAT refund rates apply. Tax optimization in such companies can be achieved through the following operational restructuring:

1. Mainland enterprises (including enterprises backed by foreign investment) may reduce their income tax and VAT costs by exporting under the commission-processing arrangements.

2. Hong Kong companies that are party to the commission-processing arrangements may apply for a 50/50 claim for offshore profit with the Inland Revenue Department of Hong Kong (IRD), as long as they have the proper documentation and information available.

3. Offshore businesses involved in trade may be located in jurisdictions that offer preferential tax treatment; furthermore, profits can be allocated among group companies through reasonable and consistently applied transfer pricing methodologies.

4. Transportation costs may be saved under a "factory transfer" arrangement.

Many companies may have undermined the importance of having their offshore companies conduct substantial business operations to justify capturing profits there.

The IRD has closely scrutinized the operations of offshore companies in recent years mainly because it appears that Hong Kong businesses are using offshore companies to avoid their tax obligations. For example, some companies may transfer the profits derived from their Hong Kong operations to offshore companies that conduct no significant business but have been incorporated in regions that are tax havens.

In a nutshell, offshore companies should substantiate their declared profits with accurate data and have well established procedures and an effective tax plan to minimize their operating costs and tax bill and optimize profit.

* Jane Chen is tax partner, Liza Pang, senior tax consultant and Joy Wang, tax associate of Deloitte Touche Tohmatsu

(HK Edition 08/09/2004 page13)