In December 2009, the Inland Revenue Department published the revised Departmental Interpretation and Practice Note No.21 (Revised) – “Locality of Profits”.
The determination of the location of a source of a given profit has caused some disputes between taxpayers and the Inland Revenue Department. It is clear that the source of a profit is “what the taxpayer has done to earn the profit in question”, and that the location of that source is “where he/she has done it”. It is accepted that this is a “hard practical matter of fact” that cannot be determined by a single set of rules – we have to look at the relevant facts without being distracted by those facts that are antecedent or incidental to the identification of the geographical location of the activities giving rise to the profit in question.
Whilst the Practice Note may provide guidance to taxpayers as to the IRD’s interpretation of the law on the locality of profits, there remain many unanswered questions.
It is obvious that the IRD places more emphasis on Lord Jauncey’s comment in HK-TVB1 that “it can only be in rare cases that a taxpayer with a principal place of business in Hong Kong can earn profits which are not chargeable to profits tax”. This is further emphasised by the following comment:
“The Department agrees with the approach in Magna and will contemplate all the relevant operations carried out to earn the profits, including the solicitation of orders, negotiations, conclusion, trade financing, shipment and performance of the contracts”.
This approach clearly ignores the application of contract law and, in essence, is more focused on where a person is carrying on a business as opposed to the location of the source of its profit. If the courts were to pursue the IRD’s approach, I would expect there to be numerous debates as to a) whether the approach focused on the location of the taxpayer’s place of business as opposed to the location of the source of profit under review, and b) what activities were in fact antecedent and irrelevant to the those activities that gave rise to the profit. This would be particularly relevant to the determination of the location of the source of trading profits, which in the Department’s view cannot be apportioned.
Further problems will arise as to whether re-invoicing income is not subject to tax. Sadly, the Practice Note raises doubts as to whether re-invoicing profits are really not taxable in Hong Kong. Whereas the previous Practice Note (1998 version) clearly stated that profits from specific activities related to a re-invoicing activity would not be taxable, the new Practice Note chooses to draw a distinction between profit derived from the actual re-invoicing activity and commission receivable from undertaking this activity on behalf of a third party. Clearly, to avoid any dispute, a Hong Kong business will need to be paid a specific arm’s-length commission for undertaking the activity in addition to booking a re-invoicing profit.
My final concern relates to manufacturing profits. Here, the issue is the Department’s intention to allocate a Hong Kong manufacturer’s profit between a manufacturing and sales activity, a proposal with which I disagree. What I cannot understand is how goods manufactured in Hong Kong can be regarded as Hong Kong-sourced wherever they are sold, whereas goods manufactured outside Hong Kong but sold through a branch in Hong Kong are subject to Hong Kong tax, albeit on the basis of apportionment. In my view, if a person manufactures goods and this is the activity that gives rise to the profit (its source being where the manufacturing activity takes place), then the question of apportionment does not apply. This also gives rise to the Inland Revenue Department’s stance on the distinction between “contract” and “import” processing. The Practice Note suggests that if a company manufactures goods in Mainland China using a third party to assemble goods under an import processing agreement or without a contract processing agreement, then the company cannot be regarded as a manufacturer. I find this illogical.
Whilst I fully appreciate that the IRD’s responsibility is to assess and collect Hong Kong tax, the absence of a clear set of impartial and logical rules for determining the location of a source of profits will only hinder Hong Kong’s ability to attract multinationals to Hong Kong.
