Most, if not all, of the recommended revisions to our tax system are based on a perceived need to maintain Hong Kong’s competitiveness. Reference is made to the World Bank’s report which places Hong Kong’s effective tax rate above the average for East Asia, Singapore, Taiwan, Korea and Malaysia.

Notwithstanding that, I question whether taxation is that important in the minds of CEOs and CFOs when a decision needs to be made as to the most favourable location for an Asian regional office. Other significant considerations are likely to include;

• Infrastructure
• Legal System
• Availability of Education
• Location
• Transportation
• Financial Services
• Quality and availability of the workforce
• Languages spoken
• Stability and convertibly of the domestic currency
• Cost of Living

As stated above I am yet to be convinced that taxation, and hence a reduction in the standard rate of profits tax, is likely to materially influence Hong Kong’s attractiveness as a place to establish an office. I would also raise the question as to which companies would benefit from a reduction in the standard rate of profits tax. In the year of assessment 2009/10 (the latest available statistics) 60% of those companies paying profits tax paid less than HK$25,000, whilst the vast majority of the profits tax collected was paid by a very small number of corporations. A two-tiered system, whereby a lower rate of tax would be payable by those companies with a low level of profit, would certainly benefit the majority without causing a huge loss in revenue by the Government. The implementation of such a proposal is unlikely to be an arduous task to either the Government or the Inland Revenue Department.

Equally, whilst there are numerous reasons to support the introduction of group relief and/or the carry back of tax losses this has been dismissed by past Financial Secretaries on grounds that such an amendment to Hong Kong’s tax legislation would diminish the Government’s revenues, over complicate the Inland Revenue Ordinance and open the door to tax avoidance. All these contentions can be easily refuted.

Sadly, very few of the General Public’s proposals are likely to be adopted. Notwithstanding that the level of reserves remains high, the latest statistics show that they are equal to 24 months of Government expenditure, and it is likely that the run of seven consecutive years of consolidated surpluses will not be broken in 2011/2012, the gloomy economic outlook for Europe and its effect on Hong Kong will provide the Financial Secretary with the weapon he needs to keep the purse strings tightly tied.

I sincerely hope that the Financial Secretary will not have to face another embarrassing situation, as he did in 2011, and be forced to significantly amend his budget in order to gain the Legislative Council’s approval.

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.

Having been involved in this process for many years, I question the value of making such submissions, as the Government rarely provides any rational explanation for repeatedly ignoring proposals penned by the majority of contributors to the process.  Examples of proposals that have had the support of the majority of the submissions over the years include:

• Group Loss relief
• Loss carry back
• Clarification of the criteria for determining the source of profits
• A small companies rate of tax
• Incentives for the establishment of a regional office in Hong Kong
• Increased relief from salaries tax for taxpayers’ voluntary contributions to approved MPF schemes

These types of proposals are neither irrational nor unrealistic in the context of Hong Kong’s current economy or medium- to long-term development strategy.  Indeed, they are common features of most modern and sophisticated tax systems.  The most frustrating issue is the Government’s apparent reluctance to debate these proposals openly, thereby denying the business community a clear understanding as to why the proposals are considered inappropriate.  Perhaps then we would not waste our time including these proposals in the 2011-12 submissions.  Perhaps for 2011-2012, people should simply ignore the Financial Secretary’s request for submissions.  Sadly, however, this would probably be seen by the Government as an acknowledgement that no improvement is necessary to our tax system and its implementation by the Inland Revenue Department.

• 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.

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”.

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.

Mr Justice Ribeiro PJ criticised the approach taken by the Inland Revenue Department in raising the additional assessments on the taxpayer and emphasised the need for the Board of Review to clearly identify the tax benefit which was being challenged by the Inland Revenue Department, the transaction which conferred the benefit on the taxpayer and the person or persons having the sole or dominant purpose of conferring the tax benefit.

In Mr Justice Ribeiro PJ’s opinion;

“The practice of the Board in Section 61A cases should be to issue directions to such particulars to be supplied by the Revenue which may be particulars in support of alternative cases before the start of the hearing. That is not to say the Revenue’s particulars cannot be altered. Amendment should be permitted if the evidence or submissions support the existence of a viable alternative or different scheme or tax benefit unless this causes unfairness which cannot be alleviated by case management measures… The aim should be that everyone knows at every stage how Section 61A is sought to be applied in the particular case.”

This opinion is refreshing and most welcome.  Only too often the Inland Revenue Department issue far reaching additional assessments that extend beyond the transaction conferring the tax benefit, a fact illustrated by Mr Ho, counsel for the Commissioner of Inland Revenue, who in the words of Mr Justice Ribeiro PJ stated that;

“It was not for the Commissioner to justify the assessments made but for the taxpayer to discharge the onus of showing that the additional assessments were excessive or incorrect pursuant to Section 68(4) of the Ordinance.”  The Court found in the present case that the exercise of the Commissioner’s power had been miscarried.

However, often in cases of this nature, a taxpayer may have been required to purchase tax reserve certificates paying derisory rates of interest should the taxpayer’s contention be found to be correct.

I have always questioned why the rate of interest payable on tax reserves certificates should not be the same as the rate of interest payable on unpaid tax, afterall the affect has been to deprive the taxpayer of working capital which is no different from the depriving the Inland Revenue Department of it’s revenue.

Following this decision I sincerely hope that considerably more care and thought is given by the Inland Revenue Department to the methodology applied in determining the profits to be assessed under Section 61A, or indeed other charging sections within the Inland Revenue Ordinance.