Technical Articles Updated One

8/3/2019 Technical Articles Updated One

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how to pass

Accss ACCAs How o passwbs or a rag o suppor ohp wh your suds

teCHniCAl

technical archive on the acca website

Accss h chca arc archv a www2.accagoba.com/suds/sud_accoua/archv/

foundations in accountancyFor mor ormao vs www2.accagoba.com/fa

28 coMpletinG the audit

Rva o ACCA QuafcaoPapr P7

throuGhput accountinG

and the theory of

constraints

Rva o ACCA QuafcaoPapr F5

honG KonG taX issues

arisinG froM outboundinvestMents by honG

KonG resident taXpayers

Rva o ACCA QuafcaoPaprs F6 (HKG) ad P6 (HKG)

taXation of

unincorporated

business

Rva o ACCAQuafcao PaprP6 (UK)

revenue audit

Rva o ACCAQuafcao Papr P6(iRl)


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completing the auditRelevant to acca qualiicationpapeR p7The completion stage of an audit isvital because it is when the auditorreviews the evidence obtained duringthe audit, together with the final versionof the financial statements, to form theauditors opinion.

In this article, Paper P7 examinerLisa Weaver explores some of thekey requirements of InternationalStandards on Auditing (ISA) that arerelevant at the completion stage, anddiscusses the practical implications ofthose requirements.

access ResouRces Relevantto acca qualiication papeR p7www2.accaglobal.com/students/acca/exams/p7/

throughput accountingand the theory ofconstraintsRelevant to acca qualiicationpapeR 5In the first of two articles, Paper F5examiner Ann Irons introduces someof the basic principles of the theory ofconstraints and throughput accounting

within the context of The Goal, anovel set in a fictional manufacturingcompany facing imminent closureunless it transforms itself fromlossmaking to profitable operationwithin three months.

access ResouRces Relevantto acca qualiication papeR 5www2.accaglobal.com/students/acca/exams/f5/

hong Kong tax issues arising

from outbound investmentsby hong Kong residenttaxpayersRelevant to acca qualiicationpapeRs 6 (HKG) and p6 (HKG)This article addresses the main issuesrelating to outbound investmentsmade by a Hong Kong residenttaxpayer namely source of profits,permanent establishment andtransfer pricing.

access ResouRces Relevantto acca qualiication papeR 6

www2.accaglobal.com/students/acca/exams/f6/


19 octobeR 2011 Relevant to acca and oundations inaccountancy students

technical articles

28 tecHnical

taxation of unincorporatedbusinessRelevant to acca qualiicationpapeR p6 (uK)Rory Fish, Paper P6 examiner, looks atthe taxation of unincorporated business

a regularly examined subject.The article focuses on issues

relating to a new business, including

the choice of business vehicleand the first years of trading. It isrelevant to the Finance Act 2010 andstudents sitting Paper P6 (UK) inDecember 2011.


revenue auditRelevant to acca qualiication

papeR p6 (iRl)This article is based on the RevenueAudit Code of Practice 2010, which iseffective from 1 October 2010 and isrelevant for students sitting Paper P6(IRL) from June 2012 onwards.

It is intended to clarify the levelof knowledge required by Paper P6(IRL) candidates to be able to identifytax issues from a given scenario,assess the likely implications of anytax defaults being identified under aRevenue audit, advise clients of theconduct of an audit and their options

in terms of disclosure and settlementwith Revenue.

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papeR p2www2.accaglobal.com/students/acca/exams/p2/technical_articles/


papeR p4

www2.accaglobal.com/students/acca/exams/p4/technical_articles/




student accountantessential guideYour Student AccountantEssential Guidecontains a range of useful articles,advice and technical content to helpyou prepare for the December exams.You can also access it online at www2.accaglobal.com/SA

changes to the catand Knowledgemodule examswith the launchof accas diploma

in accountingand businessR mr www2.g.m//_/rh/2011/120/3449163

foundations

in accountancylr mr acca r-f a www2.g.m/f

summary ofchanges to theacca qualificationfor all 2012study guides

R mr www2.g.m//_/rh/2011/124/3471830

foundations

in accountancy

lr mr acca r-f a www2.g.m/f

acca qualificationtechnical articles

papeR 1www2.accaglobal.com/students/acca/exams/f1/technical_articles/

papeR 2www2.accaglobal.com/students/acca/

exams/f2/technical_articles/







papeR 9www2.accaglobal.com/students/acca/

exams/f9/technical_articles/


29student accountant issue 21/2011
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RELEVANT TO ACCA QUALIFICATION PAPER P7 AND

PERFORMANCE OBJECTIVES 17 AND 18

2011 ACCA

Completing the audit

The completion stage of the audit is of crucial importance. It is during thecompletion stage that the auditor reviews the evidence obtained during theaudit together with the final version of the financial statements with theobjective of forming the auditors opinion. This article explores some of the keyrequirements of International Standards on Auditing (ISA) that are relevant atthe completion stage, and discusses the practical implications of thoserequirements.

Review of audit files and evaluation of misstatements

All audit work should be subject to review. This is a basic quality controlrequirement of ISA 220, Quality Control for an Audit of Financial Statements, andserves to ensure that sufficient appropriate audit evidence has been obtainedin respect of transactions and balances included in the financial statements.

From an exam point of view, candidates who have reviewed past Paper P7exams will be familiar with exam requirements that ask candidates thematters to consider and the evidence they expect to find when conducting anaudit file review in relation to various matters, and such a requirement isclearly set in the completion stage of an audit.

In performing a file review, the reviewer should consider the sufficiency ofevidence obtained and may need to propose further audit procedures ifevidence is found to be insufficient or contradictory. ISA 230, AuditDocumentation requires that documentation of the review process includes whoreviewed the audit work completed and the date and extent of such review.

ISA 450, Evaluation of Misstatements Identified during the Audit is relevant duringan audit file review. The objective of the auditor when following therequirements of this ISA are to evaluate both the effect of identified

misstatements on the audit, and the effect of uncorrected misstatements, ifany, on the financial statements.

ISA 450 requires that all misstatements identified (other than those that areclearly trivial) shall be accumulated during the audit. The auditor may need toperform further audit procedures in response to an identified misstatement for example, to determine whether further misstatements exist and it isrequired that all misstatements are communicated to management on a timelybasis, along with a request to amend the misstatement identified.

Typically, the auditor will present the client with a list of misstatements (oftenreferred to as the audit error schedule), quantifying the amount of each


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COMPLETING THE AUDIT

OCTOBER 2011

2011 ACCA

misstatement, and proposing the necessary adjustment to the financialstatements. The proposed adjustment may be in the form of a journal entry, an

amendment to the presentation of the financial statements, or a correction to adisclosure note. When management makes the necessary adjustments to thefinancial statements, the auditor should confirm that the adjustments havebeen made correctly.

When misstatements remain uncorrected by management, the auditor isrequired to reassess the level of materiality to confirm that it remainsappropriate, and should then determine if the uncorrected misstatements arematerial individually or in aggregate. The uncorrected misstatements must becommunicated to those charged with governance, and the potential

implications for the auditors report must also be communicated. The auditormust also obtain an understanding of managements reasons for not makingthe necessary corrections to the financial statements.

ISA 450 also requires that the auditor must request that management providesa written representation as to whether management believes the effects ofuncorrected misstatements are immaterial, both individually and in aggregate,to the financial statements taken as a whole. A summary of uncorrectedmisstatements should also be included within, or attached to, the writtenrepresentation.

Final analytical proceduresDuring the completion stage of the audit, the client should prepare the finalversion of the financial statements, which, as discussed above, shouldincorporate any adjustments of misstatements proposed by the auditor. Thefinancial statements should be reviewed according to the requirements of ISA520, Analytical Procedures. One of the objectives of the auditor in complyingwith ISA 520 is to design and perform analytical procedures near the end ofthe audit that assist in forming an overall conclusion as to whether thefinancial statements are consistent with the auditors understanding of theentity.

The analytical procedures performed at this stage of the audit are not differentto those performed at the planning stage the auditor will perform ratioanalysis, comparisons with prior period financial statements and othertechniques to confirm that trends are as expected, and to highlight unusualtransactions and balances that may indicate a risk of misstatement. The keyissue is that, near the end of the audit, the auditor should have sufficient auditevidence to explain the issues highlighted by analytical procedures, and shouldtherefore be able to conclude as to the overall reasonableness of the financialstatements.


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2011 ACCA

When the analytical procedures performed near the end of the audit revealfurther previously unrecognised risk of material misstatement, the auditor is

required to revise the previously assessed risk of material misstatement andmodify the planned audit procedures accordingly. This means potentiallyperforming further audit procedures in relation to matters that are identified ashigh risk.

As well as reviewing the main elements of the financial statements, the auditormust at this stage carefully review the notes to the financial statements forcompleteness and compliance with the applicable financial reportingframework. In many situations, this will be the first opportunity for the auditorto review this information, as clients often prepare the notes to the financial

statements towards the end of the audit process.

At this stage, the auditor should also read the other information to be issuedwith the financial statements for consistency with the financial statements.This is important as inconsistencies may have implications for the auditorsreport. Specific items of other information are subject to specific regulation insome jurisdictions for example, in the UK and Ireland the auditors reportmust state whether the Directors Report is consistent with the financialstatements.

Subsequent events and going concern proceduresThere are two ISAs that are particularly relevant near the end of the audit. Thefirst is ISA 560, Subsequent Events, which requires the auditor to perform auditprocedures to obtain sufficient appropriate audit evidence that all eventsoccurring between the date of the financial statements and the auditors reportthat require adjustment of, or disclosure in, the financial statements have beenidentified.

Typically, the auditor will follow a specific work programme dealing withsubsequent events, including procedures such as reviewing internal accountingrecords and minutes of management meetings since the year-end and

discussing subsequent events with management particularly the extent towhich management has established procedures adequate to identify relevantsubsequent events. It is important that procedures dealing with subsequentevents are performed up to the date of the auditors report. If they areperformed too early and not updated close to the date of the auditors report,then a significant event may not be identified by the auditor.

Secondly, ISA 570, Going Concern states that the auditor shall remain alertthroughout the audit for audit evidence of events or conditions that may castdoubt on the entitys ability to continue as a going concern. Therefore, the

auditor will conclude on going concern matters near the end of the audit


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OCTOBER 2011

2011 ACCA

having reviewed all evidence obtained and after reviewing the final version ofthe financial statements.

Going concern is the subject of an examiners article published in February2010.

Written representations and communication with those chargedwith governanceTowards the end of the audit, the auditor must consider the matters to beincluded in managements written representation, according to ISA 580,Written Representations. This is a matter to be dealt with towards the conclusionof the audit because it is a requirement of ISA 580 that the date of the written

representation shall be as near as possible to, but not after, the date of theauditors report. Written representations are necessary audit evidence, andtherefore the auditors opinion cannot be expressed and the auditors reportcannot be dated before the date of the written representations. Significantsubsequent events may come to light very late in the audit, and therefore thewritten representations should cover all of the subsequent events period, rightup to the date at which the audit report is dated.

Important outputs of the audit are the matters to be communicated inaccordance with ISA 260, Communication with Those Charged with Governance.The matters to be communicated include significant findings from the auditand matters relating to auditors independence. In addition, the auditor mustalso consider whether the two-way communication between the auditor andthose charged with governance has been adequate for an effective audit, andhave taken appropriate action if not.

Communication with those charged with governance is the subject of anexaminers article published in April 2008.

Audit clearance meetingAt the conclusion of the audit, a meeting will usually be held between the

auditor and management and/or those charged with governance of the client.At this clearance meeting the auditor will explain the various matters that havebeen discussed in this article, and any other matters to be discussed inrespect of the financial statements and the audit. Typically, at the clearancemeeting the following matters may be discussed:

The adequacy of the entitys internal controls and process of preparingthe financial statements,

any proposed adjustments to the financial statements any difficulties encountered during the audit process the details of ethical matters that may need to be clarified with the client
http://www2.accaglobal.com/students/student_accountant/archive/2008/85/3086503http://www2.accaglobal.com/students/student_accountant/archive/2010/104/3298824http://www2.accaglobal.com/students/student_accountant/archive/2010/104/3298824


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2011 ACCA

confirmation of the matters to be included in managements writtenrepresentations

an update on changes in financial reporting or other regulations thatmay impact the clients financial statements, and confirmation that the clients accounting policies are appropriate.

The audit clearance meeting is not a requirement of ISAs, but is often used asa means to ensure that there are no misunderstandings regarding the financialstatements, the auditors report and any of the other matters discussed.

ConclusionThe completion stage of the audit must be carefully planned to ensure that the

requirements of the many relevant ISAs are adhered to. If the completion stageis not adequately performed, there is a risk that an inappropriate opinion isgiven on the financial statements.

Lisa Weaver is examiner for Paper P7


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RELEVANT TO ACCA QUALIFICATION PAPER F5 AND

PERFORMANCE OBJECTIVES 12, 13 AND 14

2011 ACCA

Throughput accounting and the theory of constraints

Ive just finished reading a book. It was the type of book that you pick up andyou cannot put down (other than to perform the mandatory tasks that runninga house and looking after a family entail!) Even the much-awaited new series ofone of my favourite television programmes couldnt tempt me away from mybook.

Now obviously Im telling you this for a reason. I love reading and its notunusual to find me glued to a book for several days, if its a good one. Butyouve gathered by now that the book Ive been reading was not the usual Man

Booker or Orange prize fiction novel that you might ordinarily find tucked awayin my handbag. It was in fact The Goal: A Process of Ongoing Improvementby EliGoldratt and Jeff Cox. If by now youve settled quickly into the belief that Imust conform to societys expectations of your typical number crunchingaccountant of which by the way Ive met few in reality, you are wrong. Sowhat then, you may ask, makes this book so different from the image that thetitle conjures up? Let me tell you all about it.

The Goal, originally published back in 1984, presents the theory of constraintsand throughput accounting within the context of a novel. It tells the story of

Alex Rogo, a plant manager at a fictional manufacturing company calledUniCo, which is facing imminent closure unless Alex can turn the loss-makingplant into a profitable one within three months. In his attempt to do so, Alex isforced to question the whole belief in the US at the time that success inmanufacturing is represented by a 100% efficient factory (ie everyone andevery machine is busy 100% of the time), which keeps cost per unit as low aspossible.

To be honest, before I read the book, I wasnt really convinced aboutthroughput accounting although the theory of constraints has always made

perfect sense to me. But, having read about both in the context of a verybelievable plant that was representative of many at the time, my views havechanged. Its easy to stand in a classroom and lecture about throughputaccounting and criticise it for being nothing new, but what we have toremember is, back in 1984, this was new, and for those companies thatadopted it, it made a huge difference.

Im aware that, if I want you to share my renewed interest in throughputaccounting, I need to tell you more about the story that gripped me. If I dontdo this, youll just go away having read yet another article about throughputaccounting, and any doubts that you have about its relevance today will remain

the same. On the other hand, Im also aware that, when sitting professionalexams, you need to have a working knowledge of throughput accounting that
http://www.amazon.co.uk/Goal-Process-Ongoing-Improvement/dp/0566086654


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THROUGHPUT ACCOUNTING AND THE THEORY OF CONSTRAINTS

OCTOBER 2011

2011 ACCA

you can apply in the exam hall. Consequently, Ive decided that, in this firstarticle, Ill summarise the story contained in The Goal, bringing out some of the

basic principles of the theory of constraints and throughput accounting. Then,in the second article, Ill talk you through a practical approach to questions onthroughput accounting.

The importance of considering an organisations goal

Alex Rogos journey begins with a chance meeting with his old physics teacher,Jonah, at an airport, after attending a conference about robotics. This is justbefore Alex finds out about the threat of closure at the plant. The UniCo factoryhas been using robotic machines for some time now and Alex is proudly tellingJonah about the improvements in efficiency at the factory. Jonah is quick to

question whether these improvements in efficiency have actually led to animprovement in profits. Alex is confused by the way the conversation is going.This confusion is reflective of the US thinking at the time. There is so muchfocus on efficiency and reducing labour costs with increased automation, butwithout consideration of whether either of these things are having any impacton profit. In the case of UniCo and indeed many other real factories at thetime the so-called improvements in efficiency are not leading to increasedprofits. In fact, they seem to be leading to losses.

Jonah leads Alex to consider what the goal of UniCo really is. Until this point,he like his superiors at Head Office has just assumed that if the factory isproducing increasingly more parts at a lower unit cost, it is increasinglyefficient and therefore must be doing well. All the performance criteria that thebusiness is using support this view; all Alexs bosses are concerned aboutseems to be cost efficiencies.

After some reflection, Alex realises that the overriding goal of an organisationis to make money. Just because a factory is making more parts does not meanto say that it is making more money. In fact, UniCo shows that just theopposite is happening. The plant has become seemingly more efficient, thanksto the use of the robots, but the fact is that inventory levels are huge and the

plant is constantly failing to meet order deadlines. It is standard practice fororders to be five or six months late. An order at the plant only ever seems to goout when one of the customers loses patience and complains loudly, resultingin the order being expedited ie all other work is put on hold in order to getthe one order out. Customers are becoming increasingly dissatisfied, lossesare growing, and crisis point is reached.

Clearly, the goal that the objective of the plant is to make money needs to bemore clearly defined, in order to generate improvements, and Jonah helps Alexdo this by explaining that it will be achieved by increasing throughput whilst

simultaneously reducing inventory and operational expense. Some definitionsare given at this point:


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2011 ACCA

throughput is the rate at which the system generates money throughsales

inventory is all the money that the system has invested in purchasingthings that it intends to sell operational expense is all the money that the system spends in order to

turn inventory into throughput.

Working out how to achieve the goalHaving worked out what the goal is, Alex is then left with the difficult task ofworking out how that goal can be achieved. The answer begins to present itselfto Alex when he takes his son and some other boys on a 10-mile hike. Giventhat the average boy walks at two miles an hour, Alex expects to reach the

halfway point on the hike after about two and a half hours of walking. Whenthis doesnt happen, and Alex finds that the group is behind schedule and biggaps are appearing between them, he begins to question what is going on. Hesoon realises that the problem is arising because one of the boys is muchslower than the others. This boy is preventing the other boys from going fasterand Alex realises that, if everyone is to stay in one group as they must, thegroup can only go as fast as their slowest walker. The slow walker is effectivelya bottleneck: the factor that prevents the group from going faster. It doesntmatter how fast the quickest walker is; he cannot make up for the fact that theslowest walker is really slow. While the average speed may be two miles perhour, the boys can all only really walk at the speed of the slowest boy.

However, Alex also realises that they can increase the boys speed by sharingout the heavy load he is carrying in his bag, enabling him to walk faster. In thisway, they can elevate the bottleneck ie increase the capacity of the criticalresource. Alex cannot wait to get back and identify where the bottlenecks arehappening in his factory and find out if they can be elevated in any way,without laying out any capital expenditure.

Statistical fluctuations and dependent eventsThe other thing that Alex gains a better understanding of on the hike is the

relationship between dependent events and statistical fluctuations. Jonah hasalready explained to Alex that the belief that a balanced plant is an efficientplant is a flawed belief. In a balanced plant, the capacity of each and everyresource is balanced exactly with the demand from the market. In the 1980s, itwas deemed to be ideal because, at the time, manufacturing managers in theWestern world believed that, if they had spare capacity, they were wastingmoney. Therefore, they tried to trim capacity wherever they could, so that noresource was idle and everybody always had something to work on.However, as Jonah explains, when capacity is trimmed exactly to marketingdemand, throughput goes down and inventory goes up. Since inventory goes

up, the cost of carrying it ie operational expense also goes up. These things


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happen because of the combination of two phenomena: dependent events andstatistical fluctuations.

The fact that one boy walks at three miles an hour and one boy walks at onemile an hour on the hike is evidence of statistical fluctuations. But the actualopportunity for the higher fluctuation of three miles an hour to occur is limitedby the constraint of the one mile per hour walker. The fast boy at the front ofthe group can only keep on walking ahead if the other boys are also with him ie he is dependent on them catching up if he is to reach his three mile per hourspeed. Where there are dependent events, such as this, the opportunity forhigher fluctuations is limited. Alex takes this knowledge back to the factorywith him and sets about rescuing his plant.

Identifying bottlenecksBack at the plant, Alex and his team set out to identify which machines at theplant are the bottleneck resources. After talking to staff and walking around thefactory, where there are big piles of inventory sitting in front of two mainmachines, the bottlenecks become obvious. Eighty per cent of parts have to gothrough these machines, and the team make sure that all such parts areprocessed on the non-bottleneck machines in priority to the other 20% ofparts, by marking them up with a red label. The parts that dont go through thebottlenecks are marked with a green label. The result? Throughput increases.But the problem? Unfortunately, it doesnt increase enough to save the factory.

Elevating bottlenecksThe next step is therefore to try and elevate the capacity of the bottlenecks.This is not easy without spending money, but observation shows that, at times,the bottleneck machines are sometimes still idle, despite the labelling systemgiving priority to the parts that have to be ready to go through the bottleneckmachines. This is partly because workers are taking their breaks before gettingthe machines running again, and partly because they have left the machinesunmanned because they have been called away to work on another(non-bottleneck) machine. Both of these absences result in the machines

becoming idle. At this point, Alex learns an important lesson: an hour lost on abottleneck machine is an hour lost for the entire system. This hour can neverbe recouped. It is pointless to leave a bottleneck machine unmanned in orderto go and load up a non-bottleneck machine because there is spare capacity onthe non-bottleneck machine anyway. It doesnt matter if its not running for abit. But it does matter in the case of the bottleneck. From this point onwards,the two bottlenecks are permanently manned and permanently running. Theircapacity is elevated this way, along with another few changes that areimplemented.


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The need to accept idle timeAt this point, Alex and his team think they have saved the factory, and then

suddenly they find that new bottlenecks seem to be appearing. Parts withgreen labels on are not being completed in sufficient quantities, meaning thatfinal assembly of the companys products is again not taking place, and ordersare being delayed again (because final assembly of products requires bothbottleneck and non-bottleneck parts). Alex calls Jonah in a panic and asks forhelp. Jonah soon identifies the problem. Factory workers are still trying to beas efficient as possible, all of the time. This means that they are getting theirmachines to produce as many parts as possible, irrespective of the number ofparts that can actually be processed by the bottleneck.

Jonah begins to explain, labelling a bottleneck machine as X and anon-bottleneck machine as Y. Some products may not need to go through X, hesays, but that doesnt mean that workers should make as many parts as themachines can produce, just to keep the machines efficiency rate looking good.Y parts should only be produced to the extent that they can be used in theassembly of finished goods, and the production of these is constrained by theirneed for bottleneck parts too. Any excess Y parts will simply go to thewarehouse and be stored as finished goods, ultimately becoming obsolete andhaving to be written off at a substantial cost.

As for those products that do need to go through X, they may, for example, gofrom Y to Y to X to Y (as there are numerous steps involved in the productionprocess). But if the capacity of the first Y machine is far higher than thecapacity of the next Y machine, and it processes excessive X parts, anotherbottleneck may look like it has appeared on the second Y machine because somany red labelled parts are being fed through that it never gets to process thegreen ones, which are also necessary for final assembly. Suddenly Alex realisesthat all machines must work at the pace set by the bottleneck machines, justlike the boys on the hike that had to walk at the pace of the slowest walker.

Consequently, Alex realises that it is really important to let Y machines and

workers sit idle when they have produced to the capacity of the bottleneckmachines. By definition, they have spare capacity. Its not only wasteful toproduce parts that are not needed or cannot be processed; it also clogs up thewhole system and makes it seem as if new bottlenecks are appearing. This ideaof idle time not only being acceptable but also being essential flies in the faceof everything that is believed at the time and, yet, when you understand thetheory of constraints, it makes perfect sense. A balanced factory is not efficientat all; it is very inefficient because different machines and processes havedifferent capacities, and if machines that have spare capacity are working100% of the time, they are producing parts that are not needed. This is

wasteful, not efficient. As evidenced in the novel, inventory goes up and


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throughput goes down. Alex is quick to resolve the problem and get thingsrunning smoothly again.

Throughput and just-in-time

Given that producing excess inventories both pushes costs up and preventsthroughput, it becomes obvious that throughput accounting and just in timeoperate very well together. This becomes clear towards the end of the novelwhen UniCo secures even more orders by reducing its delivery timedramatically. It is able to do this by adopting some of the principles ofjust-in-time.

First, Alex reduces batch sizes substantially. For those unfamiliar with

throughput accounting and just-in-time, it can be hard to get past the idea thatif batch sizes are halved, financial results may still improve. The novicebelieves that if batch sizes are halved, costs must go up, because more ordersare needed, more set ups are needed, more deliveries are needed, and so on...and surely these costs must be high? But the fact is as proved in the novel inventory costs are also halved and, even more importantly, lead time ishalved, which in this case gives UniCo a competitive advantage. Throughputincreases dramatically because of increased sales volumes. These increasedsales volumes also led to a significantly lower operating cost per unit, which,along with the reduced inventory costs, more than makes up for increase in theother costs. Given that there is spare capacity for all of the non-bottleneckmachines anyway, if the number of set ups for these is increased, no realadditional cost arises because there is idle time. As Jonah says: An hour savedon a non-bottleneck resource is a mirage.

ConclusionIt is not possible, within the space of a few pages, to convey everything thatThe Goal has to say. To think that I could do so would be an insult to theauthors of this 273-page novel. Nor is the theory contained within the novelbeyond questioning and criticism; but this article was not meant as a critique.

Hopefully, however, I have told you enough to convince you that this book isworth reading should you have a couple of days to spare sometime. I havent,after all, told you the ending... Also, you should now have an understanding ofthe background to my second article, which you will find in the next issue ofStudent Accountant.Ann Irons is examiner for Paper F5


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RELEVANT TO ACCA QUALIFICATION PAPERS F6 (HKG) AND P6 (HKG) AND


Hong Kong tax issues arising from outbound investments by Hong Kong residenttaxpayersThis article is written from the perspectives of teaching and learning, with an aim to clarifyand consolidate the Hong Kong tax issues arising from outbound investments made byHong Kong resident taxpayers. Where appropriate, reference is made to Question 1 of theJune 2011 Paper P6 (HKG).

Generally speaking, cross-border investments may either be inbound or outbound.Inbound investments or transactions literally refer to non-residents investing in Hong Kongthrough a legal entity (eg a subsidiary) incorporated in Hong Kong or through a permanentestablishment (such as a branch or an agent) created or deemed to have been created inHong Kong.

In other situations, non-residents would earn income from Hong Kong without havingestablished a physical or legal presence here, such as sending goods on consignment salein Hong Kong or licensing intellectual property (eg trademark) for use in Hong Kong inreturn for a royalty. Whether or not, and to what extent these non-residents are subject totax in Hong Kong in respect of the income/profits earned from their investments in HongKong would fundamentally depend on whether such income/profits are considered asarising in or derived from Hong Kong (ie sourced in Hong Kong). Where there is atrade/business carried on in Hong Kong, including a permanent establishment (PE) in HongKong, any Hong Kong sourced income/profits would be caught by the general scope ofprofits tax charge under the domestic tax law, and become taxable.

In other situations where no trade/business (nor PE) is carried on in Hong Kong at all butHong Kong sourced income/receipts are earned, the domestic tax law contains specificprovisions seeking to bring certain designated deemed trading receipts earned bynon-residents into the Hong Kong tax net. Care must be exercised in distinguishing atrade/business carried on IN Hong Kong from that carried on WITH Hong Kong. Only theformer scenario (ie a trade/business is carried on IN Hong Kong) may potentially triggerHong Kong profits tax.

If a non-resident with no presence nor deemed PE in Hong Kong only sells goods to HongKong customers, and these receipts are not designated as deemed trading receipts by

specific provisions, the trade/business would only be regarded as carried on WITH HongKong and no Hong Kong profits tax would normally arise. The topics of carrying onbusiness in Hong Kong and income sourced in Hong Kong involve complicated issues. Itis not the aim of this article to analyse these related tax issues, however, comprehensivereadings can be found in various textbooks and reference materials. Guidance andreference can also be sought from relevant case law and Inland Revenue DepartmentalInterpretation and Practice Notes (DIPN).

Outbound investments, the focus of this article, usually refer to Hong Kong residenttaxpayers making investments directly or indirectly in foreign jurisdictions. By directinvestment, a Hong Kong resident taxpayer engages itself in a business or an activity which

is carried out in a place outside Hong Kong, without setting up a separate entity (eg asubsidiary) or a presence (eg a branch or an office) in that place. A Hong Kong residenttaxpayer will be the party entering into a contract with the customer and contract income


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would be earned by the Hong Kong resident taxpayer directly and booked in the accounts ofthe Hong Kong resident taxpayer (see Diagram A, with reference to Question 1(b) of June2011 Paper P6 (HKG)).

Alternatively, a Hong Kong resident taxpayer may choose to set up an entity or a presence(the so-called offshore intermediary) in the place where the work is required. In mostcases, it would be the offshore intermediary to directly contract with the customer andconduct the business or work as required in that place, not the Hong Kong residenttaxpayer. The contract income ($A) would be earned by the offshore intermediary andbooked in the accounts of the offshore intermediary (see Diagram B, with reference toQuestion 1(a) of June 2011 Paper P6 (HKG)).

Under the structure in Diagram B, it is common to find that the Hong Kong residenttaxpayer would not only play the role of the holding company of the offshore intermediary,but also acts as a supporting hub for the offshore intermediary in order to help it fulfill theobligations under the contract. Examples of supports provided by the Hong Kong residenttaxpayer include provision of services (eg staff support), sale of merchandise (eg rawmaterials or trading stock), provision of tangible asset (eg plant and machinery), provisionof intellectual property (eg patent rights) and provision of financing (eg a loan).

There may be scenarios where a Hong Kong resident taxpayer remains as the contractingparty with an offshore customer but outsources the work to an offshore intermediary. Thiswould generally be a combination of the two scenarios above, ie tax issues on contract

income $A in Diagram A together with tax issues on support income $B in Diagram B.


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The Hong Kong tax implications to all entities involved in Diagrams A and B are different.Care must be exercised to first identify which entity does what to earn what income to betaxed under which tax jurisdiction. Generally speaking, the major tax issues that need to beaddressed for outbound investments include, amongst all, source of profits, PE, transferpricing, overseas tax risk and withholding, treaty protection and double tax relief. Each ofthese topics is in no way straightforward and requires some degrees of study. In theremaining part of this article, only issues on source of profits, PE and transfer pricing willbe discussed.

Source of profits

In Diagram A, the Hong Kong resident taxpayer directly engages itself in the offshorebusiness or activity. This means that the business or contract, if any, would be entered intoin the name of the Hong Kong resident taxpayer. Any risk associated with the business suchas debtor risk and market risk would be for the account of the Hong Kong residenttaxpayer. Any expenditure required for completing the task would be borne by the Hong

Kong resident taxpayer. Accordingly, it would be the Hong Kong resident taxpayer to earnthe contract income (or contract revenue), ie $A. All related revenue and cost would beincluded in the books and accounts of the Hong Kong resident taxpayer.

In ascertaining whether the contract income $A should be chargeable to Hong Kong profitstax, the two-limb requirement under s.14, the profits tax charging section, would need to beassessed. The first limb requires that the Hong Kong resident taxpayer is carrying on atrade or business in Hong Kong. Assuming that the Hong Kong resident taxpayer has itscentral management and control exercised in Hong Kong and thus is considered as carryingon business in Hong Kong, the first limb would have been satisfied. In this context, it isworth noting that the fact that the company may be carrying out the work outside Hong

Kong is only helpful to ascertaining the source of income from that work, but NOT relevantto determining the place where the company is carrying on its business (a common mistakemade by candidates of Paper P6 (HKG)).

The second limb requires that the related income earned by the Hong Kong residenttaxpayer is arising in or derived from Hong Kong, ie sourced in Hong Kong. In this context,various source principles have been derived from case law; and the Inland RevenueDepartment (IRD) has accepted that the broad guiding principle is to look at what thetaxpayer has done to earn the profit in question and where he has done it (see CIR v HangSeng Bank(1990) and CIR vHK-TVB International Ltd(1992)). Different source principlesapply to different nature of income, and each case has to be assessed and determined on

its own merits and facts. Generally speaking, the source of service-type of income woulddepend on the place where the services are provided (the operations test); and the sourceof trading income would depend on the place where the contracts (both sale and purchase)are effected (the contract effected test).

In a situation where the work required involves a combination of income of different nature,such as Question 1(b) of June 2011 Paper P6(HKG), it would be wise to enter into separatecontracts for each distinct work or explicitly allocate the total contract value/income todifferent nature of income accordingly. The IRDs interpretation and practice on source ofprofits can be found in DIPN 21 (revised). In Diagram A, the source of contract income $Awould therefore depend on the nature of contract work required.

In Diagram B, three income streams are involved; contract income $A, support income $Band dividend income $C. Each income stream involves different tax issues. Assuming thatthe offshore intermediary is not carrying on business in Hong Kong and there is no deemed


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PE (discussed below) in Hong Kong, contract income $A earned by the offshoreintermediary would normally be taxed in the jurisdiction in which it is resident, and wouldgenerally not be taxed in Hong Kong. Therefore, from Hong Kong tax perspectives, contractincome $A earned by the offshore intermediary for its work done for the overseas customerwould generally not have any Hong Kong tax implication. That said, it is likely that thecontract income $A would be subject to tax in the offshore jurisdiction, either in the placewhere the offshore intermediary is resident or in the place where the services are provided.As a Hong Kong tax advisor, it would not be unreasonable to exclude offshore tax risks fromthe advice, but it would be a complement, for the best interests of the clients, to raise thepotential risk to offshore tax and the need to seek appropriate offshore tax advice.

As far as the Hong Kong resident taxpayer is concerned, it owns a 100% shareholding inthe offshore intermediary and thus is expecting to receive dividend income $C from theoffshore intermediary if profits are distributed. There would be no Hong Kong taximplication to the Hong Kong resident taxpayer as the dividend income is not taxable in

Hong Kong, on the basis that it is either capital or offshore in nature.

As regards the support income $B which may be earned by the Hong Kong residenttaxpayer in compensation for the support services, taxability of the income again dependson the nature of the income and whether or not the income is sourced in Hong Kong. At thispoint, the various source principles as mentioned above for the Diagram A structure arealso relevant here. For example, income in compensation for the staff support servicesprovided may likely be accepted as offshore-sourced if the place where the staff services areprovided is offshore Hong Kong. However, if income is derived from the sale of merchandisesuch as raw materials or trading stock, the source of income would likely be determined bythe place where the sale and purchase contracts are effected. (In Question 1(a)(i) of June

2011 Paper P6 (HKG), candidates were asked to advise the Hong Kong tax implications forthe Hong Kong resident taxpayer with respect to the profits arising from the contract (iecontract income $A). Unfortunately, most students gave answers on source rules applicableto the income from support services provided to the offshore intermediary.)

Permanent establishment

Permanent establishment is a complicated and difficult topic. Unlike many other countriesthat impose tax on residents and non-residents with different rules, Hong Kong generallyspeaking imposes tax only on Hong Kong-sourced income earned by both residents andnon-residents on similar ground. However, certain provisions are still found in the IROseeking to apply specific rules to residents and/or non-residents.

When a non-resident conducts activities or transactions in Hong Kong without establishing alegal presence (eg a subsidiary) here, it would be necessary to ascertain whether suchactivities or transactions are carried out in some other forms which are substantial enoughto constitute an economic presence (or a PE) in Hong Kong. If so, the non-resident wouldstill be regarded as carrying on business in Hong Kong for the purpose of s.14.

The general criteria for identifying the existence of such a PE are included in the definitionunder Rule 5 of the Inland Revenue Rules. In general, a branch, a management, a place ofbusiness, an agent who has and habitually exercises a general authority to negotiate andconclude contracts on behalf of his principal, or an agent who has a stock of merchandise

from which he regularly fills orders on behalf of his principal may all be regarded as a PE.

The issue of PE may arise from both structures in Diagrams A and B. In Diagram A,depending on the tax jurisdiction of the offshore customer or of the place of services, and


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whether there is a double taxation agreement (DTA) between Hong Kong and the offshorejurisdiction, the HK resident taxpayer may run a risk of establishing a PE in that offshorejurisdiction by reason of sending its staff to work there in an excessively long period orthrough the acts of other persons on its behalf. If a PE is established, the contract income$A or part thereof, would be taxable in that offshore jurisdiction. As this is an offshore taximplication rather than a Hong Kong tax implication, details would not be explained here.

Under the structure in Diagram B, the risk of PE may arise leading to HK tax implication ifthe role played by the Hong Kong resident taxpayer is in substance an agent of theoffshore intermediary. For example, the Hong Kong resident taxpayer purchased goods inHong Kong on behalf of the offshore intermediary or entered into purchase contracts onbehalf of or in the name of the offshore intermediary. In these circumstances, there is a riskthat the offshore intermediary may be regarded as carrying on business in Hong Kongthrough the Hong Kong resident taxpayer as its agent; and Hong Kong profits tax may beimposed on the offshore intermediary in respect of the contract income $A (or part thereof).

Conversely, same as the structure in Diagram A, if the concept of PE also exists in thejurisdiction of the offshore intermediary (or exists in the DTA between Hong Kong and thejurisdiction of the offshore intermediary), the Hong Kong resident taxpayer may also run therisk of being deemed as creating a PE in that jurisdiction through the conduct of theoffshore intermediary or performance of its staff sent from Hong Kong. Detailed mechanicsof how a PE may be established are outside the scope of this article; however, students areexpected to understand its concept and the possible risk and implication.

Transfer pricing

Transfer pricing used to be a mandatory topic more relevant to the study of international

taxation. With the growing volume of cross-border transactions and the increasing roleplayed by DTAs signed between countries, it is now considered unavoidable to incorporatetransfer pricing rules in the context of local tax regimes in most countries. The firstinternationally recognised guideline on transfer pricing was issued in 1979 by theOrganisation for Economic Co-operation and Development (OECD), with ongoing revisedversions published until the latest one in July 2010. Apart from the OECD membercountries (eg Australia, Korea, USA, UK and other European countries, etc) who areencouraged to follow the guidelines, certain non-member countries (eg Singapore andIndia) are also developing their own transfer pricing rules or practices making duereferences to the OECD guidelines.

In Hong Kong (a non-OECD member), there is no comprehensive transfer pricing provisionsin the IRO except for s.20, which is perceived to be specifically enacted to counteractinappropriate transfer pricing transactions but is usually found impractical to apply. As analternative, the IRD would rely on the general provisions such as s.16, s.17, s.61 or s.61Ato seek profit adjustments when need arises. In December 2009, the IRD issued DIPN 46setting out its views and practices on the methodologies of transfer pricing and relatedissues. According to DIPN 46, the above-mentioned general provisions (ie s.16, s.17, s.61and s.61A) remain as the legal basis for transfer pricing adjustment purposes. In terms ofthe approach and direction taken towards assessing transfer pricing transactions, the IRDhas stated clearly that in general, the OECD transfer pricing guidelines would be followedunless they are found incompatible with the IRO. It is worth reminding that DIPN 46 is only

a document of the IRDs views and practices. It is not a document of transfer pricing rules.

The definition of transfer pricing in DIPN 46 is adopted from Article 9 (AssociatedEnterprises Article) of the OECD Model Tax Convention on Income and Capital. Transfer


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pricing is concerned with prices charged between associated enterprises for the transfer ofgoods, services and intangible property. Two enterprises are regarded as associated if oneenterprise participates directly or indirectly in the management, control or capital of theother enterprise, or the same persons participate directly or indirectly in the management,control or capital of both enterprises. No reference is made to the shareholding threshold orresidency; leading to the definition wide enough to cover all kinds of transactions betweenany related parties, irrespective of how they are related and whether they are domesticenterprises in Hong Kong or offshore.

The commonly used yardstick to measure the pricing between associated enterprises isbenchmarking with similar transactions done by independent enterprises. It compares whatan enterprise has transacted with its associated enterprise with what a truly independententerprise would have done in the same or similar circumstances. When the pricetransacted between associated enterprises is comparable to that which would be transactedby independent enterprises dealing with comparable transactions in comparable

circumstances, the pricing is regarded as at arms length. If, however, the pricing betweentwo associated enterprises deviates from the arms length standard, distorted taxconsequences may arise such as taxable revenue might have been under-assessed ordeductible expenditure might have been over-claimed. Tax adjustments may be required inorder to bring the transaction in line with the arms length position. In doing thecomparison between controlled and uncontrolled transactions, three factors are taken intoaccount: functions performed, assets used and risks assumed by the enterprises. Thesefactors are helpful to assess the role played by the relevant enterprises in a value chainanalysis, and to identify the potential independent comparables.

To evaluate an enterprise as to whether and to what extent it has complied with the arms

length principle, certain transfer pricing methodologies have been developed by the OECDand adopted by the IRD in DIPN 46. These are comparable uncontrolled price (CUP), resaleprice, cost plus (these three are collectively known as the traditional methods), profit splitand transactional net margin method (these two are collectively known as the transactionalprofit methods). Although DIPN 46 does not contain recommended methods for specificactivities, the IRD has expressed that where all methods are equally applicable, thetraditional methods are preferred. It is, however, not the intention of this article to describethe detailed mechanics of these methodologies; and students are advised to study DIPN 46and other relevant reading materials.

In scenarios where inappropriate transfer pricing is found, adjustments may be made by

the IRD based on the existing provisions under the IRO. When an expense is found over-claimed, DIPN 46 indicated that s.16(1) is relevant and applicable to restrict the deductionof the expense to the extent to which it is incurred in the production of assessable profits.That is, if a portion of payment made from an enterprise to an associated enterprise isfound to be on a basis other than arms length, that portion would be disallowed on therationale that it was not for the purpose of the taxpayers (the paying enterprise trade butfor the purpose of the recipients (the receivingenterprise) trade. Similar effect would beachieved by applying s.17(1)(b) which prohibits deductions for any expense not expendedfor the purpose of producing assessable profits. In a situation where an expenditure or partthereof is of a capital nature, s.17(1)(c) could be used to deny the deduction accordingly.The IRDs view on the applicability of s.16 and s.17 to adjust non-arms length expenditure

is clearly stated in DIPN 46; but this view seems to be inconsistent with the Court of FinalAppeal (CFA) judgement in Ngai Lik Electronics Co Ltd v CIR (FACV No. 29 of 2008). It washeld in that case that s.16(1) and s.17(1)(b) were not applicable to disallow the purchaseprices paid by the taxpayer even if they were considered excessive . As DIPN 46 was issued


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after the CFA decision in Ngai Lik, it was assumed that the IRD has already taken the casedecision into account but considered that the applicability of s.16 and s.17 is still valid.

Where an inappropriate transfer pricing results in an understatement of taxable income,especially in an abusive profit shifting scheme, the IRD would seek to invoke s.61 or s.61Ato counteract the tax benefit conferred on a Hong Kong resident taxpayer. If successful,assessments would be raised on the Hong Kong resident taxpayer based on the armslength price as if the transfer pricing issue had never occurred. If a DTA exists betweenHong Kong and the other jurisdiction in which the associated enterprise is resident, DIPN46 notes that the IRD has the right under the Associated Enterprises Article of the DTA toadjust upwards profits of the Hong Kong resident taxpayer, so as to bring the Hong Kongassessable profits to an arms length level. Interestingly, DIPN 46 makes limited referenceto the applicability of s.20, which used to be the weapon to counteract profit shiftingtransactions with non-residents.

Under s.20, where a resident person is found to be closely connected with a non-residentperson and they carry on business together in such a manner that the profits which arise inHong Kong to the resident person are either nil or less than might be expected, thenon-resident person would be deemed to have carried on a business in Hong Kong throughthe resident person. As a result, the profit derived by the non-resident person would beassessed accordingly in the name of the resident person in the capacity of an agent of thenon-resident person. By nature of operation, s.20 does not aim at adjusting profits of anyassociated enterprise but seeks to deem a non-resident persons business to be carried onin Hong Kong through a resident agent. It is in practice very difficult for the IRD to enforces.20 especially when full information of the non-resident persons activities might not beavailable, and the profits in question might not necessarily be sourced in Hong Kong.

Therefore, from the perspectives of transfer pricing, s.20 might not be considered aneffective tool.

Applying DIPN 46 to the structure in Diagram B, it would be critical to be able to identifythat transfer pricing issues may arise in relation to the support income $B which is apayment in return for the support work provided by one enterprise to its associatedenterprise. Since the Hong Kong resident taxpayer and the offshore intermediary areassociated (by reason of shareholding), the pricing ascertained for the support workprovided by the Hong Kong resident taxpayer to the offshore intermediary would berequired to be at arms length. The basis for determining an arms length price woulddepend on the nature of support provided. For example, if trading stock is provided by the

Hong Kong resident taxpayer to the offshore intermediary (reference is made to Question1(b)(ii) of June 2011 Paper P6 (HKG)), the price charged for the sale of trading stockshould be comparable to market price. Since this involves a resale transaction, it would bereasonable to expect that a resale price approach be undertaken to ascertain how muchprice would be invoiced for the trading stock if the Hong Kong resident taxpayer would havesold the same stock to an independent enterprise.

In the normal circumstances, the Hong Kong resident taxpayer would be expected to earna commercial profit. This profit would be booked by the Hong Kong resident taxpayer, andwould be taxable in Hong Kong or not depending on the place where the sale and purchasecontracts were effected (ie whether the trading profit is sourced in Hong Kong). In a

situation where the sale is made at cost or below market value, taxable profits of the HongKong resident taxpayer would be understated. The sale transaction would be regarded asnot at arms length, and would be subject to challenge by the IRD. If there is a DTA betweenHong Kong and the jurisdiction of the offshore intermediary, the IRD may rely on the right


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empowered by the Associated Enterprises Article of the DTA to adjust upwards profits ofthe Hong Kong resident taxpayer according to the market price benchmarked to anindependent transaction. Additional assessments would be raised. Alternatively, if no DTAhas been signed, the IRD may impose s.61 or s.61A to counteract the tax benefit obtainedby the Hong Kong resident taxpayer if the IRD considers that the transaction was made forthe sole or dominant purpose of obtaining a tax benefit.

In a situation where staff support is provided by the Hong Kong resident taxpayer to helpthe offshore intermediary, the relevant portion of the staff cost (being salary and otherrelated costs for the support) should be recharged to the offshore intermediary on areasonable basis. For provision of service, the most common basis used is cost plus, whichseeks to fully recover the staff costs incurred plus a reasonable mark-up (or margin). DIPN46 does not contain any reference to an acceptable range of mark-up, but the IRDcommented that the mark-up should be calculated by reference to similar internal orexternal uncontrolled transactions, and should provide the enterprise with an appropriate

profit in view of the functions performed and the market conditions. If no cost is rechargedor a less-than-market recharge is made, the Hong Kong resident taxpayer would not only beexposed to transfer pricing challenge as explained above. The IRD may also exercise itsauthority under the Associated Enterprises Article of the DTA, if applicable, to make profitadjustments, or impose s.16 or s.17 to disallow a tax deduction of the portion of staffrelated costs which have not been duly recovered. Furthermore, if the staff cost had notbeen fully recovered from the offshore intermediary, the Hong Kong resident taxpayer mayalso run the risk of being seen to have created a PE in the offshore jurisdiction of theintermediary, and could be taxed by the offshore jurisdiction. This is another contentiousinternational tax topic which is outside the scope of this article.

In situations where the Hong Kong resident taxpayer believed that its transaction with theoffshore intermediary has been carried out on an arms length basis, it would be importantto ensure that proper documentation is in place, to demonstrate whether, how and to whatextent the transaction is in compliance with the arms length principle. Although transferpricing documentation has not been made mandatory, the IRD has made it clear in DIPN46 that such documentation requirement would fall within the scope of s.51C recordkeeping requirement. It is also regarded as a good business practice that taxpayers areencouraged to adopt.

The last major issue relating to transfer pricing adjustment is the double taxation problem.This is expected to occur when, for example, the Hong Kong resident taxpayer transacts

with the offshore intermediary, and due to the non-arms length feature of the transaction, aprofit adjustment has been made by the IRD to adjust upwards the profits of the Hong Kongresident taxpayer. Depending on the tax jurisdiction of the offshore intermediary, the HongKong-adjusted portion may not necessarily be adjusted downwards by the offshore taxauthority in arriving at the ultimate tax position of the offshore intermediary. As a result,there could be a portion of income which would be doubly taxed in both jurisdictions. If aDTA exists, the Associated Enterprises Article should provide a mechanism under which thedownward transfer pricing adjustment would be allowed by the corresponding jurisdiction inorder to eliminate double taxation. However, this reciprocal adjustment is not automaticand it usually requires a justification that the upward adjustment made by the otherjurisdiction (Hong Kong in this example) is according to the arms length principle correctly

applied. Moreover, pursuing a claim based on a DTA would be a prolonged and complicatedprocess. If unfortunately, no DTA exists between the two associated enterprises, or iftransfer pricing adjustments are made between two Hong Kong enterprises, the reciprocal


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OCTOBER 2011

16. PricewaterhouseCoopers, Hong Kong issues detailed guidance on transfer pricing,methodologies and related issues, News Flash, Hong Kong Tax, Issue 12, December

2009.

Betty Kwok and Shirley Kan are co-examiners for Papers F6 (HKG) and P6 (HKG)


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RELEVANT TO ACCA QUALIFICATION PAPER P6 (UK) AND


2011 ACCA

Taxation of unincorporated business

Part 1 The new business

This is the Finance Act 2010 version of this article. It is relevant for candidatessitting the Paper P6 (UK) exam in December 2011. Candidates sitting Paper P6(UK) in 2012 should refer to the Finance Act 2011 version of this article, to bepublished on the ACCA website in 2012.

This is the first of two articles on the unincorporated business. It covers issuesrelating to a new business including the choice of business vehicle and the firstyears of trading. Part 2 of this article (to be published in the next issue of

Student Accountant) will look at issues relating to a change of accounting dateand the final years of a business. The articles cover a selection of issues; thereare other matters that, while not featuring in these articles, may still be thesubject of a question in the exam.

The taxation of the unincorporated business is an important part of the PaperP6 (UK) syllabus and is examined regularly. All of the relevant technical rulesrelating to income tax and national insurance contributions are covered in thePaper F6 (UK) syllabus, so that there is nothing new at Paper P6 (UK).

However, these rules continue to be of vital importance at Paper P6 (UK) asound knowledge of these rules will enable candidates sitting the advancedtaxation paper to identify the relevant issues and taxes from the informationprovided, and to consider the implications of alternative courses of action.

This is not an introductory article; it is relevant to students coming to the endof their studies and finalising their preparations to sit the exam. It is intendedto be read proactively ie statements made should be confirmed as true byreference to the readers understanding of the rules or to a relevant study text.This approach will enable future situations to be analysed from first principles

rather than by reference to a rigid set of memorised planning points.

What is required at Paper P6 (UK)?Questions in the exam are likely to be based around the commercial decisionsof the taxpayer. They will require candidates to have a strong knowledge of thetechnical rules and an ability to apply those rules briskly and accurately.Candidates may be required to identify options that are obviouslyadvantageous, disadvantageous or irrelevant, without preparing detailedcalculations for example, by recognising that a particular strategy relating tothe use of losses would simply result in a waste of the personal allowance.


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TAXATION OF UNINCORPORATED BUSINESS

OCTOBER 2011

2011 ACCA

SOME FUNDAMENTALS

The basis of assessmentThe taxable profits of an unincorporated business are determined in twostages:

1. The profits per the accounts are adjusted for tax purposesFor a partnership, the tax-adjusted profits are then divided between thepartners in accordance with the profit-sharing arrangements of the tradingperiod.

2. The basis of assessment rules are then applied to the sole trader orpartners tax adjusted profits of the trading periods.

Example 1 Basis periods in the opening yearsZhou began trading on 1 June 2011. Accounts will be prepared to either:(i) 31 December, or(ii) 30 April.

What are the basis periods for the first three tax years and what is the overlapperiod?

The solutions are provided at the end of this article.

Losses

Where there is a loss in a basis period, the traders taxable income for therelated tax year will be zero. There will also be a loss available for offsetagainst income and/or capital gains. There are two main issues thatcandidates need to be sure of in order to be able to calculate the potential taxsaving from the offset of the losses:

1. The precise income and/or capital gains that the losses can be offsetagainst, and

2. The periods in which the offset can occur.

Candidates must then take care to consider all of the relevant possibilities inthe detail necessary to provide the advice requested.

Example 2 Losses in the opening yearsPaula began trading on 1 June 2010. She has a tax adjusted trading loss forthe tax year 2010/11.

What are the alternative reliefs available in respect of the trading loss?The solution is provided at the end of this article.


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2011 ACCA

CHOICE OF BUSINESS VEHICLE

A new business can be operated as an unincorporated entity (sole trader orpartnership) or as a company. The choice will be made by reference tocommercial and legal issues in addition to taking into account the taximplications of the alternative business structures. Commercial issues includethe effect of the chosen business vehicle on the ability of the business to raisefinance, and the possible belief that a company may be regarded as larger ormore financially sound than an unincorporated business. Legal issues includethe existence of limited liability for a company.

Taxation of business profits

From a tax point of view, an unincorporated business is a simple structure. Theprofits of the business, as adjusted for tax purposes, are subject to income taxand Class 4 national insurance contributions in the hands of the sole trader orpartners who own the business. There will also be a liability to Class 2 nationalinsurance contributions.

Where a business is operated via a company, the tax position is morecomplicated. It is likely that the individual(s) who formed the company andwho are running the business will extract profits from the company principallyin the form of salary or dividends (they may also be paid rent in respect of abuilding or pension contributions). The payment of a salary results in a liabilityto Class 1 employers and employees national insurance contributions and adeduction for both the salary and the national insurance contributions for thepurposes of calculating the companys taxable profits. Dividends do not giverise to a liability to national insurance contributions and are not tax deductiblefor the company. Any profits retained in the company are subject tocorporation tax only.

When comparing alternative strategies, it may be necessary to consider thetotal tax cost (ie including national insurance contributions) of each of themwhile recognising that other (non-tax) factors are also relevant. This will be

covered in more detail in Part 2 of this article Taxation of the unincorporatedbusiness The existing business.

In addition to affecting the total tax payable, the choice of business vehicle willalso affect the timing of the liabilities with the self-employed making paymentson 31 January in the tax year and 31 July following the end of the year andemployees making payments monthly. The companys tax liability will be duenine months and one day after the end of the accounting period, unless it isrequired to pay its tax in instalments.


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OCTOBER 2011

2011 ACCA

Initial lossesWhere there is an expectation of losses in the early life of the business, there is

a considerable advantage to operating the business as an unincorporatedentity. This is because the losses can then be offset against the other incomeand/or capital gains of the sole trader or partners.

It should be recognised that the relief available here is particularly generous inthat, as well as being able to offset the losses in the year of loss and/or theprevious year, the losses of the first four tax years can be offset against theincome of the previous three years on a first in, first out basis. This means, forexample, that where an employee resigns in order to start a new business, anyinitial losses can be offset against employment income arising prior to the start

of the business.

Where losses arise in a new company, the relief available is far less generous.In these circumstances it is likely that the only significant relief available willbe against future profits of the same trade. Relief for the losses is thereforedependent on the company eventually making profits (never a certainty!) and,even then, the relief is delayed until such profits are realised.

Capital gains taxAn unincorporated business and shares in a company are both potentiallyqualifying assets for the purposes of gift relief and entrepreneurs relief.However, the circumstances and precise conditions must always be consideredcarefully.

Inheritance taxBusiness property relief is likely to be available on a future disposal of thebusiness regardless of the choice of business vehicle. However, it is morestraightforward to transfer shares in a company than to transfer a share in anunincorporated business.

CHOICE OF YEAR END

The choice of year end affects when the profits of the business will be subjectto income tax. For example, where a 31 March year end is chosen, the profitsearned in a tax year are taxed in that same tax year (the profits earned in theyear ended 31 March 2010 are taxed in the tax year 2009/10). Alternatively,where a 30 April year end is chosen, the majority of the profits earned in a taxyear are not subject to income tax until the following tax year (the profitsearned in the year ended 30 April 2010 are taxed in the tax year 2010/11).

When a new business begins to trade, the profits assessed to tax in the first

two tax years will vary, perhaps considerably, depending on the choice of yearend.


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OCTOBER 2011

2011 ACCA

Illustration 1Mizuki began trading on 1 January 2011. Her tax adjusted profits per month

are set out below.

January to March 2011 (three months) 3,000April to September 2011 (six months) 4,000October to December 2011 (three months) 8,000January 2012 onwards 12,000If Mizuki adopts a 31 March year end, her taxable trading income for the firstthree tax years of trading would be calculated as follows:

1. Profit for each trading period

Three months ending 31 March 2011(3,000 x 3) 9,000

Year ending 31 March 2012((4,000 x 6) + (8,000 x 3) + (12,000 x 3)) 84,000

Year ending 31 March 2013 (12,000 x 12) 144,000

2. Taxable profit for each tax year

2010/11 (1 January 2011 to 5 April 2011) 9,000

2011/12 (Year ending 31 March 2012) 84,0002012/13 (Year ending 31 March 2013) 144,000Total taxable profits for the first three tax years 237,000

If Mizuki adopts a 30 April year end, her taxable trading income for the firstthree tax years of trading would be calculated as follows:

1. Profit for each trading period

Four months ending 30 April 2011((3,000 x 3) + 4,000) 13,000

Year ending 30 April 2012((4,000 x 5) + (8,000 x 3) + (12,000 x 4)) 92,000

Year ending 30 April 2013(12,000 x 12) 144,000

2. Taxable profit for each tax year

2010/11 (1 January 2011 to 5 April 2011)3/4 x 13,000 9,750

2011/12 (1 January 2011 to 31 December 2011)13,000 + (8/12 x 92,000) 74,333


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OCTOBER 2011

2011 ACCA

2012/13 (Year ending 30 April 2012) 92,000Total taxable profits for the first three tax years 176,083

With a 30 April year end the taxable profits in the first three tax years are60,917 (237,000 176,083) less. This is because the profits areincreasing and early profits are being taxed twice (giving rise to overlap profits)in place of later, higher profits.

This is a timing difference as opposed to an absolute saving. The profitsearned in the period 1 May 2012 to 31 March 2013 of 132,000 (12,000 x11) are not taxed in the first three tax years if a 30 April year end is chosen.These profits, as reduced by the overlap profits of 71,083 (9,750 + 61,333

(8/12 x 92,000)), represent the difference between the total profits taxed.

OTHER MATTERS

Pre-trading expenditureExpenditure incurred in the seven years prior to the commencement of trade istreated as having been incurred on the first day of trading. Where the first

period of trading is the basis period for more than one tax year (as inIllustration 1 above), such expenditure, together with other costs (and capitalallowances) of the first period will be counted more than once when calculatingtaxable profits see Illustration 2 below.

Capital allowancesThe annual investment allowance is reduced for trading periods of less than 12months. Accordingly, the length of the trading period in which significantcapital expenditure is incurred can have an effect on the speed with which abusiness obtains relief for its capital expenditure.

Illustration 2Irina began trading on 1 January 2011. In December 2010 Irina spent 70,000on equipment for use in her business. For the purposes of capital allowances,equipment purchased prior to the commencement of trading is treated ashaving been purchased on the first day of trading.

The capital allowances claimed by Irina will depend on the date to which sheprepares her first set of accounts.


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OCTOBER 2011

2011 ACCA

Accounts prepared to 31 March 2011Main pool Allowances

Period ended 31 March 2011Additions qualifying for AIA 70,000AIA (maximum 100,000 x 3/12) (25,000) 25,000

45,000WDA (20% x 3/12) (2,250) 2,250

42,750 27,250Period ending 31 March 2012WDA at 20% (8,550) 8,550Tax written down value carried forward 34,200

Total allowances for the first two tradingperiods 35,800

Accounts prepared to 30 September 2011Main pool Allowances

Period ended 30 September 2011Additions qualifying for AIA 70,000AIA (maximum 75,000 (100,000 x 9/12)) (70,000) 70,000Tax written down value carried forward

Period ending 30 September 2012No tax written down value brought forward

Total allowances for the first two tradingperiods

70,000

The effect of the accelerated capital allowances becomes more marked whenthe basis of assessment rules are applied to the tax adjusted profits of thebusiness as, with a 30 September year end, the profits of the first nine months(as reduced by the capital allowances) form part of the calculations of the

taxable profits for the first two tax years.

Illustration 3Continuing from Illustration 2, Irinas business has tax adjusted trading profits,before deduction of capital allowances, of 12,000 per month.

If Irina adopts a 31 March year end, her taxable trading income for the firsttwo tax years of trading would be calculated as follows.


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OCTOBER 2011

2011 ACCA

1. Profit for each trading

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