Earlier this year, at the request of the Financial Services and the Treasury Bureau, the Joint Liaison Committee on Taxation (JLCT) submitted a proposal to the Hong Kong Government to amend the Inland Revenue Ordinance (“IRO”) so as to allow Hong Kong taxpayers a profit tax deduction for plant and equipment used, free of charge, outside Hong Kong in the manufacture of goods that produce profits subject to Hong Kong tax.
In response to this proposal, The Secretary for Financial Services and The Treasury stated that there was no need to amend the IRO. The reasons given were:
(1) A tax deduction in the form of depreciation allowances may already be claimed by a Hong Kong taxpayer in respect of plant and machinery used in Mainland China for the purposes of manufacturing under a “contract processing” agreement. However, as only 50% of the profits generated under a contract processing agreement are assessed to Hong Kong tax, the depreciation allowances claimed in respect of the plant and machinery used for this purposes are also reduced by 50%.
(2) Profits derived from “import processing”, i.e. an agreement under which the PRC manufacturer raises a sales invoice for the goods manufactured, are not considered to be manufacturing profits, but are instead considered to be trading profits from the purchase and sale of goods. Hence, the cost of the plant and machinery, purchased by the Hong Kong taxpayer and provided free of any form of rent, which is used for the manufacture of the goods in the PRC, is deemed by the Inland Revenue Department not to have been incurred in respect of the business carried on in Hong Kong. Furthermore, had rent been received for the hire of the plant and machinery, this would have been derived from a non-Hong Kong source of profit and therefore depreciation allowances would not have been available.
As mentioned in previous articles, the concept of import and contract processing has been included in the Inland Revenue Department’s Departmental Interpretation and Practice Notes No 21 (Revised) (“DIPN”) “Locality of Profits”, issued in December 2009, shortly before the Commissioner of Inland Revenue at that time, Lau Mak Yee-ming, Alice, retired. Whilst the DIPNs are issued for information purposes only, they are stated as including “the Department’s interpretation and practices in relation to the law as it stood at the date of publication”. It is interesting to note that this was not the approach adopted by the Department’s counsel in the case of CG Lighting, where Counsel stated that he was not bound by the DIPNs and wished to resort to basic principles.
In my opinion, the concept of “import processing” as the sole means of characterising the nature of a person’s trade is inappropriate. The IRO makes no reference to import and contract processing, clearly seeking to tax only those profits that arise in or are derived from Hong Kong and that accrue to a business carried on in Hong Kong. The Courts have made it clear that to determine whether a profit has been derived from Hong Kong, you must first look to see what the taxpayer did to earn the profit and then where the activities were undertaken. Furthermore, the Inland Revenue Department, in applying the concept of import processing, has adopted a form-over-substance approach by ignoring the involvement of the Hong Kong taxpayer in the offshore manufacturing activity on the basis that all such activities are antecedent or incidental, simply because purchase and sales invoices were issued. This appears to be the case, notwithstanding the fact that the Hong Kong company has total day-to-day management control of the subsidiary company manufacturing in the PRC.
The continued adoption of the concept of import processing, as a means to determine the nature of a business conducted by a Hong Kong taxpayer, needs to stop. The Inland Revenue Department should assess a taxpayer based on the totality of the facts presented to it, evaluating the involvement of the taxpayer and its relevance to the earning of the profit in question.
