Fok J’s decision in the case of the Commissioner of Inland Revenue v CG Lighting Limited, heard before the Court of First Instance (Inland Revenue Appeal NO.8 of 2009 on Appeal from B/R 92 of 2007), provides an interesting insight into the attitude of the Inland Revenue Department (“the Department”) and the lower courts of Hong Kong as to what constitutes an offshore source of profit for the purposes of Hong Kong profits tax.
Fok J’s decision addresses the appeal by the Department against the decision of the Board of Review, which concluded:
“We believe that in a case, like here, where the operation is a multi-facet one, this Board must have regard to the practical commercial reality. Such reality dictates that the Taxpayer’s participation in the production process was as much a part of its profit-producing transaction as the obtaining of a purchase order.
Plainly, part of the Taxpayer’s profit-producing transactions was located in the Mainland and therefore its contention that part of its profits was sourced from outside Hong Kong and not chargeable to profits tax is correct.”
The facts of the case were that CG Lighting Limited (“CGL”), a private company carrying on business in Hong Kong, which described its principal activity as “the manufacturing of lighting fixtures”, maintained that 50% of its profits should be regarded as not taxable in accordance with the Department’s Interpretation and Practice Note No 21 (“DIPN 21”). Prior to January 1994, CGL’s products were manufactured by a third-party factory under a contract processing agreement. In January 1994, CGL established a foreign investment enterprise, CGES, which assumed responsibility for the manufacturing process. CGES manufactured only for CGL and was reimbursed for its expenditure by the payment of a monthly processing fee.
The Board of Review accepted the following facts:
(a) CGL was responsible for design, product testing and prototype production (such works were carried out partly in Hong Kong and partly at CGES in the Mainland).
(b) Purchases from third parties were concluded by CGL. Sales work orders and production orders were prepared in Hong Kong and faxed to CGES.
(c) Raw materials necessary for the manufacture of finished goods were purchased by CGL in Hong Kong and then transferred to CGES in the Mainland according to the production schedule set in Hong Kong.
(d) Quality assurance engineers and production control staff from the CGL would visit CGES to train and update the subsidiary’s staff.
(e) A number of senior management staff employed by CGL were stationed in the subsidiary to monitor and manage its operation.
(f) The subsidiary provided the factory premises and the labour for the production of lighting fixtures, in return for monthly processing fees paid by CGL. The amounts of the processing fees were no greater than the subsidiary’s operating costs and overhead.
(g) There were no sales of materials by CGL to CGES, or of finished products by CGES to CGL.
(h) All capital expenditure incurred by CGL for the factory was recorded as fixed assets in CGL’S accounts.
(i) All finished products, stock of unused materials and finished products not yet sold or shipped were recorded in the accounts of CGL.
At the beginning of the Board of Review hearing, Counsel for the Department stated it was not bound by the concession set out in DIPN 21, and that the appeal should be resolved by applying the relevant charging provisions of the Ordinance as construed by case law. However, acknowledging that apportionment was possible under the charging provision and that the Board of Review had found that part of the CGL’s profits were sourced from outside Hong Kong, the case was remitted back to the Commissioner of Inland Revenue to decide the appropriate apportionment.
The Commissioner appealed the decision on the basis that:
(a) The Board had erred in law in failing to focus only on the geographical location of the CGL’s profit-producing transactions themselves (namely the sale of goods).
(b) The Board had erred in law in having regard to antecedent or incidental matters that are legally irrelevant (namely the activities of CGL’s staff in CGES).
(c) Having taken into account antecedent or incidental matters that are legally irrelevant, the Board’s conclusion that the sources of CGL’s profits were partly Hong Kong and partly outside Hong Kong is one that no reasonable tribunal properly directed could reach.
In support of these conclusions, Counsel for the Commissioner emphasised that:
(a) When determining the operations that produced the relevant profits and where those operations took place, it is the operations of CGL, and not those of CGL’s subsidiary or sub-contractor, that are the relevant consideration.
(b) In order to determine the source of CGL’s profits, it is of critical importance to properly identify the profit-producing transactions. The profit-producing transactions are only properly identified if the “antecedent or incidental activities” are excluded.
(c) The Board found that CGES was the manufacturer, and further found that the acts or operations of CGES did not constitute the acts or operations of CGL. In other words, CGES was not CGL’s agent and the manufacturing activities carried on by CGES were not the activities of CGL. The Board was incorrect to have regard to the management by CGL’s staff in the production at CGES, which were activities antecedent or incidental to the profit-producing transactions. This error vitiates the Board’s conclusion that the profits were sourced partly from outside Hong Kong.
(d) CGL earned its profits by acquiring the finished products from CGES and selling them to customers at a profit. Even though CGL’s participation in CGES’s production process might have been “commercially essential to the operations and profitability of CGL’s business”, they do not provide the legal test for ascertaining the geographical source of profits for the purpose of s.14.
(e) The representative transaction studied at the Board plainly included the sale of the finished goods by CGES to the Taxpayer.
(f) Notwithstanding (e) above, the Board did not make any findings regarding the mode of transfer of the finished goods by CGES to CGL. The Board only accepted the evidence of CGL’s witness that the documents concerning CGES were prepared “in such a way as to satisfy the requirements of the Mainland authorities”. The Board did not find that all such documents were a sham or of no effect.
In delivering his judgment, Fok J:
(a) had no hesitation in concluding that the Board made a clear finding of fact that there was no sale of the unfinished products by CGES to CGL, and that the facts of the case would place the arrangement into the category of contract processing as opposed to import processing. However, Fok J was of the opinion that:
“these descriptions of import processing and contract processing activities appear to derive from DIPN 21, which, as I have noted above, is not relevant since the ultimate question depends on the application of s.14, the relevant charging provision.”
(b) found as relevant that CGES was the manufacturer and that the Board did not find that CGES was an agent of CGL in the production of the lighting fixtures.
(c) dismissed the relevance of the accounts by agreeing with the Commissioner’s Counsel that:
“It would make little difference, in terms of the accounting treatment, if, instead of being entered as a processing charge, the fee paid to CGES by the Taxpayer was described as the cost of purchase.”
Based on the above, Fok J concluded:
“Once it is accepted that the manufacturer of the lighting fixtures was CGES and not the Taxpayer and that CGES was not the agent of the Taxpayer in the manufacturing process, I do not see that it is possible to avoid the conclusion that the activities of the Taxpayer in relation to the manufacturing process itself are simply antecedent or incidental to the profit-producing transactions here.
I am therefore unable to accept the submission on behalf of the Taxpayer that the source of its profits was its business of manufacturing lighting fixtures for export, which business it carried on, with the assistance of agents, in the PRC and Hong Kong.”
Fok J continued:
“Instead, the transactions which produced the profits for the Taxpayer were the sales of the finished products to its customers. Those sales were effected in Hong Kong and so the profits deriving from the sales are chargeable under s.14.
I am satisfied that, even though there was not a sale of the finished products by CGES to the Taxpayer, the fact remains that the Taxpayer did not manufacture the finished goods and only had them transferred to it pursuant to the sub-contracting arrangements between it and CGES. On analysis, I conclude that the profit-producing transactions of the Taxpayer consisted of the acquisition of the finished goods from CGES, for which the Taxpayer paid a processing fee under the Processing/ Subcontracting Agreement in respect of the manufacturer of the goods by CGES, and on selling of the same to its customers.”
I have difficulty in accepting Fok J’s interpretation of the findings of the Board of Review. In my opinion, the Board did not find that CGL was not a manufacturer or that CGES was the only manufacturer, nor did the Board find that CGES was not an agent of CGL. Certainly, the Board did not state that the arrangement between CGL and CGES was consistent with a sub-contracting arrangement.
Perhaps the most difficult position to accept is the manner in which Fok J disregarded the fact that CGES did not make any independent management decision, indeed would not undertake any manufacturing or other activity without authorisation from CGL. It is clear from the statements of the witnesses, which were accepted by the Board, that CGES was managed and controlled by CGL.
Furthermore, I do not understand the analysis of CGL’s accounts made by the Commissioner’s Counsel and accepted by Fok J. It was accepted by the Board that the audited accounts were prepared to Hong Kong and international standards and in accordance with CGL’s principal activity being that of a manufacturer.
Fok J appears to have placed substantial reliance on the decisions in Datatronics, ING Bearings and Ngai Lik Electronics, which can be clearly distinguished from the facts of the current case.
In my opinion, any reasonable person would conclude, based on the findings of the Board, that CGL was a manufacturer and that its involvement in the manufacturing process of CGES was fundamental to the activities that gave rise to its profits. The determination that CGL was no more than a trader and that the involvement in the activities of CGES were antecedent or incidental to the profit-producing activities of CGL is to ignore the realities of CGL’s business and the activities of its staff.
I sincerely hope that the case is appealed to the Court of Appeal, although I suspect that, because of the importance of the case to the Department, it will end up in the Court of Final Appeal.
