In DIPN 21, the Department reiterates the “broad guiding principle” on source explained by Lord Bridge in CIR v Hang Seng Bank Ltd [1991] AC306:

“the question whether the gross profit resulting from a particular transaction arose in or derived from one place or another is always in the last analysis a question of fact depending on the nature of the transaction.  It is impossible to lay down precise rules of law by which the answer to that question is to be determined.  The broad guiding principle, attested by many authorities, is that one looks to see what the taxpayer has done to earn the profit in question.”

This was further expanded by Lord Jauncey in CIR v HKTVB  International Limited [1992] 2 AC 397:

“Thus Lord Bridge’s guiding principle could be properly expanded to read “one looks to see what the taxpayer has done to earn the profit in question and where he has done it.””

More recently in Kwong Mile Services Ltd v CIR [2004] 3 HKLRD 168 Bokhary PJ remarked:

“Apart from the words of the statute themselves, the only constant is the need to grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters.”

The subject of the majority of “offshore claims”, i.e., profits that are claimed by the taxpayer as not having arisen in or not having been derived from Hong Kong, concern profits earned from trading and manufacturing activities.  In the remainder of this article, I will focus on trading profits, whilst the thorny issue of what constitutes an offshore manufacturing profit will be dealt with in a subsequent article.

Lord Bridge in Hang Seng Bank stated that the relevant activities that gave rise to the profits from commodity trading were the contracts of purchase and sale and that the location of the source of such profits was determined by the location where these contracts were effected.  In DIPN 21, however, the Department states that it “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, trading financing, shipment and performance of the contracts.”  The following reflects the Department’s current assessing practice:

“(a)   Where both the contract of purchase and contract of sale are effected in Hong Kong, the profits are fully taxable.

(b)    Where both the contract of purchase and contract of sale are effected outside Hong Kong, no part of the profits are taxable.

(c)    Where either the contract of purchase or contract of sale is effected in Hong Kong, the initial presumption will be that the profits are fully taxable.  Matters, such as those mentioned in paragraph 18 above, will be examined to determine the issue.

(d)    Where the sale is made to a Hong Kong customer (including the Hong Kong buying office of an overseas customer), the sale contract will usually be taken as having been effected in Hong Kong.

(e)    Where the commodities or goods are purchased from either a Hong Kong supplier or manufacturer, the purchase contract will usually be taken as having been effected in Hong Kong.

(f)     Where the effecting of the purchase and sale contracts does not require travel outside Hong Kong but is carried out in Hong Kong by telephone, fax, etc., the contracts will be considered as having been effected in Hong Kong.

(g)    The purchase and sale contracts are important factors but all the relevant operations that produce the trading profits must be looked at to determine the locality of the profits.”

However, it must be remembered that it is the taxpayer who is making the claim that the profits are not subject to Hong Kong tax, and hence it is incumbent on the taxpayer to provide sufficient evidence to the Department to justify the claim.  I have seen many examples where the taxpayer or the taxpayer’s representative simply states that the said profits have been excluded because “they arose offshore”, or that “the sales and purchase contracts were concluded offshore” etc., without further explanation or documentary support.  In my opinion, the taxpayer should not be surprised to receive a five-page letter from the Department requesting such information as is necessary to enable the Department to assess the correctness of the taxpayer’s claim.  Typical information required would include:

• A copy of the organisational chart of the taxpayer.

• Details of the taxpayer’s offices, both in Hong Kong and abroad.

• The functions of each office.

• Details of the persons employed by each office, their title, job description and whether they have any authority to execute contracts on behalf of the taxpayer.

• The nature of the taxpayer’s products, together with catalogues, price lists etc.

• A full description of the taxpayer’s mode of trading, including but not limited to:

-     How and by whom was the original contact made with the customer?

-     Who negotiated the contracts of sale?

-     Where were the sales contracts negotiated?

-     Where was the customer’s purchase order sent, and who approved it?

-     Where were the sale invoices prepared and who provided the information necessary to prepare the invoice?

-     Who approved the invoice and where was that person located?

-     Who identified the suppliers and where did such meetings take place if appropriate?

-     Who was responsible for negotiating the purchase price?

-     Who prepared and approved the purchase order?

-     Who arranged for the shipment of the goods?

-     Who approved the suppliers’ invoices for payment?

-     Who authorised the payment of suppliers’ invoices, and where were the payments effected?

• The Department will also ask for a comprehensive set of documents relating to one or two specific purchase and sale transactions.

• A schedule may be required illustrating the taxpayer’’ 10 largest suppliers in a given year of assessment.

• A schedule may be required illustrating the taxpayer’’ 10 largest customers in a given year of assessment.

• A full description of the basis of the offshore claim.

• Identification of the general overhead administrative expenses attributable to the offshore income.

Sadly, even if it can be demonstrated that both the contracts of purchase and sale were negotiated and concluded offshore, the IRD may still attempt to refute the taxpayer’s contention if any activity is undertaken in Hong Kong, however ancillary or incidental it may be to the earning of the trading profit.

In order to avoid such unnecessary and protracted correspondence, I would strongly recommend that all taxpayers who are considering making an offshore profits claim provide the Department with a full description of the activities giving rise those profits said to have an offshore source.  The taxpayer may even consider attaching a set of documents relating to a representative transaction for which the claim has been made.

Whilst this process may seem very tedious, once the claim has been agreed with the Department it is very unlikely that the enquiry will be repeated for several years, unless the taxpayer’s mode of trading changes.  This should enable the taxpayer to plan its affairs in a tax-effective manner and to confidently estimate any profits tax due.

In the next article I will deal with how to make an offshore claim in respect of manufacturing profits.

When discussing the definition of the word “business”, I concluded that it takes only a relatively low level of activity for the courts to deem that a person is carrying on a business.  However, whether a person is carrying on a business in Hong Kong is a question of fact.

Many persons who are not Hong Kong residents may have incorporated a company in Hong Kong into which they may have “booked” profits, with the belief that the said profits would not be taxed.  Typically, the Hong Kong company (“HKCo”) may have no employees and no office in Hong Kong.  All the contracts of purchase and sale may have been negotiated outside Hong Kong by persons not resident in Hong Kong.  The principal activities carried on in Hong Kong may have been those required under Hong Kong law, i.e., HKCo will require a registered office in Hong Kong and a Hong Kong-resident Company Secretary, and must have the company’s accounts audited.

Companies such as HKCo may appoint a third party, such as a corporate services provider, to undertake those and other administrative services.  Prior to the revision of the “Departmental Interpretation and Practice notes No.21 (Revised) – Locality of Profits” in December 2009, the Inland Revenue Department (“the Department”) would have accepted that HKCo’s profits were not subject to tax.  The Department’s practice prior to December 2009 was as follows:

“There may be cases where the activities of a Hong Kong trading business are limited to the following –

a)issuing and accepting an invoice (not order) to or from an ex-Hong Kong customer or supplier (whether related or not) on the basis of contracts of sale or purchase already effected by an ex-Hong Kong associate;

b)      arranging letters of credit;

c)operating a bank account, making and receiving payments, and

d)     maintaining accounting records.

This situation commonly arises when a Hong Kong business, as a member of a group pursuant to a group directive, carries out the above activities and “books” the profits in Hong Kong.  Provided the activities of the Hong Kong business do not include the acceptance or issue of sale or purchase orders in or from Hong Kong, the profits would not be taxable.”

This paragraph has been withdrawn, and has been replaced by a comprehensive discussion on the “source” of profit that, among other things, explains the operations that the Department considers to be of importance in its determination of whether a profit is derived from Hong Kong.  Inevitably, this has given rise to uncertainty and has created opportunities for the Department to challenge many of the claims previously made by taxpayers and accepted by the Department.

A favourite case cited by the Department is D107/96.  The case concerned a company incorporated in Hong Kong, established to book the profits derived from a single overseas customer.  All the contracts of purchase and sale were negotiated and concluded by an individual permanently resident outside Hong Kong.  As the company in question had no employees or business premises in Hong Kong, it employed a Hong Kong-based corporate services company to undertake certain administrative services.  Such services included the preparation and issuance of purchase orders and pro-forma sales invoices from information provided by the offshore individual, settlement of letters of credit, arranging for the preparation of the audit, etc.

The Board of Review held that:

“In the present case, there were activities outside Hong Kong.  Negotiations prior to the issuing of purchase orders or proforma invoices were carried on outside Hong Kong.  But the vast majority of the activities that followed were in Hong Kong.  Purchase orders and proforma invoices were issued in Hong Kong.  Letters of credit were received and transferred in Hong Kong.  Documents were prepared and presented here in order to obtain payment.  Payments were obtained and made in Hong Kong.  Without these activities, no profit could have gone into the Company’s bank account.”

Having concluded that the corporate services company acted as the agent for the company in question, the Board of Review stated:

“The Company had its directors in Hong Kong.  The books were kept in Hong Kong.  The bank account was in Hong Kong and the authorised signatories were in Hong Kong.”

The Board of Review found that:

“We have no hesitation in finding that the Company did carry on business in Hong Kong.”

The Board of Review then went on to discuss whether the profits arose in or were derived from Hong Kong.  The Board of Review then assumed that the said profits were derived from the business carried on in Hong Kong, which by the Board of Review’s own finding was limited to administrative activities undertaken after the negotiation and conclusion of the contracts for purchase and sale.  Clearly the profit arose from the activities undertaken by the persons resident outside Hong Kong, but could that be said to be a separate business from the administrative services provided by the corporate services company?

With this uncertainty and the change in the Department’s practice, it is not surprising that most claims made by taxpayers under Section 14 IRO relate not to whether a business is being carried on in Hong Kong, but rather to whether the said profit arose in or was derived from Hong Kong.

In my next article, I will briefly discuss the concept of source, and will review the questions that the Department commonly asks when evaluating the substance of a taxpayer’s claim.

The word “profession” is not defined in the IRO, and hence will be given its ordinary meaning, as commonly used.  The Board of Review and courts of law are seldom asked to consider the meaning of the word “profession”, as activities conducted by a profession are likely to fall within the definition of a “trade” or “business”.

Whilst it is important to be able to determine whether a person is carrying on a trade, the concept of carrying on a business is more difficult to define, and requires a significantly lower level of activity than a trade, hence the comment that “every trade is a business, but every business is not a trade.”

The word “trade” has been the subject of many tax disputes.  Cases concerning whether a person is carrying on a trade or an adventure in the nature of a trade will normally be determined by reference to the six “badges of trade”.  These six determining factors are derived from the Final Report of the Royal Commission on the Taxation of Profits and Income 1955, and are as follows:

(1)  the subject matter of the realisation

(2)  the length of the period of ownership

(3)  the frequency or number of similar transactions by the same person

(4)  supplementary work on or in connection with the property sold

(5)  the circumstances that were responsible for the realisation

(6)  motive

The word “business” is defined in Section 2(1) IRO as follows:

“business” includes agricultural undertaking, poultry and pig rearing and the letting or sub-letting by any corporation to any person of any premises or portion thereof, and the sub-letting by any other person of any premises or portion of any premises held by him under a lease or tenancy other than from the Government.

Clearly this is not an exhaustive definition, as indicated by the use of the word “includes” at the beginning of the definition.  Whilst there is no single comprehensive definition of the word “business”, courts of law have sought to outline the characteristics of a “business” but have emphasised that each case can be determined only on its own facts.  Some of the comments that are frequently referred to include:

(1)   “Every trade is a business, but every business is not a trade.”  [Wethwell v BIRD (1834)]

(2)   “It is true that in many areas of taxation law the threshold for carrying on a business is very low and easily satisfied.”  [D86/99]

(3)   “While engaging in activities with a view of profit making is an important indicator, and in some cases an essential characteristic, of a business, a profit making purpose does not conclude the question whether the activities constitute a business.  Whether or not they do depends on a careful analysis of all the circumstances surrounding the activities.”  [Lee Yee Shing v CIR [2008] 3 HKLRD 51

In practice, I have seen many cases where a person has incorporated a Hong Kong company, yet because management and control are exercised offshore, all contracts for the purchase and sale of merchandise are concluded offshore and only administrative services are undertaken in Hong Kong, it is assumed that no business is undertaken in Hong Kong.  In support of this claim, it is stated that the only infrastructure and activities conducted in Hong Kong are those required by the statute, i.e.:

• the company has a Hong Kong-resident company secretary, often an outsourced third-party service provider
• the company has a Hong Kong-registered office, usually the address of the taxpayer’s corporate service provider
• accounts are prepared for the Hong Kong operation
• accounts are audited in Hong Kong
• annual returns and tax returns are filed by the company’s agents
• the company has purchased a Business Registration Certificate
• the company maintains a bank account in Hong Kong

Of equal importance, the company does not:

• maintain an office in Hong Kong,
• have any employees in Hong Kong, or
• retain people in Hong Kong with the authority to negotiate and conclude contracts on behalf of the company, including contracts of purchase and sale.

Despite the fact that the company may be able to support this contention with clear factual evidence, the Inland Revenue Department (“the Department”) is extremely reluctant to state that the company is not carrying on business in Hong Kong.  In support of its rejection of the company’s claim, the Department frequently refers to the case of CIR v Bartica Investment Limited 1HKRC90, the Board of Review decision in D107/96 and the fact that the taxpayer has applied for a Business Registration Certificate.

In Bartica, Cheung J maintained that the systematic placing of the company’s funds on deposit and the use them as security for loans advanced by banks to the taxpayer’s hotel company was a “gainful use of the assets of the taxpayer which, in the words of Lord Diplock, constitute prima facie a carrying on of a business”.

The Department has stated that the decision in Bartica must be viewed in relation to its own facts, and has also stated that its current position is that:

• the mere receipt of interest by a company does not constitute the carrying on of a business
• actions that go beyond “mere passive acquiescence” may constitute the carrying on of a business
• a period of inactivity does not rebut the fact that a company is still carrying on business

Nonetheless, Bartica does emphasise just how little needs to be done to fall within the concept of carrying on a business.  The reality of this was supported by the decision in D107/96.  In that case, a Hong Kong company purchased goods in Hong Kong and sold them to the company’s client in a foreign jurisdiction.  All the negotiations relating to the contracts of purchase and sales were conducted outside Hong Kong by persons not resident in Hong Kong.  Although a Hong Kong company (“Company C”) provided corporate services, including the provision of two nominee directors, the control and management of the company emanated from outside Hong Kong.  Company C was given instructions by various offshore parties and provided the necessary administrative services on behalf of the taxpayer, including the preparation of purchase documents, negotiations of letters of credit, pro-forma invoices etc.

It was found that, notwithstanding that all instructions were given from outside Hong Kong, Company C was the taxpayer’s agent and its activities constituted the carrying on of a trade on behalf of the taxpayer.  This case will be discussed later in relation to whether the business was carried on in Hong Kong, another requirement of Section 14 IRO.

All persons carrying on a business in Hong Kong are required to register that business under the Business Registration Ordinance.  This Ordinance, which is administered by the Department, defines a “business” as “any form of trade, commerce, craftsmanship, profession, calling or other activity carried on for the purpose of gain and also means a club”.

Sadly, the Department will use the fact that a taxpayer has applied for a business registration certificate as a strong indication that a business is being conducted in Hong Kong.  Coupled with the fact that case law has demonstrated that very little needs to be done in Hong Kong for a decision to be reached that a taxpayer is carrying on a business, this makes it a difficult and frustrating task to obtain the Department’s acknowledgement of such a claim.

By contrast, the Department will accept that a person is not carrying on a business if the activities are related to:

• the maintenance of a showroom in Hong Kong where no person has the authority to negotiate and conclude contract of sale,
• a buying office where activities are restricted to the purchase of goods, and
• the collection of information.

In conclusion, whilst specific activities undertaken in Hong Kong will not constitute the carrying on of a business, it is only in very rare circumstances that the Department will accept such a contention.  Accordingly, if a person is seeking to claim that a company’s profits are outside the scope of Section 14 IRO, it would be worthwhile to concentrate on ensuring that factual evidence can be provided to demonstrate that the profits in question did not arise in Hong Kong and were not derived from Hong Kong.  In subsequent articles, I will briefly review this issue and the nature of the information needed to support such a claim.

Authorised tax representatives may participate in the Department’s Block Extension Scheme, under which the tax representative’s clients included in the scheme are able to benefit from the following extended filing deadlines:

Persons not participating in the block extension scheme may apply in writing to the Department to request an extension of time to file their profits tax return.

The profits tax return must be completed in its entirety, and must be signed and dated by an authorised representative of the taxpayer.  The taxpayer must also attach an audited set of accounts (Hong Kong companies only) and, preferably, a tax computation.  Failure to submit the tax return or the audited set of accounts will constitute an incomplete return, which may lead to the levying of a penalty if the omission is not rectified.  Foreign companies, registered under Part XI of the Companies Ordinance (“CO”), that are carrying on business in Hong Kong, do not need to provide audited accounts.

Section 121 requires every company to keep proper books and records to accurately reflect their transactions.  This responsibility falls on the directors, and failure to keep such records is an offence punishable by a fine and/or imprisonment.

The accounting records should be kept at the registered office or such other place as the directors determine, and must be open to inspection by all the directors of the company.  If the records are kept outside Hong Kong, records (or presumably copies of the records) no more than six months old must be maintained at the registered office so that they can be inspected by the directors.

Audited accounts need to be produced annually and presented for adoption at the company’s AGM.  The AGM should be held within nine months of the company’s year end.

As stated above, the audited accounts must be attached to the profits tax return.  However, Section 14 Inland Revenue Ordinance (“IRO”) states that profits accruing to a person will be subject to profits tax only if all the following criteria apply:

(1)     the person is carrying on a trade, profession or business in Hong Kong,

(2)     the said profits were derived from a business carried on in Hong Kong,

(3)     the profits arose in or were derived from Hong Kong,

(4)     the profits were revenue in nature, and

(5)     the profits arose in the year of assessment in question.

The fact that a person is of the opinion that the profits are not subject to tax for one of the above reasons does not absolve the person of responsibility to file a profits tax return.  What should happen is that the person should attach a profits tax computation to the profits tax return and provide a comprehensive explanation as to why it is considered that the said profits fall outside the parameters of Section 14 IRO.

It is inevitable that the Department will fully investigate the taxpayer’s claim, often sending the taxpayer and his/her representative a four- or five-page letter.  Whilst this may frustrate the taxpayer, it should be remembered that the onus of proof to establish the non-taxation claim rests with the taxpayer; the onus to disprove the taxpayer’s contention does not rest with the Department.

Since Hong Kong has started negotiations with other countries to establish a comprehensive double taxation treaty network, the Department’s enquiries have become more detailed, clearly to ensure that tax is administered properly and to prevent Hong Kong from being considered as a tax haven.

In a subsequent article, I will discuss the nature of the enquiries asked by the Department in respect of such claims.

The FS announced a consolidated surplus of HK$66.7 billion for 2011-2012 making this the 8th consecutive year that the government have announced a budget surplus, and far in excess of that previously forecast. The aggregate consolidated surpluses over the 8 year period amount to a staggering HK$386.8bn which, assuming HK has a population of 7 million, represents HK$55,000 per individual. The current year surplus represents 22 months of government expenditure. However the FS anticipates that for the next few years Hong Kong will experience balanced budgets including a small consolidated deficit, in the amount of HK$3.43bn, for 2012-13.

The community had made it known that they had expected the government to tackle poverty, provide relief for the middle class, assist SMEs through the forthcoming turbulent period, deal with Hong Kong’s air pollution and to amend certain aspects of the Inland Revenue Ordinance. How did the FS deal with these issues?

Tackling Poverty
• The government will provide one months extra allowance to those claiming CSSA (social security), old age allowance and disability allowance, at a one-off cost to the government of HK$2.1bn. Hardly generous with no permanent benefit!

• For those people living in public housing or who pay rent to the Hong Kong Housing Authority the government will pay 2 months rent, again a one-off relief. This does not address the plight of those people not living in government accommodation and whose living conditions are very harsh. The government will also subsidize all residential electricity accounts subject to a threshold of HK$1,800. As there is no distinction as to the householder it is envisaged that this will favour 2.5 million households at a cost of HK$4.5bn.

• Other social welfare proposals include the extension and improvement of the short-term food assistance programme, transport concessions, increasing the number of subsidized rental care houses and community centres for the aged.

The list may seem impressive but bearing in mind that an able bodied person over sixty, who satisfies the income and assets tests of eligibility, receives the standard rate of CSSA in the amount of HK$2,660 per month, this is barely enough to live. I would have liked to have seen the government do far more to relieve poverty, as an absolute minimum a substantial and permanent increase to the standard rates of CSSA. Out of ten I would award the Financial Secretary a 3.

Middle Class
The relief and concessions applicable to the middle class are more extensive. As with the elderly this class will benefit from the electricity subsidy, but also a waiver of government rates, subject to a ceiling of HK$2,500 per quarter for each rateable property, a reduction in their salaries tax liability for 2011-12 by 75%, subject to a ceiling of HK$12,000, an increase in personal allowances, HK$108,000 to HK$120,000 and HK$216 to HK$240 for the basic and married persons allowance respectively. There are a number of increases in other personal allowances including the child allowance by HK$3,000 to HK$63,000 and all of the allowances relating to the maintenance of dependent grandparents, parents and siblings. As expected the period of relief for mortgage interest has been extended from 10 to 15 years. Whilst, the increases in the personal allowances may take a number of people outside the charge to salaries tax, the increase in those allowances for the assistance to dependent family members, when translated into cash, will hardly compensate a person for the increased cost of maintaining a dependent. Hence, I would give the government a solid 7 for their efforts but I would have been happier had the FS removed stamp duty on property purchases under HK$5m, making the cost of home ownership cheaper and doubled the allowances for maintaining dependents.

Assistance For SMEs
The measures proposed include an extension and improvement of the current SME Financing Guarantee Scheme, the waiver of the business registration fee, a reduction in profits tax for 2011-12 by 75%, subject to a ceiling of HK$12,000, and a reduction in the charges for import and export declarations. These proposals whilst welcome provide no long term benefits. Sadly, the government shied away from a small companies rate of tax and the abolition of the need for audits for companies with a turnover less than HK$2m. The temporary nature of these reliefs limits the long term value of the proposals for SMEs – at best a 6.

Other Issues
For larger companies, whilst they will benefit from the profits tax reduction of HK$12,000 the Financial Secretary refused to consider the introduction of group relief, the carry back of tax losses, the promised reduction in the standard rate of profits tax or even a general review of the Inland Revenue Ordinance. His week explanations as to why the government will not deal with these issues earns a score of 2.

Improving Hong Kong’s air quality is an issue always on the mind of most Hong Kong people. There were no new announcements, merely a repetition of what was in the Chief Executive’s policy address; a big disappointment, score 1.

The temporary nature of the reliefs, concessions and tax reductions may be explained by the impending end to the current-term government, but with surpluses at their current levels and the plight of the elderly and poor, this budget was a disappointment notwithstanding the measures proposed for the middle class.

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 Introduction to DIPN21, as with all other DIPNs issued by the Inland Revenue Department, states:

“These notes are issued for the information of taxpayers and their tax representatives. They contain the Department’s interpretation and practice in relation to the law as it stood at the date of publication.”

Given these remarks, a taxpayer has a legitimate expectation that the Inland Revenue Department will actually stand by the information and guidance it is providing. Otherwise, what is the point of issuing DIPNs in the first place? The introduction continues with the following advice:

“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.”

The introduction gives no indication that the Inland Revenue Department can choose whether and when it will follow its own stated practice.

The issue of “Revenue guidance” was also considered in the case of R (Davies and James and Gaines-Cooper) v HMRC [2011] a case better known for its decision on the determination of residency for UK tax purposes. Nonetheless, the taxpayer was reliant on the HMRC practice stated in its booklet, “IR20”.

In considering the issue of “Revenue guidance”, Lord Wilson, in his judgment on the Supreme Court hearing, referred to the judgment of Moses LJ in the Court of Appeal:

”12. The importance of the extent to which thousands of taxpayers may rely upon guidance, of great significance as to how they will manage their lives, cannot be doubted. It goes to the heart of the relationship between the Revenue and the taxpayer. It is trite to recall that it is for the Revenue to determine the best way of facilitating collection of the tax it is under a statutory obligation to collect. But it should not be forgotten that the Revenue itself has long acknowledged that the best way is by encouraging co-operation between the Revenue, and frank and open dealing by the public.”

Lord Wilson later states:

“27. The Revenue accepts first that, were it in the booklet to have made the representations about the circumstances necessary for the achievement of non-residence for which either the first appellants or the second appellant contend, such would have been within its powers; and second that, for so long as the representations remained operative, an individual would have had, and therefore have been able to reference, a legitimate expectation that it would appraise his case by reference to them notwithstanding that they failed to reflect the ordinary law.”

It is very clear that CG Lighting Limited had a legitimate expectation that the Inland Revenue Department would accept that CG Lighting Limited’s mode of operation was in accordance with its own DIPN and that it should have applied the concession stated in DIPN 21 to CG Lighting Limited’s tax affairs. This should have been done “notwithstanding that (the DIPN) failed to reflect the ordinary law”.

In my opinion, there is no doubt that the behaviour of the Commissioner in this case left a lot to be desired. CG Lighting Limited should have been entitled to press its case for the 50% concessionary tax treatment. The Commissioner’s denial of this right was, at best, unfortunate.

“I fully appreciate that Board members give up their valuable time in order to render voluntary public service for little or no remuneration. But it seems to me that by any standard, a delay of 3½ years in handing down a decision must be unacceptable.”

Reyes rightly suggested that six months from the date of the hearing was quite sufficient for the Board of Review to hand down its decision.

The Inland Revenue Department was also taken to task in the judicial review, Yue Yuen Marketing Company Ltd & Ors v CIR [2010] HACL 49/2009. The case concerned the Inland Revenue Department’s practice of issuing protective assessments shortly before the expiry of the six-year statutory time limited for raising assessments. Furthermore, the assessments ignored the taxpayer’s offshore claims, and the Commissioner of Inland Revenue demanded that the taxpayer purchase tax reserve certificates for the full amount of the tax in dispute. At the time of the judicial review, which was more than 10 years after the first year of assessment under objection, the taxpayer’s affairs had not been finalised. Reyes J concluded that there had been an “inordinate delay” and that a determination should be made within six months from the date a taxpayer objected to an assessment.

Surprisingly, a similar failure to determine a taxpayer’s affairs was brought to the attention of the Court of First Instance in Kong Tai Shoes Manufacturing Company Limited v CIR [2011] HCAL 34/2011. In this case, the Commissioner of Inland Revenue had failed to respond to the taxpayer’s objections for periods ranging from 3.5 to 6.5 years. Again, Reyes J suggested that six months was more than enough time for the Commissioner of Inland Revenue to determine an objection.

Sadly, whilst these cases highlight the delay that can occur in determining an objection, they do not illustrate the frustration that many taxpayers face in having to answer six-page standard letters, large parts of which are frequently irrelevant, several years after tax returns have been filed. As if this was not hard enough, a taxpayer might have to wait many months for a response.

I sincerely hope that the Commissioner of Inland Revenue takes notice of Reyes J’s comments and endeavours to ensure that his staff conclude taxpayers’ affairs with greater alacrity.

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.

The Appeal Committee’s determination was issued on 24th August 2011 and, for the first time in 16 tax appeals to the CFA, leave to appeal was refused. To be honest, it has taken me two months to be objective as opposed to venting my thorough disgust at the action of the Department and the judiciary system.

Let me go back to the beginning of this saga. CGL structured its affairs in accordance with paragraphs 15 and 16 of the Inland Revenue Department’s Departmental Interpretation and Practice Notes (“DIPN”) No.21 (Revised) issued in March 1998 (a revised version of DIPN21 was subsequently issued in December 2009). CGL’s objective was to take advantage of the 50% tax concession given by the Department to Hong Kong taxpayers who manufactured their products in both Hong Kong and Mainland China. Paragraphs (15) and (16) DIPN 21 provided that:

“(15) A Hong Kong manufacturing business, which does not have a licence to carry on a business in the Mainland, may enter into a processing or assembly arrangement with the Mainland entity. Under these arrangements, the Mainland entity is responsible for processing, manufacturing or assembling the goods that are required to be exported to places outside the Mainland. The Mainland entity provides the factory premises, the land and labour. For this, it charges a processing fee and exports the completed goods to the Hong Kong manufacturing business. The Hong Kong manufacturing business normally provides the raw materials. It may also provide technical know-how, management, production skills, design, skilled labour, training and supervision for the locally recruited labour and the manufacturing plant and machinery. The design and technical know-how development are usually carried out in Hong Kong.

(16) In law, the Mainland processing unit is a sub-contractor separate and distinct from the Hong Kong manufacturing business, and the question of apportionment strictly does not arise. However, recognising that the Hong Kong manufacturing business is involved in the manufacturing activities in the Mainland (in particular in the supply of raw materials and the training and supervision of the local labour) the Department is prepared to concede, in cases of this nature, that the profits on the sale of the goods in question can be apportioned. In line with paragraphs 21-22 below, this apportionment will generally be on a 50:50 basis.”

CGL had always described its principal business activity to be that of a manufacturer, and its audited accounts have reflected that CGL owned all the unused raw materials, unfinished products and finished products at the factory. The factory was owned by its wholly owned subsidiary, CGES, in the PRC, and CGL provided the factory with all the raw materials, technical know-how, management staff, production skill, computer software, product design, skilled labour, family, supervision and the manufacturing plant and equipment. CGL did not charge for the provision of this assistance. There were no sales and purchase agreements between CGL and the factory – CGL merely paid the factory a processing fee.

However, every DIPN comes with the following health warning:

“These notes are issued for the information of taxpayers and their tax representatives. They contain the Department’s interpretation and practices in relation to the law as it stood at the date of publication. Taxpayers are reminded 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.”

Nonetheless, I had always assumed that any reasonable person would expect that reliance could be placed on the information provided by the Department in its own DIPNs, otherwise what is the point in publishing them? Hence it came as a complete surprise to the taxpayer, the taxpayer’s counsel and to myself that Mr Eugene Fung, Counsel for the Commissioner of Inland Revenue (“CIR”), stated at the commencement of the Board of Review (“BOR”) hearing that the CIR was not bound by its own concession set out in DIPN21 and that the case should be determined on established source principles.

The BOR was then faced with a need to establish the facts and, based on its findings, to determine:

(1) what the operations of CGL were that produced the relevant profits, and
(2) where those operations took place.

The BOR reached the determination that:

“In respect of the first question, the profits in question did not arise from a trading operation, as contended by the CIR. With respect, such contention is premised upon the Company D documents and ignores a raft of materials produced by the Taxpayer to demonstrate otherwise.”

However, whilst rejecting the contention that CGL was a trader, the BOR equally rejected the contention that CGL was a manufacturer. In the BOR’s words:

“This is a case where the Taxpayer was a seller of Product J which it designed and participated in their production… We believe that in a case, like here, where the operation is a multi-facet one, this Board must have regard to the commercial reality. Such reality dictates that the Taxpayer’s participation in the production process was as much as part of its profit-producing transaction as the obtaining of a purchase order.

Plainly, part of the Taxpayer’s profit making 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 BOR remitted the case back to the CIR for apportionment.

This was a determination that everyone, other than the CIR, had hoped for. It was an accurate reflection of the facts and the evidence given by CGL. It reflected the practice that the CIR had adopted for many years and on which CGL had relied and had arranged its affairs.

The CIR appealed the decision to The High Court of the Hong Kong Special Administrative Region Court of First Instance. Benjamin Yu SC, Counsel for the CIR, submitted that:

(1) the BOR had erred in law by failing to focus on the geographical location of the actual profit-producing activities of CGL, i.e., the sale of goods, and

(2) the activities undertaken by CGL outside Hong Kong were antecedent or incidental and therefore legally irrelevant.

(3) In the light of (2) above;

“Having taken into account antecedent or incidental matters that are legally irrelevant, the Board’s conclusion that the source of the Taxpayer’s profits was partly Hong Kong and partly outside Hong Kong is one which no reasonable tribunal properly directed could reach.”

In the court of First Instance, the Hon Fok J, having reviewed the BOR’s decision and relevant case law, concluded that:

“It is necessary to recognize that the Board in the present case found that CGES was the manufacturer and did not find that CGES was an agent of the Taxpayer in the production of the lighting fixtures. This is a material finding and is not affected by the fact that, because of the relationship between it and the Taxpayer, CGES only received a processing fee which was no greater than its operating cost and overheads.

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.”

Hence Fok J found for the CIR on the basis that CGL was not the manufacturer and that the activities that CGL undertook to support the manufacturing process were “antecedent or incidental”. Incidentally, the question of CGES being an agent for CGL was not raised in the BOR. Whilst the judgment was extremely clear and well written, it left the general public clearly confused.

Following Fok J’s decision, a parent company that owns all the raw materials and finished goods located at a factory owned by a third party, and that is responsible for every facet of the manufacturing activity, cannot be considered to be significantly involved in the manufacturing of its own products, notwithstanding the fact that Fok J accepted that there were no sales and purchase activities between CGL and CGES and that CGL simply paid CGES a processing fee for the manufacture/assembly of its products. Therefore are we to assume that the word “manufacturer” can only be applied to the person who physically owns the factory?

I strongly believe that the Counsel for the CIR was surprised that he was successful at the Court of First Instance, particularly as Fok J appears to have based his decision on Counsel’s secondary submission that no reasonable person could conclude that CGL was the manufacturer. CGL appealed the case to the Court of Appeal and sought to establish that Fok J had:

a) not understood the reality of CGL’s case and that the involvement of CGL in the manufacturing process was not “antecedent” or “incidental”;
b) substituted his own view of the facts as opposed to the determination of the facts found by the BOR;
c) adopted an incorrect legal analysis of the facts found by the BOR, and
d) incorrectly concluded that the BOR’s decision was unreasonable.

The judgment of Court of Appeal was delivered by the Hon Tang Ag CJHC. In my opinion it must rank as one of the poorest judgments regarding taxation that I have read. The judgment simply reiterates the facts, attempts to interpret the facts in a manner inconsistent with the decision of the BOR, and makes no attempt to independently analyse the law other that to express the view that the BOR might have reached a different decision had the case been heard after the Court of Appeal’s decision in CIR v Datatronic [2009] 4 HKC 518, a case heard by the Hon Tang Ag CJHC himself. An example of this can be found in paragraph 21 of the judgment:

“The Board’s finding that the reality of the transaction between CGES and the Taxpayer was that there was no sale of the finished products by CGES to the Taxpayer was not challenged on the case stated. It is therefore not something with which we are required to deal. The implication of the Taxpayer’s case appeared to be that all the raw material supplied by the Taxpayer to CGES as well as the finished products belonged to the Taxpayer throughout. However, I do not wish to give the impression that I agree with the Board’s finding. With respect, what the Board referred to as the reality of the situation probably only represented the subjective intention of the Taxpayer, namely, that for Hong Kong tax purposes it should be regarded as the owner of the raw material and the finished products. That is presumably because the Taxpayer thought that from the Hong Kong tax liability point of view it would be advantageous that its transactions with CGES should be not regarded as a sale of the finished product by CGES to the Taxpayer. I doubt whether the ownership of goods could solely depend on the subjective intent of the Taxpayer. But, as I have said, this is not something we need to decide.”

It therefore came as no surprise that the appeal was dismissed. In my view, one would be forgiven for thinking that the judgment was given on the assumption that the case would be appealed to the CFA where the facts would be reviewed together with the decision of the BOR, the decision given by Fok J in the Court of First Instance and the relevant case law in order to provide much-needed guidance on the location of the source of profits made by Hong Kong taxpayers from manufacturing in Mainland China by way of a processing agreement with a third party.

Nobody was under the illusion that Tang Ag CJHC would find in favour of the taxpayer. It was always anticipated that the case would need to be heard by the CFA, which would normally seek to have a UK judge specialising in taxation sitting on the bench.

However, when the CIR was asked to consent to CGL’s application for leave to appeal to the CFA, being as of right, the CIR refused. Of the 16 tax cases that have previously been appealed to the CFA, the CIR has given consent on each occasion. Again, one would be forgiven for believing that the CIR had been advised that the CFA had decided to restrict the number of cases to be heard before it, and certainly taxpayers should not consider that the CFA was obligated to hear tax appeals. Clearly, the progress of the case relating to Nina Wang’s estate would have endorsed the view that the CFA intended to take a harder approach to adding to its case load.

The application for leave to appeal to the CFA was referred back to the Court of Appeal for its approval. The Hon Tang Ag CJHC dismissed CGL’s application for leave to appeal on the grounds that the application did not satisfy the provision of Section 22(1)(a) or 22(1)(b) of the Hong Kong Court of Final Appeal Ordinance.

Section 22(1)(a) allows a case to be heard by the CFA “as of right” in a civil matter where the amount in dispute amounts to the value of HK$1,000,000. The second option is where the Court can, at its discretion, allow the appeal on the basis that it is a question of great general or public importance or the Court otherwise believes the appeal ought to proceed.

The Hon Tang Ag CJHC was of the opinion that the tax in dispute was similar to the assessment of unliquidated damages and therefore did not satisfy Section 22(1)(a). With regard to Section 22(1)(b) Tang was of the opinion that the law had been correctly applied by referring to the CFA’s decisions in Ing Barings & Securities (Hong Kong) Limited v CIR (2007) to HKCFAR 417 and Ngai Lik Electronics Co. Ltd v CIR (2009) 12 HKCFA 296. Tang further stated that:

“It is said that we have misapplied or misunderstood the decisions. Even if that is right, that is not a question of great general or public importance … In any event, the solution is not leave to appeal to the Court of Final Appeal but legislation.”

Leave to Appeal to the CFA having been dismissed by the Hon Tang Ag CJHC, CGL’s remaining option was to appeal directly to the Leave Committee of Court of Final Appeal. In his determination, Mr Justice Bokhary PJ stated:

“Monetary claims which require assessment – and are therefore unliquidated rather than liquidated – do not come within S22(1)(a). Tax requires assessment. So tax demands do not come within S22(1)(a). The appeal which the taxpayer seeks to bring does not lie as of right.”

As Mr Justice Bokhary PJ was also of the opinion that there was no legal principle to be resolved, leave to appeal was refused and so the case became final without a satisfactory conclusion.

Several very interesting issues arise from this. Firstly, nowhere in S22(1)(c) is reference made to liquidated damages. If such a phrase was used, I disagree that a person’s tax liability could be described as “unliquidated”, as it has already been assessed and quantified. At the appeal hearing, the Court asked whether it should be “harried” with every tax dispute appealed from a lower court, a view enhanced by the CIR, who suggested that hearing tax appeals, as of right, would open the “floodgates” for tax litigation. My answer to this is quite simple – is that not every taxpayer’s right? Why should a taxpayer’s right of appeal be prejudiced by the apparent workload of the CFA? Equally, I was very surprised that the CIR and Mr Justice Bokhary PJ concluded that this case was not of “general or public importance”, when every tax professional, manufacturing association and manufacturer had followed this case with great interest.

In my opinion, this was a very distasteful end to an unsatisfactory case.