I refer to Mr Sun’s comments in Denise Tang’s article “Manufacturers claim hundreds of firms hit by unfair tax rule” published in the Wednesday 23rd September edition of the South China Morning Post.
I whole heartedly support Mr Sun’s views and indeed I have been very frustrated with the Inland Revenue Department’s (“the Department”) intransient stance on this issue.
In my view many taxpayers regard the Department’s published Departmental Interpretation and Practice Notes (“DIPN”) as being a clear statement as to how the Department will interpret the provisions of the Inland Revenue Ordinance (“IRO”). However, in the introduction of each DIPN it is stated that;
“These notes are issued for the information and guidance of taxpayers and their authorized representatives. They have no binding force and do not effect a person’s right of objection or appeal to the Commissioner, the Board of Review or the Courts”.
Sadly, many manufacturers believed if they structured their businesses in accordance with the guidelines stated in paragraphs 15 and 16 of DIPN 21 that they would be entitled to a 50:50 apportionment of their profits from manufacturing in Mainland China. Not only have the Department taken a tougher stance on offshore claims but also appear to apply the DIPN21 concession when it suits it (Board of Review decision D92/07).
It is clear that, at some point in time, the Department changed its approach from exercising a liberal approach to offshore manufacturing, allowing 50:50 claims, to the implementation of a regime focused on the classification of the manufacturing agreements into import and contract processing agreements. Where the agreement was regarded as an import processing agreement the Department has not accepted the taxpayers’ claims for apportionment.
In correspondence the Department has defined the two types of agreement as follows;
“Contract Processing
(a) Processing trade （加工貿易）is a system under which exported goods are processed or produced with raw materials imported into PRC. The initial form of a processing trade is “contract processing” [also know as loi liao jia gong or來料加工].
(b) Chinese foreign trade (or industry and trade) companies which are legal persons and which have the power to conduct business with foreign entities may sign Processing/Assembly Contracts with foreign entities. Under a typical contract processing arrangement, the foreign enterprise will provide the PRC enterprise with imported equipment, imported raw materials and technology. The PRC enterprise will, in return for a processing fee, provide the premises and labour to process the imported raw materials into the finished goods. All the processed finished goods are exported back to the foreign enterprise. The title to the raw materials and the finished goods always belong to the foreign enterprise. The title to the raw materials and the finished goods always belong to the foreign enterprise under this arrangement.
Import processing
(c) There is another form of processing trade called “import processing” [also known as jin liao jia gong or進料加工].
(d) Import processing [進料加工] is an agreement whereby a foreign enterprise or a PRC domestic production enterprise with the rights to import and export [“the Manufacturer”] is allowed to import raw materials to manufacture goods for export. Here, the Manufacturer buys raw materials from overseas suppliers and sells the finished goods to overseas or Hong Kong customers.”
I have been advised that in many instances the Hong Kong manufacturer has been required to establish a foreign investment enterprise or a wholly foreign owned enterprise in the Mainland to facilitate the successful negotiation of the terms of a processing agreement, export contract etc with the local government. Agreements may also have been reached with the local tax bureau as to the level of PRC tax to be paid by the Mainland company. Whilst the true legal form of these contracts may be that of an import processing agreement the reality has been that they are more closely aligned to a contract processing agreement. The Department has had no interest in recognizing the true form of those contracts focusing only on the fact that the contracting parties are two separate legal entities who have entered into an import processing agreement.
An example of this is the Board of Review case D92/07 where the taxpayer provided virtually all the materials needed for the production of the products, the machinery, technology and senior employees at the factory in Southern China. The factory was owned by a wholly owned subsidiary of the taxpayer. The factory manufactured/assembled the products for a fee. The audited accounts of the Hong Kong taxpayer illustrated the payment of a processing fee and that the taxpayer owned all the stock of finished goods, unfinished goods and unused materials held at the factory. In contrast the financial statements of the Mainland subsidiary accounted for the fee as a sale in order to conform with the agreement signed with the local government. The Department chose to ignore the audited Hong Kong accounts and focus solely on the strict legal form of the agreement which they concluded was in the form of an import processing agreement.
The Board of Review found in favour of the taxpayer and remitted the case back to the Commissioner of Inland Revenue (“the Commissioner”) to determine the basis of apportionment of profits. Another interesting point in this case was that the Counsel for the Commissioner stated that the Commissioner was not bound by DIPN21. I understand that the case has been appealed by the Commissioner.
Sadly, this case is likely to be influenced by the decision in CIR v Datatronic Limited which the taxpayer lost at the Court of Appeal but may appeal the decision to the Court of Final Appeal. The facts differ from the Board of Review case referred to above but nonetheless the Datatronic’s decision is likely to impact any offshore tax claim relating to manufacturing.
Whatever the outcome of the Datatronic appeal it should be appreciated that Hong Kong’s profits tax system only taxes Hong Kong sourced profits and that there is no legal reason why manufacturing profits cannot be apportioned between onshore and offshore activities. The 50:50 basis of apportionment referred to in DIPN21 was designed to avoid endless arguments as to the appropriate basis of apportionment applicable to a taxpayer. If the Inland Revenue Department continue to refuse all offshore claims where the form of the contract is that of an import processing agreement taxpayers will need to revert to basics and make an offshore claim using the operations test, i.e. the taxpayer will need to analyse each step of their manufacturing process and determine the appropriate percentage that occurs offshore whatever it may be i.e. 10%, 23%, 74% etc. Yes, this will give rise to considerable debate between the taxpayer and the Department but that is not the taxpayer’s fault.
A draft revision to DIPN21, which has yet to be published, appears to have dramatically revised the paragraphs relating to manufacturing, focusing on contract processing and import processing, recognising that apportionment is possible but making no reference to a simple 50:50 solution.
Until such time that the courts refer cases back to the Commissioner to determine a basis of apportionment there is no incentive for the Commissioner to seek a workable solution. Bearing in mind also that a taxpayer is required to fund it’s own costs of an appeal to the Board of Review.
It is refreshing to read that the Federation of Hong Kong Industries are seeking to bring this issue to the attention of the Government.
