Hitting the target

In recent years, the Hong Kong tax authority - the Hong Kong Inland Revenue Department (IRD) - has strengthened its resources on tax audits to ensure each taxpayer pays the correct amount of tax and to counteract tax evasion and avoidance. Kaiser Kwan and Ignatius Cheng explain how the IRD selects its audit targets and discusses the current development of the issue

The Hong Kong IRD currently adopts the 'Assess First Audit Later' assessment program whereby profits tax assessments are issued before returns and accounts are examined. As taxpayers' returns are not examined on an annual basis, cases for examination are selected for desk audit by two methods through a computer program designed to provide an objective and efficient process for this purpose.

By the 'random selection' method, all returns have an equal chance of being selected. The 'risk-based selection' method entails the assignment of different weightings and scores for each risk-bearing item - e.g. claims for bad debt deductions. The data of each return are input into the computer so that returns with high scores are selected for desk audit. Information and data in the returns can be viewed as the basic information upon which the IRD implements its three-tier audit system, the 'Audit Trilogy - desk audit, field audit and investigation'. When suspected irregularities are detected through the desk audit process, the case will undergo a field audit process.

Apart from cases sourced through the desk audit, the IRD obtains field audit cases externally through informers, inter-department referrals and media reports. Internally, the IRD has an effective mechanism through which suspected cases are referred to the Field Audit & Investigation Unit for detailed enquiries. The Estate Duty Office and Salaries Tax Sections make frequent referrals. Field auditors also play an active role in singling out suspected cases - e.g. cases with qualified audited reports, exceptionally low gross profit ratio, low effective tax rates and apparent discrepancies between salaries charged in the accounts and employer's returns of employees' remunerations. In recent years, field auditors have flagged suspected cases where companies have been substantially engaged in related party transactions. Also targeted by the field auditors are pricing issues or aggressive tax planning schemes.

The methodologies which field auditors commonly employ to quantify the understatement, if any, of profits or income include the asset betterment statement (net worth) method, bank deposits method and business economics method, which may involve the application of a certain ratio (e.g. the gross profit ratio of a similar business) to the target case. Of course, taxpayers or their representatives have the right to discuss and negotiate the approaches or methods that suit the circumstances of their cases. In most cases, a compromise can be reached between the field auditors and the taxpayers in this area.

Hong Kong adopts the territorial concept in determining whether profits are assessable in Hong Kong. Only profits sourced in Hong Kong are chargeable to Hong Kong profits tax. Therefore, the question of profit source has become one of the most problematic, and at times contentious, issues. The IRD has taken a tougher stance in cases where a company has used location of profits as part of its tax planning.

Field auditors are now closely examining cases where there are apparent artificial attempts to turn profits derived from Hong Kong (onshore profits) into profits which are derived from outside Hong Kong (offshore profits). Companies incorporated in tax haven countries but suspected to have business carried out in Hong Kong, and transactions between Hong Kong and these tax haven countries, are subject to close scrutiny by field auditors in their mission to counteract tax avoidance.

Confusion

Hong Kong, now a special administrative region of the PRC, has a close commercial and financial relation with mainland China. Business transactions between the two territories, which have different tax systems, are so frequent that there is confusion over the the locality of profits. In the course of conducting a field audit, the field auditors often need to make extensive enquiries which will inevitably cause disruption to the smooth running of the taxpayer's business. In addition, the onus on proving the assessment as excessive lies with the taxpayer.

It is quite clear that the IRD has been exercising reasonable care when invoking the anti-avoidance provisions and there appears to be no evidence indicating any abuse of power in this area. However, to maintain Hong Kong's simple tax system and its fair administration, it is hoped that field auditors will be encouraged to exercise their professional discretion and judgement in striking a fair balance between the application of the law and the practical environment of the commercial sector. Taxpayers, in the majority of cases, cannot take a position equal to that of the Revenue in terms of the time and costs involved in tax litigation.

It is hoped that as soon as the trend of improved general compliance is secured, which will provide the Revenue with a higher level of confidence, the resources deployed to this audit mechanism can be substantially reduced.

Kaiser Kwan is tax partner, and Ignatius Cheng special consultant - tax investigation, of Deloitte Touche Tohmatsu, Hong Kong.