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.

Corporate groups in Hong Kong may:
• pay tax as a group even though the consolidated group accounts may show a loss
• have a higher effective tax rate
• be disadvantaged from a cashflow standpoint
• feel forced to adopt contrived strategies to utilise stranded tax losses
• have inadequate resources to embark on new business initiatives that would suffer losses in the initial years of operation

In March this year, Professor KC Chan, the Secretary for Financial Services and the Treasury, stated:

“The “group loss relief” suggestion involves a number of complicated issues, such as how to ascertain whether companies are members of the same group, and their loss set-off arrangements with each other. The proposed measure could also be easily abused for tax avoidance. Hence, its implementation must be complemented by complicated legislative provisions to define clearly the scope of application so as to avoid tax abuse. This would inevitably complicate our simple tax regime. Separately, as small and medium enterprises (SMEs) in general do not operate as a group, the “group loss relief” suggestion would not benefit the SMEs at large, which constitute 98% of business establishments in Hong Kong.
As for the “loss carry-back” suggestion, since the proposed measure may result in tax refunds at any time, it may cause drastic and unpredictable fluctuations in tax revenue, rendering the tax revenue more vulnerable to economic cycles. We believe that our current arrangement for enterprises to carry forward their losses without time limit to offset profits in future years should be able to assist enterprises to manage their losses and remains attractive to investors.
Given the above considerations, we are of the view that it is not appropriate to introduce the “group loss relief” and “loss carry-back” arrangements at this juncture.”
This view is not shared by our neighbours, with which Hong Kong competes to be recognised as the favoured location for the establishment of regional headquarters or as a base for Asian business operations. Australia, New Zealand, Singapore, Malaysia and Japan, Hong Kong’s principal competitors, permit group relief, whether on consolidation or in the form of loss transfer.
Personally, I find the reasons advanced by the Government a poor excuse for its failure to undertake a thorough review of this issue. It is also very sad that the Government does not feel it appropriate to issue a consultation paper to the appropriate interested parties for their views and recommendations as to how group relief could be implemented in Hong Kong. Of course doing nothing is the easier option.

The examples I am referring to are as follows:

• The increase in stamp duty payable on properties acquired after November 20, 2010, and sold within 24 months after acquisition. Despite the fact that Hong Kong’s existing corporate tax legislation provides a mechanism to charge property speculators a profits tax on their profits from the purchase and sale of property, the Government clearly believes that the use of stamp duty is an effective tool to dampen the surge in property prices. I would like to think the Government recognises that this is only a temporary measure and not a reason for ignoring Hong Kong people’s real need: affordable accommodation.

• The Government has increased the first registration tax by 15% on private cars costing more than HK$200,000. The purpose of this increase in indirect tax is to reduce road congestion, particularly as “new infrastructure is becoming expensive and difficult to control in Hong Kong’s unique geographic situation”. What happened to the “user pays” principle, i.e. ERP, or other ideas that have been suggested? Again, is this just an easy way out? Certainly the one thing that will happen is that people will be likely to think twice about buying a new car – great for pollution!

• Finally the duty on cigarettes and other tobacco products has been increased by 41.5%. A recent advertising campaign has advised us that smoking costs the Government substantial sums of money in relation to the provision of medical services to deal with smoking-related illnesses and the loss of productivity through smoking-related sickness. I am a non-smoker who has no wish to inhale second-hand smoke, but I feel that the use of indirect tax to make smoking more expensive is simply delaying a decision the Government needs to make, i.e., whether to further restrict the smoking of tobacco. If the decision is to permit smoking, albeit in restricted locations, why should it become a luxury that only the more affluent can afford?

You may consider these issues to be insignificant, but to my mind, the use of taxation for social engineering is a trend that should be avoided. I would encourage the Government to address the true causes of the problems rather than using taxation as a quick fix or band-aid.

At the Board of Review, the Commissioner of Inland Revenue (“the CIR”) suggested that L&F operated a “supply chain management business” and that the 4% commission paid to the affiliates was for the offshore services, whilst the 2% retained by L&F was for the management of the services undertaken in Hong Kong, and was therefore taxable. The Board of Review applied the principles enunciated by the Court of Final Appeal’s judgment in ING Baring Securities (Hong Kong) Ltd v CIR (2007) to HKCFAR 417, namely that section 14 of the Inland Revenue Ordinance required the identification of those activities that directly gave rise to the earning of the commission profits as opposed to those activities that, whilst important, were incidental or antecedent. Having ascertained the relevant activities, it was then essential to determine where they were performed.

The Board of Review held that L&F was a commission agent and that the services for which it received a commission were undertaken offshore. Accordingly, the Board held that L&F’s profits from this source had been correctly filed as offshore and were not taxable.

On appeal to the Court of First Instance, Mr Benjamin Yu, SC on behalf of the CIR, suggested that the commission income was derived from both a Hong Kong source and an offshore source and hence should be apportioned. This opinion was based on the “brain analogy”, in that the knowledge of the business rested with the senior management, to whom junior staff frequently referred. Reyes J rejected the “brain analogy”, previously cited in ING Barings, on the basis that the administrative and oversight functions undertaken in Hong Kong were not relevant criteria for ascertaining the geographical location of the commission profit.

Reyes J concluded that the Board of Review had directed itself correctly in the analysis of the facts, in that “it was not the Board’s function to investigate every facet of L&F’s operations and then decide which matters were qualitatively the most important towards making a profit. What instead had to be done was what the Board actually did. That was to discern in a practical manner those activities of L&F which directly (as opposed to indirectly) led to the production of profits”.

Inevitably Reyes J, having decided in favour of the taxpayer, has had his judgment appealed by the CIR to the Court of Appeal, which, as we have seen, has a track record of finding in favour of the CIR. I await the decision with interest, and am also curious to see which judges are chosen to sit on this case.

The Court of Appeal’s decision, delivered by The Hon Tang Ag CJHC, dismissed the appeal by CG Lighting Limited (“CGL”) against Fok J’s judgment in the Court of First Instance and upheld the position of the Commissioner of Inland Revenue (“CIR”) that 100% of CGL’s profits were sourced in Hong Kong. This came as no surprise, as past experience has indicated that only when cases are heard at the Court of Final Appeal, for which experienced international tax judges are brought in to sit on the bench, can a taxpayer expect a clear interpretation of Hong Kong’s tax laws.

I assume that many people who have read the decision will share my opinion that there was a strong expectation by the Court of Appeal that the case would be appealed to the Court of Final Appeal. Such people will probably not be surprised that the judgment lacks substance in its analysis of the law. However, I was surprised by the comments of the Court of Appeal that were directed at the Board of Review’s findings on fact which, in Tang’s own words, were “not something with which we are required to deal”, yet were expressed anyway, albeit in passing. This is certainly a practice that should be avoided.

Whatever my opinion of the decision, it pales into insignificance when compared with my disgust at the CIR’s refusal to grant consent to CGL’s application to appeal the Court of Appeal’s decision to the Court of Final Appeal. CGL has now applied to an appeal committee of the Court of Final Appeal for leave to appeal to that Court. I suspect that such an appeal has been based on the amount of tax involved, and also on the fact that the issues are of great or general public importance. Certainly for the case to be concluded at this stage would be a huge, if not unexpected, bonus for the Inland Revenue Department.

Personally, I am extremely disappointed that neither the CIR nor the Court of Appeal was able to appreciate the importance of taking this case to its final conclusion. If you were a cynic, you might conclude that the CIR saw this as an easy way to win the case before it could be heard by an experienced revenue judge. In my opinion, such a course of action, whilst to the CIR’s benefit, shows a total lack of interest in seeking an important decision on one of Hong Kong’s more contentious issues. Similarly, it would also be easy to conclude that the Court of Appeal did not wish to have its own decision in this case, and the decision in the earlier case of Datatronics, reviewed and possibly overturned by a court of higher authority.

I sincerely hope that common sense prevails and that leave to appeal to the Court of Final Appeal is forthcoming.