For many years Hong Kong manufacturing companies have taken advantage of the considerably lower labour costs in other Asian countries, particularly Mainland China. Inevitably the nature of these arrangements varies but a large number of enterprises have established their own manufacturing/assembly plants in Mainland China.
Structured correctly, such arrangements may also reduce the tax burden of the manufacturer as the Hong Kong Inland Revenue Ordinance (”IRO”) only seeks to tax profits accruing to a business carried on in Hong Kong from sources that are located in Hong Kong. Hence, where manufacturing activities take place outside Hong Kong there is a basis for establishing an “offshore” claim. However, where activities take place in more than one jurisdiction it may be appropriate to apportion the profit to more than one location.
Although there is no specific provision in the IRO for the apportionment of profits the judgments of Lord Bridge in CIR v Hang Seng Bank Ltd (IHKRC 90-044) and Ribeiro SC in Emerson Radio Corp v CIR (HKRC-90-095) clearly support the proposition that apportionment is possible. Thus, in order to reduce the many arguments that would arise as to the correct basis of apportionment the Inland Revenue Department (”the Department”) in its “Departmental Interpretation and Practice Notes – No 21 (Revised) – Locality of Profits” provides for a 50:50 basis of apportionment where a Hong Kong manufacturing business “is involved in the manufacturing activities in the Mainland (in particular in the supply of raw materials, training and supervision of the local labour).”
However, in the past few years the Department has sought to restrict the application of this “concession”. Firstly, the Department has taken the position that the words “involved in the manufacturing activities in the Mainland” cannot apply to “import processing”. Import processing applies where the Mainland entity purchases raw materials, often from the taxpayer, and sells finished goods for its own account, again to the taxpayer. Frequently, these arrangements are structured in this manner for PRC customs or tax purposes whereas the substance of the arrangement is in effect a “contract processing” agreement i.e. an arrangement whereby the materials sent to the Mainland are on a consignment basis such that title to all stock of raw materials and finished goods remain with the Hong Kong taxpayer.
Secondly, in the recent appeal to the Court of First Instance in the case of CIR v Datatronic Ltd (2008) HKRC 90-2008 the Counsel for the taxpayer sought to establish that the 50:50 apportionment given in DIPN 21 was not binding on the Commissioner of Inland Revenue (”CIR”) and was not Hong Kong law hence could not be considered by the Court. The Hon Andrew Ching J concluded that the Board of Review was correct to conclude that an apportionment of profits should be made on a 50:50 basis. The decision is under appeal.
Furthermore, in a more recent Board of Review case, currently unreported, the CIR claimed from the outset that it was not bound by DIPN21 and argued that the form of the arrangement between the taxpayer and the manufacturer in Mainland China was that of an import processing agreement hence all the profit derived by the taxpayer was from the manufacturing and sales activities undertaken in Hong Kong and were taxable. In contrast The Board of Review found that part of the taxpayer’s profits was sourced outside Hong Kong and that the profits should be apportioned.
Many taxpayers and the Department wait with interest the outcome of the appeal in the Datatronics case. However, what is evident is that there needs to be a clear statement as to the Department’s approach to offshore manufacturing, and to the extent that a concessionary apportionment is appropriate that it is applied on a consistent basis that can be relied upon by taxpayers.
The reluctance of the Department to accept that a Hong Kong business can have offshore profits is becoming very obvious. To refute such a contention the taxpayer is often faced with substantial professional fees and lengthy arguments all of which create unnecessary uncertainty.
Taxpayers and their advisers are also expecting the release of a revised DIPN21, but I doubt any changes reflected therein will be for the benefit of taxpayers or the development of Hong Kong’s role as a location for establishing a regional head office.
