Will a taxpayer who earns income from business conducted through overseas affiliates, but manages and supervises the business of the overseas affiliates in Hong Kong, incur a profits tax liability on the income?

Courts have reiterated that a taxpayer’s profits taxable income should not be allocated based on the fact that the management and supervision of an overseas affiliate in Hong Kong is a key factor in generating the taxpayer’s profits. To determine the source of the taxpayer’s income profits, the taxpayer must first identify the transactions that directly generated the profits.

Background

CIR v Li & Fung (Trading) Limited

The taxpayer in this case was a local company carrying on agency business. The Hong Kong agent provided services to its unaffiliated customers in relation to the manufacture, sale and purchase of goods. These services include sourcing suppliers to manufacture goods which are then sold to the Hong Kong agent’s customers by these unrelated manufacturers. Many of these services are provided by the agent’s offshore affiliates, and the Hong Kong agent’s activities are “limited” to managing the procurement and manufacturing process to ensure that the goods are delivered to the customer’s satisfaction.

The taxpayer is compensated as an agent at 6% of the FOB value of the goods supplied. The taxpayer also contracts with a local company (usually a subsidiary) that provides services to the taxpayer in exchange for 4% of the value of the goods.

The IRD considers that the difference between the 6% received by the taxpayer from its customers and the 4% paid to its subsidiaries represents its profit. The IRD assesses the taxpayer as earning 2% of the difference from its Hong Kong business.

The taxpayer objected to the assessment on the ground that the relevant profits were offshore in nature and were not subject to profits tax.

The case was argued and appealed, with the Board of Tax Appeals holding that the taxpayer’s commission was earned at the place where the overseas purchasing affiliate carried out its instructions and that the 6% commission should not be allocated based on the activities of the overseas purchasing affiliate and the taxpayer.

The Court of First Instance ruled that the Board’s findings and conclusions regarding the source of the taxpayer’s profits were irrefutable. There is no basis to say that the Board of Tax Appeals should have allocated the 6% commission in the manner recommended by the IRS. It could not be said that the Board of Tax Appeals acted unreasonably or that its conclusions were not supported by the available evidence.

The case was ultimately appealed to the Court of Appeals.

Controversy

Hong Kong has a territorial taxation system and only profits derived from Hong Kong are subject to profits tax. Did the taxpayer in this case, as an agent, source its profits from goods supplied outside Hong Kong from overseas?

The Court of Appeal’s decision

The Court of Appeal handed down its judgment on 19 March 2012, agreeing with the Court of First Instance’s decision and stating that its conclusion was well-founded. The Court of Appeal considered the taxpayer’s submissions and highlighted the important distinction between the taxpayer’s management of its business in Hong Kong and the source of profits of its affiliated companies outside Hong Kong.

On the issue of where the profits came from, the Court of Appeal reiterated its approach in ING Baring Securities (Hong Kong) Ltd v CIR that it was appropriate to look at what the taxpayer did to earn the profits and where he did it.

The Court of Appeal also noted that the Board of Review should not be accused of failing to address the arguments made by the Commissioner of Inland Revenue in the Court of Appeal. The Board’s delay in issuing the decision did not render the decision unsafe. There was no basis to return the case to the Board for additional factual findings.

The court ultimately denied the IRS’s appeal. The taxpayer prevailed.

Conclusion

The court’s current approach is more “factual” and not limited to contractual matters. In addition, section 14 of the IRO only applies where the profit-generating transaction is carried out in Hong Kong.

However, it is important to note that the IRD attempts to prove that some of the activities in the agency contract are performed in Hong Kong. However, as this point was not raised before the Board of Review, the Court of Appeal ruled that the matter should not be referred back to the Board so that the Commissioner of Inland Revenue could raise this new argument.

Determining whether the source of the income from profits is Hong Kong is not a straightforward matter and is often confused with prior or incidental activity. If you have any questions, please consult a tax or legal professional.