For many years Mr Leung has been employed as a sales representative of a real estate company, Hit and Run Limited (‘HAR'). At all relevant times, he has paid salaries tax on his earnings at the standard rate. His earnings consist of a basic salary (which must be repaid if his sales results do not reach a prescribed minimum level) plus commission. His commission earned over the past two years has been very high. He has a wife who operates a trading business. The couple has two young children attending schools in Hong Kong.

Mr Leung has been told that the test of deductibility for outgoings and expenses for salaries tax purposes is ‘notoriously rigid, narrow and restrictive.' Mr Leung thinks that if he were subject to profits tax instead of salaries tax he would be able to claim many deductions for outgoings and expenses that are presently not allowable to him for salaries tax purposes.

Mr Leung therefore approached the accountant of HAR for advice. The accountant advised him to resign from his job with the company, incorporate a new company, Leung Fun Limited (‘LFL'), and arrange for LFL to enter into a new contract with HAR to provide Mr Leung's services as a sales representative. Under this arrangement, LFL would receive income from HAR and claim against this all allowable expenses.

LFL would employ Mr Leung at a reasonable salary to provide the agreed sales services on its behalf to HAR. A few days ago, HAR's accountant informed Mr Leung that the company will agree to enter into the proposed arrangement on basically the same terms as it now employs Mr Leung, but without any obligation to pay any minimum monthly sum to LFL.

Required:

a Evaluate the comment by the accountant of HAR in respect of the deductibility of expenses and outgoings under Hong Kong salaries tax and profits tax.

b Explain in detail to Mr Leung whether there is any danger of the Commissioner challenging the suggested arrangement and the possible consequences, quoting the relevant sections of the Inland Revenue Ordinance where appropriate. Further, advise Mr Leung on what he can do to lessen the chance of the application of the relevant Inland Revenue Ordinance provisions in a situation like this.