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My first appearance was on the 24th of February edition of Hong Kong Today, the morning of the HK Budget’s release.

Click HERE to listen;

The following day I was asked onto the show Back Chat, as a panellist, to review and discuss the content of the Financial Secretary’s Budget.

Click HERE to listen;

Please let me know your opinions in the comment box below.

As expected the leaked “one off” giveaways proved to be correct i.e. the Government will;

• Pay two months rent on behalf of public housing tenants,
• provide an additional one month of CSSA payment, old age allowance and disability allowance,
• waive rates for 2010-11, subject to a cap of HK$1,500 per quarter
• reduce salaries tax by 75%, subject to a cap of HK$6,000
• waive the business registration fee
• provide a $1,000 allowance to students receiving CSSA or student financial assistance

Sadly, as predicted the Government has chosen to use the tax system for social engineering i.e. increasing stamp duty on property transactions valued over $20 million as a means to dampen the luxury property market, it also stated that it may increase the duty on tobacco to discourage smoking.  In my view the increase in stamp duty will have no impact on the decision of most people to purchase luxury properties, however it is only sad that having made the decision to tinker with stamp duty the Government did not take this opportunity to reduce the rate of stamp duty on properties valued below HK$6 million as a means of assisting first time buyers and lower income earners.  Similarly, people should be able to make up their own minds whether they wish to smoke tobacco without this sort of Government intervention.

Our hopes and aspirations for SME’s did not materialize either, no reductions in tax rates nor an agreement to carry back tax losses for a three year period.  Of more significance was the fact that there was no immediate willingness to extend the Government loan guarantee schemes.  However, the Financial Secretary did appear to acknowledge the inequity of not giving tax relief for capital expenditure incurred on the cost of registering trademarks, copyrights and registered designs.  Perhaps the financial services industry had more clout as they were able to obtain a stamp duty concession in the trading of exchange traded funds and a profits tax concession applicable to income and gains from qualifying debt instruments.

Perhaps I should not complain too much as I am fully supportive of the measures announced to strengthen public health care and to provide additional care and financial assistance to the needy, the only doubt I have is whether these proposals have gone far enough.

Hong Kong’s fiscal reserves are budgeted to increase to $508.2 billion by 31st March 2010 dropping to $470 billion by 31st March 2015, the equivalent of 15 months of Government expenditure.  The Financial Secretary’s conservative, perhaps political approach, is keeping the boat steady but, I just hope that land transactions continue to bear fruit as very little attempt is being made to stimulate entrepreneurs or encourage businesses to expand their operations in Hong Kong.

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?

Mr Chu became an Assistant Assessor in July 1975 and has been employed by the Inland Revenue Department (“IRD”) ever since.  Mr Chu has had considerable experience working with various departments within the IRD but, in my opinion, the most significant being his direct involved with the assessment, objection and appeal procedures relating to corporate taxpayers.  Mr Chu is very familiar with the problems and issues which taxpayers face and find very frustrating.

I wait with interest to see the impact that he will have on the IRD and whether he will be able to facilitate a mutual understanding between the IRD and taxpayers as to the correct interpretation of the provisions of the Inland Revenue Ordinance and case law precedents, in particular those relating to offshore profits and income.

I wish Mr Chu well in his new office.

Where the transactions are with a country with which HK does not have a CDTT, the IRD will revert to those provisions of the Inland Revenue Ordinance that it considers are capable of capturing the revenue lost through the implementation of a tax-driven scheme.

The relevant sections are:

Section 16 IRO                        this section restricts the deduction of outgoings and expenses to the extent to which they are not incurred in the production of assessable profits.

Section 17 IRO                        prohibits deductions for “any disbursements or expenses not being money expended for the purposes of producing such profits”

Section 20 and 20A IRO          Transactions between a Hong Kong company and an offshore company not conducted on an arm’s-length basis.

Section 61 IRO                        Seeks to negate tax benefits derived from artificial and fictitious transactions

Section 61A IRO                     Contains Hong Kong’s general anti-avoidance provisions

Whilst these provisions do not necessarily have the sophistication of the Associated Enterprise Article and other related provisions found in CDTTs, they are capable of achieving the IRD’s objective that there should be no loss of tax revenues due to transfer pricing policies that are considered to be conducted at non-arm’s-length prices.

Although Hong Kong does not have any mandatory requirements to provide documentary evidence of pricing policies, Section 51C does require a person to keep sufficient records to enable the IRD to evaluate the appropriateness of the assessable profit ascribed to a Hong Kong business.

It’s unlikely that there will be any change in the IRD’s approach to the policing of transfer pricing policies, but taxpayers should always remember that at the end of the day, it is their own responsibility to prove that the pricing policies they adopt are considered to be comparable to those that would have been used by independent parties carrying on business at arm’s-length prices.

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.