I suspect that Mr Yu, SC, leading counsel for the Commissioner, was as surprised as anyone to have succeeded at the Court of First Instance, particularly as The Hon Fok J did not find for the Commissioner on its principal submission, i.e. that because the taxpayer had acquired products from its subsidiary by way of a purchase and sale agreement, as opposed to a process manufacturing agreement, the Board of Review should have focused only on the sale of goods in determining the geographical location of the Taxpayer’s profit-producing transactions.  Instead, The Hon Fok J agreed with Mr Yu’s subsidiary submission that the Taxpayer’s involvement with the manufacturing process, conducted by the Taxpayer’s subsidiary (CGES), was antecedent or incidental to the source of the Taxpayer’s profits.  The Hon Fok J stated:

“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.”

And later:

“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.”

He concluded:

“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 manufacture of the goods by CGES, and the on-selling of the same to its customers.”

I sincerely hope that this case will be appealed to the Court of Appeal, although I suspect it is destined to proceed ultimately to the Court of Final Appeal.  The grounds for the appeal are likely to be comprehensive, and will, I hope, address such issues as:

• the manner in which the Board of Review’s decision has been interpreted;
• the application of previous decisions to this case, in particular the identification of those activities that were responsible for generating the profits of the taxpayer;
• the conclusion that the Taxpayer’s involvement in the manufacturing process was antecedent or incidental;
• the characterisation of the Taxpayer as a trader, notwithstanding the contrary presentation in audited accounts, and
• the failure to consider the legal aspects of whether CGES acted as an agent for the Taxpayer etc.

It will be interesting to follow this case through the appeal procedure, and I also hope the decision by the Court of Appeal in the case of CIR v Datatronic [2009]4 HKLRD 756 will be reviewed.  Until this case has reached its final conclusion, it is unlikely that those cases with similar facts, and which are currently under objection or appeal, will be decided.

Withholding Tax Rates Under Hong Kong Treaties

• The Hong Kong General Chamber of Commerce (“HKGCC”)
• The British Chamber of Commerce
• The Hong Kong Institute of Certified Public Accountants
• The Taxation Institute of Hong Kong

On reviewing the submissions from those organisations, I noticed that all were lobbying the Government to enact new provisions to allow group relief for losses and/or the carry-back of agreed tax losses to prior years of assessment.  Whilst there is strong support for the introduction of group relief provisions, the minimum the business community sought was the ability to carry back losses.

This was not the first time that this request had been made.  In his 2006 Budget speech, Henry Tang made the following argument for not introducing group relief:

“With the development of today’s financial tools, group loss relief can easily be observed as a means to evade tax, and such activities would be very difficult to combat.  I estimate that the suggested exemption, if implemented, would cost billions of dollars a year in lost tax.”

However, such countries as Australia, France, Germany, Japan, the Netherlands, the United Kingdom, the United States and Singapore, to name but a few, have provisions that provide for group relief, on either a consolidated basis or a loss transfer basis.

The absence of group relief places a conglomerate, operating through a group structure, at a tax disadvantage when compared with a single legal entity that can offset profits and losses between its business divisions.  There are many reasons why a group structure makes commercial sense.  For example, it could be a means of protecting individual businesses from non-tax risks.  So it makes no sense for modern legislation to create this uneven playing field.

Again, I refer to the HKGCC’s response to the allegations that such legislation would require additional complex legislation and that there could be a loss of revenue through schemes for avoiding profits tax:

“Singapore only added one section (Section 37C) to the Singapore Income Tax Act when it introduced the group loss transfer system… Singapore did not deem it necessary to enhance its own anti-avoidance legislation and, to the best of our knowledge, has not had to resort to application of even the existing regulations to any taxpayer.”

Clearly, the more simplistic of the two proposals is the carry-back of agreed tax losses for a given period.  All that this legislation would require is that current year’s agreed tax losses could be offset against prior-year profits for a given period, commencing with the proceeding year, with any unrelieved loss being carried forward.  The taxpayer would receive a refund of tax paid as opposed to a reduction of future tax liabilities.  Loss carry-back provisions can be found in the legislation of many countries, including Canada, France, Germany, Ireland, Japan, the Netherlands, Singapore, the United Kingdom and the United States.

Whilst the current Financial Secretary has been quiet on this issue, Henry Tang commented in 2006:

“While taxpayers who suffer losses in their business may be helped to a certain extent to tide over difficult times by loss carry-back arrangements, this would place enormous pressure on tax revenue during periods of economic downturn.  The government would not only suffer a loss in tax revenue, but also have to refund tax collected in proceeding years.”

I am unsure as to the significance of the “loss in tax revenue”, as there would be no additional loss of revenue in the year the loss was incurred and the value of the losses carried forward would be reduced.  Furthermore, the reality is that this is only a timing difference as opposed to an actual loss of revenue, unless, of course, the taxpayer never became profitable again.

The benefits to taxpayers of these two proposals are very clear.  They could facilitate better cash flow; encourage companies to expand their activities in Hong Kong, and reduce the amount of additional capital that may be required.

Clearly the business community considers that these amendments to the Inland Revenue Ordinance are both appropriate and necessary.  Notwithstanding the fact that such proposals have been adopted by many other jurisdictions, they have been steadfastly ignored by the Financial Secretary.  Despite assurances to the contrary, I feel that the Government is not listening to the business community.  However, I do fully endorse the view that issues of this nature need to be discussed more frequently and openly, not simply by select committees.

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?

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.

In my opinion, this makes a great deal of sense and would facilitate the earlier filing of tax returns for smaller companies.  There is little risk of fraud, as the directors of the company remain responsible for the accuracy of the company’s financial reports, in terms of both tax filings and the company’s obligations to its shareholders.

I would strongly encourage the Government to consider the sense of this and move towards implementing similar provisions in Hong Kong.

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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An across the board reduction in the rate of taxation will benefit all people carrying on business in Hong Kong whether it is major corporation or a sole trader. Is it necessary to benefit large multi-nationals at the expense of the Government’s revenue? If there is a desire to assist SMEs perhaps the Government should be encouraged to introduce a small companies rate, i.e. say a 10% profits tax rate for companies whose profits or turnover (whichever is considered appropriate) falls below a specific threshold.

In contrast an issue of importance to SMEs is their ability to obtain immediate relief for agreed tax losses. At present losses can only be carried forward against future profits. I would strongly urge the Government to permit the carry back of losses, for say a period of 3 years, and give consideration to allowing the transfer of losses within a group of companies. Such a proposal will not give rise to a tax leakage it will merely accelerate the timing of relief to a taxpayer. After all it can be argued that a person should not be paying tax when their aggregated revenue results show a loss position.

Finally, I would add that the reduction of tax rates neither solves the Government’s problem regarding Hong Kong’s narrow tax base nor will it assist the Government’s ability to fund its social welfare programme.

Whilst the Government will look to amend Section 51 Inland Revenue Ordinance to enable the Inland Revenue Department to obtain information that may be relevant to a person’s liability to tax in a territory outside Hong Kong, such information can only be given relative to an exchange of information article contained in a comprehensive double taxation arrangement; Hong Kong has no such arrangement with the US at the present time.

Furthermore, the requesting authority must be able to satisfy the Inland Revenue Department that the information is necessary for the enforcement of that country’s tax laws.  The Inland Revenue Department has indicated that it would need to be convinced that there was an investigation in progress into the affairs of the taxpayer and that there were grounds to believe that the Hong Kong authorities had information relevant to that investigation – ‘fishing’ exercises will not be entertained.

It has also been indicated that the Inland Revenue Department will advise a Hong Kong resident of any such request and of any information it will release to a foreign authority.

In conclusion, whilst I do not condone tax planning through willful non-disclosure, it is wrong to suggest that any overseas tax authority will have unrestricted access to information held by the Hong Kong Inland Revenue Department.