Consider this: If a taxpayer is unable to settle an objection against an assessment, the case will be referred to the Commissioner of Inland Revenue (CIR) for his determination. I have only a vague recollection of a case ever being overturned by the CIR. The next step is to appeal the CIR’s determination to the Board of Review (BOR). This requires a case stated, which will incur professional fees.

The BOR is an independent tribunal charged with establishing the facts and expressing a legal opinion based on those facts. A taxpayer with a factually sound case has a reasonable chance of success at the BOR, but more professional fees will be incurred and they cannot be reclaimed, even if the taxpayer should ultimately win the appeal.

Assuming the case was won at the BOR, the taxpayer must expect the CIR to appeal the decision to the Court of First Instance or the Court of Appeal. Why? Because the CIR’s costs are met by the HK Government out of taxpayers’ taxes, whereas the taxpayer will be faced with meeting all the costs, including those of the CIR, should the appeal fail. However, that is not the only reason. Consider also the fact that most tax appeals heard by the Court of Appeal, under the Hon Tang Ag, CJHC, fail. Worse still, we have recently seen that even if a taxpayer was inclined to pursue a case to the Court of Final Appeal (“CFA”), the CFA either has no wish to be inundated by tax cases or is just too busy to hear more appeals from lower costs, so there is little chance of having the case heard by the CFA. The result is that the case will get no further than the Court of Appeal, which appears to be very pro the CIR.

So at the end of the day, the taxpayer will have lost his appeal and will be required to pay the tax in dispute, plus possibly interest as well, and will have incurred around HK3-4 million in professional fees. Would you appeal? Probably not, so do not be surprised if the CIR becomes more aggressive in pursuing tax cases.

Corporate groups in Hong Kong may:
• pay tax as a group even though the consolidated group accounts may show a loss
• have a higher effective tax rate
• be disadvantaged from a cashflow standpoint
• feel forced to adopt contrived strategies to utilise stranded tax losses
• have inadequate resources to embark on new business initiatives that would suffer losses in the initial years of operation

In March this year, Professor KC Chan, the Secretary for Financial Services and the Treasury, stated:

“The “group loss relief” suggestion involves a number of complicated issues, such as how to ascertain whether companies are members of the same group, and their loss set-off arrangements with each other. The proposed measure could also be easily abused for tax avoidance. Hence, its implementation must be complemented by complicated legislative provisions to define clearly the scope of application so as to avoid tax abuse. This would inevitably complicate our simple tax regime. Separately, as small and medium enterprises (SMEs) in general do not operate as a group, the “group loss relief” suggestion would not benefit the SMEs at large, which constitute 98% of business establishments in Hong Kong.
As for the “loss carry-back” suggestion, since the proposed measure may result in tax refunds at any time, it may cause drastic and unpredictable fluctuations in tax revenue, rendering the tax revenue more vulnerable to economic cycles. We believe that our current arrangement for enterprises to carry forward their losses without time limit to offset profits in future years should be able to assist enterprises to manage their losses and remains attractive to investors.
Given the above considerations, we are of the view that it is not appropriate to introduce the “group loss relief” and “loss carry-back” arrangements at this juncture.”
This view is not shared by our neighbours, with which Hong Kong competes to be recognised as the favoured location for the establishment of regional headquarters or as a base for Asian business operations. Australia, New Zealand, Singapore, Malaysia and Japan, Hong Kong’s principal competitors, permit group relief, whether on consolidation or in the form of loss transfer.
Personally, I find the reasons advanced by the Government a poor excuse for its failure to undertake a thorough review of this issue. It is also very sad that the Government does not feel it appropriate to issue a consultation paper to the appropriate interested parties for their views and recommendations as to how group relief could be implemented in Hong Kong. Of course doing nothing is the easier option.

At the Board of Review, the Commissioner of Inland Revenue (“the CIR”) suggested that L&F operated a “supply chain management business” and that the 4% commission paid to the affiliates was for the offshore services, whilst the 2% retained by L&F was for the management of the services undertaken in Hong Kong, and was therefore taxable. The Board of Review applied the principles enunciated by the Court of Final Appeal’s judgment in ING Baring Securities (Hong Kong) Ltd v CIR (2007) to HKCFAR 417, namely that section 14 of the Inland Revenue Ordinance required the identification of those activities that directly gave rise to the earning of the commission profits as opposed to those activities that, whilst important, were incidental or antecedent. Having ascertained the relevant activities, it was then essential to determine where they were performed.

The Board of Review held that L&F was a commission agent and that the services for which it received a commission were undertaken offshore. Accordingly, the Board held that L&F’s profits from this source had been correctly filed as offshore and were not taxable.

On appeal to the Court of First Instance, Mr Benjamin Yu, SC on behalf of the CIR, suggested that the commission income was derived from both a Hong Kong source and an offshore source and hence should be apportioned. This opinion was based on the “brain analogy”, in that the knowledge of the business rested with the senior management, to whom junior staff frequently referred. Reyes J rejected the “brain analogy”, previously cited in ING Barings, on the basis that the administrative and oversight functions undertaken in Hong Kong were not relevant criteria for ascertaining the geographical location of the commission profit.

Reyes J concluded that the Board of Review had directed itself correctly in the analysis of the facts, in that “it was not the Board’s function to investigate every facet of L&F’s operations and then decide which matters were qualitatively the most important towards making a profit. What instead had to be done was what the Board actually did. That was to discern in a practical manner those activities of L&F which directly (as opposed to indirectly) led to the production of profits”.

Inevitably Reyes J, having decided in favour of the taxpayer, has had his judgment appealed by the CIR to the Court of Appeal, which, as we have seen, has a track record of finding in favour of the CIR. I await the decision with interest, and am also curious to see which judges are chosen to sit on this case.

The Court of Appeal’s decision, delivered by The Hon Tang Ag CJHC, dismissed the appeal by CG Lighting Limited (“CGL”) against Fok J’s judgment in the Court of First Instance and upheld the position of the Commissioner of Inland Revenue (“CIR”) that 100% of CGL’s profits were sourced in Hong Kong. This came as no surprise, as past experience has indicated that only when cases are heard at the Court of Final Appeal, for which experienced international tax judges are brought in to sit on the bench, can a taxpayer expect a clear interpretation of Hong Kong’s tax laws.

I assume that many people who have read the decision will share my opinion that there was a strong expectation by the Court of Appeal that the case would be appealed to the Court of Final Appeal. Such people will probably not be surprised that the judgment lacks substance in its analysis of the law. However, I was surprised by the comments of the Court of Appeal that were directed at the Board of Review’s findings on fact which, in Tang’s own words, were “not something with which we are required to deal”, yet were expressed anyway, albeit in passing. This is certainly a practice that should be avoided.

Whatever my opinion of the decision, it pales into insignificance when compared with my disgust at the CIR’s refusal to grant consent to CGL’s application to appeal the Court of Appeal’s decision to the Court of Final Appeal. CGL has now applied to an appeal committee of the Court of Final Appeal for leave to appeal to that Court. I suspect that such an appeal has been based on the amount of tax involved, and also on the fact that the issues are of great or general public importance. Certainly for the case to be concluded at this stage would be a huge, if not unexpected, bonus for the Inland Revenue Department.

Personally, I am extremely disappointed that neither the CIR nor the Court of Appeal was able to appreciate the importance of taking this case to its final conclusion. If you were a cynic, you might conclude that the CIR saw this as an easy way to win the case before it could be heard by an experienced revenue judge. In my opinion, such a course of action, whilst to the CIR’s benefit, shows a total lack of interest in seeking an important decision on one of Hong Kong’s more contentious issues. Similarly, it would also be easy to conclude that the Court of Appeal did not wish to have its own decision in this case, and the decision in the earlier case of Datatronics, reviewed and possibly overturned by a court of higher authority.

I sincerely hope that common sense prevails and that leave to appeal to the Court of Final Appeal is forthcoming.

Paragraph 27 of the Departmental Interpretation and Practice Notes No.21 (Revised), dated December 2009 (“DIPN”), clearly states that it is the Department’s view that profits derived by a re-invoicing vehicle from the provision of services will be taxable, whereas those profits derived from the purchase and sale of products, not being service income, should fall outside the charge to profits tax.  However, paragraph 28 of DIPN 21 states that it is not possible to categorise the circumstances under which income or profits derived by a re-invoicing vehicle would be regarded as service fee income as opposed to trading profits.

The tightening of the IRD’s practice has already started to create confusion, primarily due to the fact that some of the Department’s assessors appear to be reluctant to allow any form of offshore claim.  The IRD’s focus appears to be on the words of Lord Jauncey in HK-TVBI, i.e. “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”.  In my view, this disregards the accepted approach adopted by the courts for the determination of the source of a given profit.  At no time has the maintenance of a place of business in Hong Kong been regarded as being indicative of the source of profit.

I would like to share with you a typical example of this practice.  The relevant facts of the case are as follows:

• An offshore business was incorporated a company in Hong Kong to book a particular type of trading profits.
• The company did not trade with any person carrying on business in Hong Kong.
• The taxpayer advised the IRD that all the negotiations and the conclusion of the contracts of purchase and sale took place outside Hong Kong.
• The only activity that took place in Hong Kong was the preparation of the hard copy of the sales invoice, based on information supplied from overseas.  Even then, the invoice had to be approved by senior staff outside Hong Kong before it could be sent to the customer.
• The company did not have a physical office in Hong Kong; it had no employees in Hong Kong, and it did not engage anyone in Hong Kong with the authority to negotiate or conclude contracts on its behalf.

Although initially the company was not able to provide a comprehensive set of documents in support of the claim, this has now been done.  Notwithstanding the fact that there are no activities in Hong Kong capable of generating the profits in question, and the profits are not derived from Hong Kong, the IRD has stated that the profits in question are subject to Hong Kong tax.  The IRD concluded that the earning of the profit was due to the special nature of the company incorporated in Hong Kong, and hence the profits have a Hong Kong source.  To make matters, worse, the company has been fully assessed and the IRD has refused to give the taxpayer an unconditional holdover.

In the 30 years I’ve been practising tax in Hong Kong, I’ve never heard of such an unusual interpretation of section 14 of the Inland Revenue Ordinance and of the case law relevant to section 14.

I would like to think that this is an anomaly, but I fear it is symptomatic of the IRD’s current practice.  This will not only create unnecessary uncertainty, it will also ensure that it will become an expensive exercise for a taxpayer to establish that a source of profit is not subject to tax.

Notwithstanding the fact that there are mixed views on a number of issues, there is a clear message that Hong Kong’s legislation needs to be reviewed with regard to a number of issues, including:

- the rules for determining the source of employment income;
- the rules for determining the location of the source of corporate profits;
- the carry-back of tax losses, and
- the implementation of group relief.

Even though the Inland Revenue Department recently published a revised Departmental Interpretation and Practice Note on the question of the Location of Profits, uncertainty and disagreement remain as to the legal correctness of its contents.
Equally, the proposals for loss relief are consistent with those submitted in past years; they have been met with resistance from the Financial Secretary on the basis that such legislation will give rise to a loss in revenue, complex tax law and the use of tax-avoidance arrangements. All these can be resolved if there is now a willingness to do so.

Although there are differences of opinion as to whether the standard rate of profits tax and salaries tax should be reduced, the same cannot be said about the concept of providing assistance to SMEs in the form of a small companies rate of profits tax. This is unlikely to cause a significant loss in tax revenue, as the larger corporations pay the majority of profits tax collected, i.e. the top 1,200 corporate taxpayers contributed 72.6% of the profits tax collected in 2007/2008.

There are many other proposals, all of which are credible, ranging from accelerated relief for expenditure on green buildings, the implementation of transfer pricing legislation, deductions for private medical contributions, incentives for Hong Kong’s fund management industry, a comprehensive review of the legislation dealing with intellectual property, increasing Hong Kong’s double taxation treaty network etc. etc.

There is no doubt that the Financial Secretary would like to please all sectors of the community, but the question remains: How are such incentives to be funded? Even though there may be better-than-expected collections from Stamp Duty and Land Premium, turning a HK$39.9bn deficit for 2009/10, as predicted in the Medium Range Forecast, into a budget surplus will require significant improvements in all aspects of the Government’s income and expenditure. Even though the Government has very significant financial resources, the Financial Secretary is unlikely to implement proposals that are likely to erode the Government’s reserves. Sadly, the proposals do not consider ways of increasing revenues, but merely suggest that the Government should review the opportunities to widen Hong Kong’s tax base. Seeing that repeated attempts to introduce a sales tax have been thwarted, this may prove difficult. However, there are a number of proposals that are tax-neutral and that should be evaluated and debated.

Hong Kong’s direct and indirect tax rates are already amongst the lowest in Asia, and whilst a reduction in the headline rates will initially be acknowledged by potential investors, it is unlikely to result in attracting significant investment. It is the totality of Hong Kong’s attributes that’s important, i.e. its location; its education system; its communications, logistics and transportation infrastructure; its legal and political system etc. So why arbitrarily reduce the rate of corporate tax when funds are clearly needed to implement social programmes?

I agree that the DIPN “health warning” does say that;

“Taxpayers are reminded that their right of objection against the assessment and their right of appeal to the Commissioner, the Board of Review or the Court are not affected by the application of these notes”

This is fair enough as the taxpayer should have a right of appeal if the person does not agree with the approach taken by the Department, however what is not stated is that the Department also considers that it is not bound by its own DIPN.  This was made clear in the case BR92/07 in which the Board reaffirmed that “the IR (Commissioner of Inland Revenue) contends that it is not bound by the concession set out in DIPN 21 and this appeal should be resolved by applying the relevant charging provisions of the Ordinance as construed by the case law”.

This is disturbing from two perspectives.  Firstly, that it would appear that the Department cannot be relied upon to apply its own stated practice and secondly that the most important of all the DIPNs i.e. No.21 (Revised) “Locality of Profits” is clearly out of date.  Whilst the Department may endeavor to keep the DIPNs current it concerns me that the one DIPN that is fundamental to understanding whether a source of income is taxable in Hong Kong simply cannot be relied upon.  Whilst I appreciate that the health warning does say that a DIPN is based on the law “as it stood at the date of publication” there is no excuse for not amending such an important document as and when court decisions provide further clarification on the interpretation of the Inland Revenue Ordinance.  I have said in past “Rants” it is extremely important for corporations, particularly persons looking to establish a business in Asia, that they are able to budget for their future liability to tax.  This current uncertainty does not help Hong Kong’s cause.

I suspect I am one of many who look forward to DIPN 21 being updated, a lot has happened since it was last revised in 1998!

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People may consider this a futile exercise, but in my opinion this is far from being the case.  The 2009 budget lacked substance, or at the very least any original thought, as to how the Government will help people suffering from the economic downturn.  It wasn’t until the community expressed its own dissatisfaction with the budget proposals and reinforced the needs of both individuals and business that something was done.

Our tax rates are affordable, and although our competition seeks to lower headline direct tax rates, this is usually done at the expense of raising the rates of indirect taxes or introducing new taxes such as value-added taxes or other forms of consumption or sales taxes.  Direct and indirect taxes, together with the land premium, account for most of the Government’s revenue.  Implementing proposals that have the net effect of eroding this tax basis without increasing collections from other sources will severely hamper the Government’s ability to fund its social welfare programmes.  My first “wish list” therefore consists of proposals that would enhance Hong Kong’s attractiveness as the prime location for establishing a business in Asia, with minimal loss of revenue to the Government.

The following is a very brief description of these measures.  Some of them have been voiced in the past, have been ignored and now need to be restated.  I intend to comment further on those issues in subsequent “Rants”.

(1)     Greater Clarity and Understanding of How to Ascertain Whether Income is Subject to Hong Kong Tax Section 14 Inland Revenue Ordinance (“IRO”)

A corporate manager needs to have a clear understanding of a company’s liability to taxation.  It’s unfortunate that there is widespread uncertainty about how the Inland Revenue Department (“the Department”) will apply S.14 IRO, Hong Kong’s charging section to Profits Tax.

The Department needs to amend its “Departmental and Interpretation Practice Note No21 – Locality of Profits” to reflect recent case decisions that have considered the meaning of the words “profits arising in or derived from Hong Kong” and that are accepted as legal precedents.  These include the determination of what constitutes an offshore employment and the correct approach that the Department should adopt in determining whether profits accruing to a business are subject to Hong Kong tax.  In particular, the Courts have clearly stated that the adoption of a “totality of facts” approach leads to an unnecessary and time-consuming review of antecedent and inconsequential acts, and have recommended that the Department focus instead on a company’s activities more immediately responsible for earning the profit in question.

(2)     Introduction of Group Relief for Losses

This has been on every businessperson’s agenda for a very long time.  This regime enables group companies (to be defined by a percentage of shares held) to surrender or sell tax losses to other companies within the same group.  There is no loss of tax revenue to the Government unless a company is liquidated or sold, merely an acceleration of relief for the taxpayer.  Group relief provisions are made available by most sophisticated jurisdictions and should be introduced in Hong Kong. This would also avoid the need for companies within a group to charge each other “tax-driven” management fees etc.

(3)    Carry Back of Losses

Whilst group relief provisions are common, those jurisdictions that do not permit group relief will normally allow a taxpayer to carry back losses for a period up to five years.  Again there is no loss of revenue to the Government, merely an acceleration of relief, as losses would normally be set off against future profits earned by the company.

(4)   Expansion of Tax Treaty Network

We have seen an increase in activity in this area, which will soon be facilitated by an amendment to the Inland Revenue Ordinance to permit the Department to provide wider exchanges of tax information to tax-treaty partners.  However, every attempt should be made to negotiate double taxation treaties with Hong Kong’s trading partners.

(5)   Tax Incentives for Research and Development

Whilst this will cost the Government tax revenues, it is nevertheless an integral part of a strategy to attract and retain talent and knowledge in Hong Kong.  In order to be competitive with other Asian countries, the Government should consider introducing incentives in the form of additional tax deductions for qualifying expenditure.  I suggest that this should initially be 150% of the expenditure incurred and should focus on scientific research.

(6)     A Reduced Taxation Rate for Small Companies

To assist small companies, I would recommend a 10% tax rate for companies with an assessable profit of less than HK$2m.  Whilst this will inevitably cause a reduction in revenue for the Government, I do not anticipate that this will be significant, as “small” companies account for only a relatively small percentage of profits tax collected.  Such a two-tiered system would do nothing more than put Hong Kong on a similar basis as our Asian neighbours, and would encourage entrepreneurs and new enterprises to locate their operations in Hong Kong.

These are just a few of my preliminary thoughts.  I would appreciate hearing from you about the issues that are close to your heart and need a bit of a “push”.