Withholding Tax Rates Under Hong Kong Treaties

Secretary for Financial Services & the Treasury, Professor Chan commented that “the agreement will encourage Hong Kong enterprises to leverage on the success of Irish companies in the areas of technology, research and development, while facilitating Irish enterprises to tap into the Asian market, particularly the vast mainland market, using Hong Kong as a gateway”.

Under the CDTA, the withholding tax deducted from the payment of dividends by an Irish company to a Hong Kong resident has been reduced from 20% to nil.  The withholding tax on the payment of royalties and interest will be capped at 3% and reduced to 10% respectively.

As with the CDTAs concluded since the enactment of the Inland Revenue (Amendment) Ordinance 2010, the Hong Kong/Ireland CDTA adopts the latest Organization for Economic Co-operation and Development standard on the Exchange of Information.

Under the CDTA, dividends paid by a company will be exempt from tax, and dividends paid by a UK Real Estate Investment Trust will be subject to a withholding tax of 15% (previously 20%).  Hong Kong residents receiving royalties and interest from the UK are subject to a current withholding tax rate of 20% respectively in the UK.  Under the CDTA, the royalty withholding tax rate will be capped at 3% and the withholding tax on interest will be exempted.

Of particular relevance to Hong Kong expats returning to the UK is Article 17 of the CDTA, which provides that:

“Pensions and other similar remuneration (including a lump sum payment) arising in a Contracting Party and paid to a resident of the other Contracting Party in consideration of past employment or self-employment and social security pensions shall be taxable only in the first mentioned Party.”

This will enable Hong Kong expats planning to return to the UK to ensure that pensions payable by a Hong Kong company are structured in a tax-efficient manner.

The term “resident” is not a normal feature of Hong Kong tax legislation.  However, since a liability to tax is dependent on the source of income (and, in the case of corporations, whether the corporation is also carrying on business in Hong Kong), it is interesting to note the definition given in Article 4.

The term “a resident of Hong Kong” means:

1. an individual who ordinarily resides in Hong Kong,
2. a person who stays in Hong Kong for more than 180 days during a year of assessment or for more than 300 days in two consecutive years of assessment, one of which is the relevant year of assessment, or
3. a company incorporated in Hong Kong and a company centrally managed and controlled in Hong Kong.

As with all treaties concluded in 2010 by Hong Kong, the CDTA with the UK incorporates the latest Organization for Economic Co-operation and Development standard on Exchange of Information.

Following the enactment of the Inland Revenue (Amendment) Ordinance 2010 (“IR(A)O 2010”) and the Inland Revenue (Disclosure of Information) Rules, Cap.112 BI (“Disclosure Rules”), the Department now has the authority to collect and disclose tax information, from whatever source is available to it, in order to comply with a tax treaty partner’s request for information regarding a taxpayer’s affairs. There is no requirement for the Department to seek approval from a court of law before releasing the information.

In an effort to assure taxpayers that information will not be provided indiscriminately, the Department has stated that:

a) the Department will restrict the exchange of information to specific requests, and that there will be no automatic or spontaneous exchanges,

b) information will only be provided with regard to bona fide requests from the competent authority of a treaty partner in justifiable cases, and

c) only information that is considered “foreseeably relevant to secure the correct application of the provisions of the CDTA or of the domestic law of the contracting party” shall be provided.

With regard to (c) above, to avoid “fishing expeditions” the Department has published details of the “Particulars to be Contained in a Disclosure Request”. These are very comprehensive, and include the following:

(a) a statement of the information requested and its relevance to the disclosure request, and

(b) the grounds for believing that such information is available in Hong Kong, and

(c) a statement that the government of the contracting party has pursued all means available in its territory to obtain the information, and

(d) if applicable, reasons why the disclosure of the request to the taxpayer may frustrate or undermine the enforcement of tax laws in the treaty partner’s jurisdiction.

Subject to the Department’s agreement to (d) above, details of the request for information will be provided to the taxpayer. The taxpayer will, in most cases, be allowed to review the information and correct any errors of a genuine nature. However, it is unlikely that any amendments will be entertained if they are not received in a timely manner. Taxpayers should be aware that the Department will adhere to the OECD’s standard response time of 90 days.

Where does this leave Hong Kong? It is abundantly clear that the Hong Kong Government and the Department want to be seen to be supporting the concept of tax transparency and the effective exchange of tax information, and do not wish to stand in the way of the development of Hong Kong as a financial centre.

However, it is difficult to evaluate the impact of this “modernisation” of Hong Kong’s tax regime until such time as we are able to gauge the validity of new treaty partners’ desire for information and the willingness of the Department to undertake a rigorous review of all requests for information before sending it to such treaty partners.

Here is a summary of the withholding tax rates applicable to Hong Kong’s 11 CDTAs:

Withholding Tax Rates Under Hong Kong Treaties

Fok J’s decision addresses the appeal by the Department against the decision of the Board of Review, which concluded:

“We believe that in a case, like here, where the operation is a multi-facet one, this Board must have regard to the practical commercial reality.  Such reality dictates that the Taxpayer’s participation in the production process was as much a part of its profit-producing transaction as the obtaining of a purchase order.

Plainly, part of the Taxpayer’s profit-producing 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 facts of the case were that CG Lighting Limited (“CGL”), a private company carrying on business in Hong Kong, which described its principal activity as “the manufacturing of lighting fixtures”, maintained that 50% of its profits should be regarded as not taxable in accordance with the Department’s Interpretation and Practice Note No 21 (“DIPN 21”).  Prior to January 1994, CGL’s products were manufactured by a third-party factory under a contract processing agreement.  In January 1994, CGL established a foreign investment enterprise, CGES, which assumed responsibility for the manufacturing process.  CGES manufactured only for CGL and was reimbursed for its expenditure by the payment of a monthly processing fee.

The Board of Review accepted the following facts:

(a) CGL was responsible for design, product testing and prototype production (such works were carried out partly in Hong Kong and partly at CGES in the Mainland).

(b) Purchases from third parties were concluded by CGL.  Sales work orders and production orders were prepared in Hong Kong and faxed to CGES.

(c) Raw materials necessary for the manufacture of finished goods were purchased by CGL in Hong Kong and then transferred to CGES in the Mainland according to the production schedule set in Hong Kong.

(d) Quality assurance engineers and production control staff from the CGL would visit CGES to train and update the subsidiary’s staff.

(e) A number of senior management staff employed by CGL were stationed in the subsidiary to monitor and manage its operation.

(f) The subsidiary provided the factory premises and the labour for the production of lighting fixtures, in return for monthly processing fees paid by CGL.  The amounts of the processing fees were no greater than the subsidiary’s operating costs and overhead.

(g) There were no sales of materials by CGL to CGES, or of finished products by CGES to CGL.

(h) All capital expenditure incurred by CGL for the factory was recorded as fixed assets in CGL’S accounts.

(i) All finished products, stock of unused materials and finished products not yet sold or shipped were recorded in the accounts of CGL.

At the beginning of the Board of Review hearing, Counsel for the Department stated it was not bound by the concession set out in DIPN 21, and that the appeal should be resolved by applying the relevant charging provisions of the Ordinance as construed by case law.  However, acknowledging that apportionment was possible under the charging provision and that the Board of Review had found that part of the CGL’s profits were sourced from outside Hong Kong, the case was remitted back to the Commissioner of Inland Revenue to decide the appropriate apportionment.

The Commissioner appealed the decision on the basis that:

(a) The Board had erred in law in failing to focus only on the geographical location of the CGL’s profit-producing transactions themselves (namely the sale of goods).

(b) The Board had erred in law in having regard to antecedent or incidental matters that are legally irrelevant (namely the activities of CGL’s staff in CGES).

(c) Having taken into account antecedent or incidental matters that are legally irrelevant, the Board’s conclusion that the sources of CGL’s profits were partly Hong Kong and partly outside Hong Kong is one that no reasonable tribunal properly directed could reach.

In support of these conclusions, Counsel for the Commissioner emphasised that:

(a) When determining the operations that produced the relevant profits and where those operations took place, it is the operations of CGL, and not those of CGL’s subsidiary or sub-contractor, that are the relevant consideration.

(b) In order to determine the source of CGL’s profits, it is of critical importance to properly identify the profit-producing transactions.  The profit-producing transactions are only properly identified if the “antecedent or incidental activities” are excluded.

(c) The Board found that CGES was the manufacturer, and further found that the acts or operations of CGES did not constitute the acts or operations of CGL.  In other words, CGES was not CGL’s agent and the manufacturing activities carried on by CGES were not the activities of CGL.  The Board was incorrect to have regard to the management by CGL’s staff in the production at CGES, which were activities antecedent or incidental to the profit-producing transactions.  This error vitiates the Board’s conclusion that the profits were sourced partly from outside Hong Kong.

(d) CGL earned its profits by acquiring the finished products from CGES and selling them to customers at a profit.  Even though CGL’s participation in CGES’s production process might have been “commercially essential to the operations and profitability of CGL’s business”, they do not provide the legal test for ascertaining the geographical source of profits for the purpose of s.14.

(e) The representative transaction studied at the Board plainly included the sale of the finished goods by CGES to the Taxpayer.

(f) Notwithstanding (e) above, the Board did not make any findings regarding the mode of transfer of the finished goods by CGES to CGL.  The Board only accepted the evidence of CGL’s witness that the documents concerning CGES were prepared “in such a way as to satisfy the requirements of the Mainland authorities”.  The Board did not find that all such documents were a sham or of no effect.

In delivering his judgment, Fok J:

(a) had no hesitation in concluding that the Board made a clear finding of fact that there was no sale of the unfinished products by CGES to CGL, and that the facts of the case would place the arrangement into the category of contract processing as opposed to import processing.  However, Fok J was of the opinion that:

“these descriptions of import processing and contract processing activities appear to derive from DIPN 21, which, as I have noted above, is not relevant since the ultimate question depends on the application of s.14, the relevant charging provision.”

(b) found as relevant that CGES was the manufacturer and that the Board did not find that CGES was an agent of CGL in the production of the lighting fixtures.

(c) dismissed the relevance of the accounts by agreeing with the Commissioner’s Counsel that:

“It would make little difference, in terms of the accounting treatment, if, instead of being entered as a processing charge, the fee paid to CGES by the Taxpayer was described as the cost of purchase.”

Based on the above, Fok J concluded:

“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.

I am therefore unable to accept the submission on behalf of the Taxpayer that the source of its profits was its business of manufacturing lighting fixtures for export, which business it carried on, with the assistance of agents, in the PRC and Hong Kong.”

Fok J continued:

“Instead, the transactions which produced the profits for the Taxpayer were the sales of the finished products to its customers.  Those sales were effected in Hong Kong and so the profits deriving from the sales are chargeable under s.14.

I am satisfied that, even though there was not a sale of the finished products by CGES to the Taxpayer, the fact remains that the Taxpayer did not manufacture the finished goods and only had them transferred to it pursuant to the sub-contracting arrangements between it and CGES.  On analysis, I conclude that the profit-producing transactions of the Taxpayer consisted of the acquisition of the finished goods from CGES, for which the Taxpayer paid a processing fee under the Processing/ Subcontracting Agreement in respect of the manufacturer of the goods by CGES, and on selling of the same to its customers.”

I have difficulty in accepting Fok J’s interpretation of the findings of the Board of Review. In my opinion, the Board did not find that CGL was not a manufacturer or that CGES was the only manufacturer, nor did the Board find that CGES was not an agent of CGL.  Certainly, the Board did not state that the arrangement between CGL and CGES was consistent with a sub-contracting arrangement.

Perhaps the most difficult position to accept is the manner in which Fok J disregarded the fact that CGES did not make any independent management decision, indeed would not undertake any manufacturing or other activity without authorisation from CGL.  It is clear from the statements of the witnesses, which were accepted by the Board, that CGES was managed and controlled by CGL.

Furthermore, I do not understand the analysis of CGL’s accounts made by the Commissioner’s Counsel and accepted by Fok J.  It was accepted by the Board that the audited accounts were prepared to Hong Kong and international standards and in accordance with CGL’s principal activity being that of a manufacturer.

Fok J appears to have placed substantial reliance on the decisions in Datatronics, ING Bearings and Ngai Lik Electronics, which can be clearly distinguished from the facts of the current case.

In my opinion, any reasonable person would conclude, based on the findings of the Board, that CGL was a manufacturer and that its involvement in the manufacturing process of CGES was fundamental to the activities that gave rise to its profits.  The determination that CGL was no more than a trader and that the involvement in the activities of CGES were antecedent or incidental to the profit-producing activities of CGL is to ignore the realities of CGL’s business and the activities of its staff.

I sincerely hope that the case is appealed to the Court of Appeal, although I suspect that, because of the importance of the case to the Department, it will end up in the Court of Final Appeal.

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

“Once it is accepted that the manufacturer of the lighting fixtures was CGES and not the Taxpayer and that CGES was not the agent of the Taxpayer in the manufacturing process, I do not see that it is possible to avoid the conclusion that the activities of the Taxpayer in relation to the manufacturing process itself are simply antecedent or incidental to the profit-producing transactions here.”

And later:

“Instead, the transactions which produced the profits for the Taxpayer were the sales of the finished products to its customers.  Those sales were effected in Hong Kong and so the profits deriving from the sales are chargeable under s.14.”

He concluded:

“I am satisfied that, even though there was not a sale of the finished products by CGES to the Taxpayer, the fact remains that the Taxpayer did not manufacture the finished goods and only had them transferred to it pursuant to the sub-contracting arrangements between it and CGES.  On analysis, I conclude that the profit-producing transactions of the Taxpayer consisted of the acquisition of the finished goods from CGES, for which the Taxpayer paid a processing fee under the Processing/Subcontracting Agreement in respect of the manufacture of the goods by CGES, and the on-selling of the same to its customers.”

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

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

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

On May 5, Professor Chan advised that revenue collections by the Inland Revenue Department from Salaries Tax and Profits Tax were estimated to be $179.1 billion, 6% less than for 2008-2009.  The total amount of Salaries Tax paid by the top 10 salary taxpayers was estimated at $367 million, a decrease of $92 million as compared to the previous year.  As for Profits Tax, the top 10 taxpayers paid $11.07 billion, which was $8.63 billion less than in 2008-2009.  Interestingly, had the top 10 corporate taxpayers, who accounted for 6.2% of the direct tax collected in 2009-2010, maintained their 2008-2009 level of assessable profits, the fall in revenue would have been only around 1.5%.  If my arithmetic is correct, the contribution by the top 10 corporate taxpayers for 2009-2010 is likely to fall from approximately 10% to 6.2% of the direct tax collected.

On May 12, Professor Chan responded to concerns that G20 members may impose sanctions on Hong Kong because the Government had not concluded agreements with 12 other countries for the exchange of tax information.  He highlighted the considerable pace of development in this area, which started with the amendment to the Inland Revenue Ordinance that gave the Commissioner of Inland Revenue the authority to collect information not otherwise required for Hong Kong tax purposes.  Furthermore, as of May 13, the Government had signed 10 CDTA’s, with the magical number of 12 in sight.

Professor Chan’s concluding comments were clear, and echo my own views: “Hong Kong has never been a tax haven.  We will continue to expand our CDTA network with a view to enhancing Hong Kong’s position as an international financial and business centre.”

Withholding Tax Rates Under Hong Kong Treaties

“On 15 April 2010, Hong Kong and Switzerland had initialed an agreement for the avoidance of double taxation (CDTA) between Hong Kong and Switzerland in Berne.  Both sides had reached a consensus on all the provisions of the agreement after the 2nd round of talks held this week, which lasted for 4 days.  Both sides will arrange to have the agreement formally signed and put into effect as soon as practicable.

This is the 10th CDTA that Hong Kong has concluded so far that adopts the latest international standard on exchange of information.”

With 10 down, there are just two to go; any guesses as to which two countries will be next and when the CDTAs will be concluded?  As I’ve stated in previous “Rants”, the Department’s only negotiation tool has been the adoption of the 2004 OECD Exchange of Information Article.  Taxpayers should be aware of this, and also of the power the Department now has to ascertain financial information about a taxpayer and its ability to report this information to a treaty partner if it receives an appropriate request.