Different Cases on Tax Calculation and Basic Principles for Determining the Locality of Profits of Taxpayer Setting up a Business in HK

In this blog we will discuss some cases related to the decisions of the Inland Revenue department and board of review for profits arising in or derived by the taxpayers from Hong Kong. Then we will explore the basic principles that are mandatory for determination of the DIPN 2 ‘locality of profits’.

The main test is to observe that to earn the profits in question, what has been done by a taxpayer that have local or offshore company formation Hong Kong. If a taxpayer is not agent then it is absolutely wrong to look at what the other person has accomplished. In the source of profit cases this thing is an important point. It was considered by the court of appeal in case of Wardely Investment Services that, it was not valid to look at what the foreigner brokers did outside Hong Kong for determination of source of rebate earned for tax purposes by taxpayer. The determination of source of rebate is same as determining who was an investment advisor for clients. It appeared from the case that these agents were agents of the client not the agents of taxpayer. Also seen in the case ING Baring, Indosuez WI Carr Securitites LTD, D 72/03 the different investments stock brokers / advisers cases dealing with the question that whether or not group / broker companies acted as agents of taxpayers.

In a case D 20/02 it was observed that, the acts of a Hong Kong company were considered to be acts of taxpayer in Hong Kong. The actions of the company in Hong Kong were carried out as shipping and banking transactions for taxpayer who had Hong Kong open company.

In several cases of board of review, it was argued by the taxpayer companies that, as manufacturing of different stuff was carried out in Mainland China such that profits of taxpayer companies should be offshore. Although, the contracts for finished goods’ sale might be more effected in Hong Kong then Mainland China. The reference for this statement is taken from the cases D 55/00 and D 132/99. The board of review did not accept this argument of taxpayer companies. The reason behind this rejection was that, manufacturing in Mainland China was managed by separate legal entities. The manufacturing that was taken place in Mainland China had no involvement of taxpayer companies of Hong Kong.

Also in another case D 3/05 it was observed that, offshore claim of taxpayer having offshore company formation Hong Kong was failed. It was found by the board of review that; Mainland entities were not agents of taxpayer rather these were principals selling to retail customer in Mainland. The acts of these companies were not operations of taxpayer.


In a case of Kim Eng. Securities Ltd, it was concerned by the court of final appeal that, with the source of commission in regard of transactions on exchanges of foreign stocks so-called to have been carried out on T’s instructions, a company of Hong Kong acting outside Hong Kong for the clients. The perceived difficulty was that, profits in question were not derived on its’ own rather from the operations of the stockbroker. To overcome this earlier described difficulty, it was argued by T that, though acting through the agents, clients’ order had executed by itself.

It was observed by the judge Lord Herschell in case of Kennedy that, no word is more constantly and commonly abused than the word agent. An agent is basically an alleged person who acts on behalf of the other person. That other person is called ‘principal’. These actions are usually to affect the legal relations of principal with the third party. Where a contract is entered into by an agent who acts on behalf of the principal, it becomes the duty of principal not the agent to incur the liabilities and obtain rights under the contract. In such scenario, it is accurate to describe the contract not as contract of agent rather as contract of the principal.

According to the judge Lord Millett in ING Baring:

A lot of professional persons that act on the behalf of client and described popularly as agents are not agents at all in this sense, for example stockbroker and estate agents. The business is transacted by the stockbrokers on stock exchange, not as the agents of their clients rather as the principals. On the contracts that they make with each other they are liable as principals and under those contracts, their clients have no liability. The only contractual liability undertaken by the client is his own stockbroker under the contract between them. In that contract each of them acts as principal.

In the consideration of source of profits, it is not mandatory for taxpayer who had Hong Kong open company if:

  • The taxpayer was acting:
  • In return of commission, for the account of a client; or
  • On the account of his own with a view to profit
  • That the transaction that caused the profit was carried out in full legal sense by him or his agent.

It was observed in the case of Chunilal Mehta that, a business was carried out by T in Bombay as a regular business and as a broker in commodity futures. T entered into a contract on his own behalf. The losses and profits that he gained on the basis of that contract in which he entered on his own account belonged to him. The commission was charged by T in regard to the business carried out for his clients. All the profits and losses belonged to T. The brokers were hired by T for transactions on foreign markets. These broker dealt on the relevant markets. The business was carried out by T from an office in Bombay. Everything he did to earn the profit and strengthen the business he did in Bombay. This fact was argued by the commissioner that T had to employ the brokers outside British India did not mean that what he earned on his own effort was earned where he hired the brokers. The Privy Council disagreed and did not accept the argument of the commissioner. The argument of the commissioner was that everything done by T to engage in each transaction in specific to the decision and the providing of instructions to foreigner brokers to carry it out was done in British India. So it was followed by the commissioner that the profits arose in British India.

For the determination of place at which such a profit arises to any transaction or not by the reference to the transaction, but only the reference to a place in India in the view of their leadership to proceed in a way that cannot be supposed if the profit of each transaction considered by themselves and the transactions are to be looked at separately.

The instructions of T were carried out in Mehta by foreigner brokers. They did so as not principals rather as agents. No reference to agency was contained in the opinion of the Privy Council. This opinion also does not depend on any alleged identity of his principal and agents. According to the judge Lord Millett in the case of ING baring, it was adequate that the profits arose from the transactions carried on by brokers acting on the instructions of taxpayer rendering Hong Kong company incorporation services. The same scenario was legal in Hang Seng Bank.

Locality of Profits DIPN 21

The ‘locality of profits’ DIPN 21 was issued by the Inland Revenue department on 4 December 2009. It was stated by the Inland Revenue department in this issuance that, in the decision of Hang Seng Bank the ground principals for determining the locality of profits pronounced, HK-TVBI, ING Barring, Orion Caribbean, Kim Eng. and Kwong Mile can be compressed as follows:

  • The assurance of the source of profits is though a practical, hard matter of fact. An accurate legal analysis of the transaction is required by it.
  • The query of locality of profits is a practical and hard matter of fact. No universal judge-made test will be able to cover all the cases. Whether profits derived from or arise in Hong Kong depends on the transactions giving rise to them and on the nature of the profits.
  • According to the board guiding principal one views to see what has been done by taxpayer to earn profit and where he has done it. In the similar way, proper approach is to assure that what were the operations that helped in the production of relevant profits and where those operations took place.
  • The profits for each transaction is considered on their own and the transaction must be viewed at separately.
  • The relevant operations do not consist of the whole activities of taxpayer that were carried out in the course of his business. These consists of only those which produce the in question profit. It is mandatory to appreciate the reality of each case that without being diverted by incidental matters or predecessor focuses on the effective causes of earning.
  • The operation of the taxpayer must also be the operation in question.
  • In some specific situations, such as the conditions where gross profits from an individual transaction arise in separate places, these profits can be divided as arising partly outside and partly inside Hong Kong.
  • The reference to gross profits is used to made the distinction between offshore profits and Hong Kong profits. The gross profits are those that are arising from the individual transactions.
  • The examination of operations of taxpayers is mandatory regardless of the fact that the within a group, taxpayer may be a company. If a taxpayer produces the profit, then the source of profits must be assigned to operations of that taxpayer. These should not be assigned to the operations of other members of group. It should not be looked by the operations of group on the question of source. However, in some suitable cases, if in fact a related company is acting on the behalf of taxpayer, then it will be considered to see the activities of the related companies if suitable, weight should be granted thereto.
  • The locality of profits is not determined generally by the place where day-to-day investment decisions are taken.
  • It is not mandatory in the brokerage business that, the transactions that produced the profits was carried out by agent of taxpayer or taxpayer himself / herself in the complete legal sense. (i.e. a person or party that enters into a contract on behalf of his / its principal and creating the contractual principal relationship between a third party and his / its principal). It is adequate that a person acting on instructions of taxpayer carried out the transaction on the behalf of taxpayer having local and offshore.
  • While identifying the acts of an agent with those of its principal, so imposing some unity on the law applicable to scenario where action or representation is done by one company for other, should not be taken too literally or to an unsuitable degree, since this is not useful for arriving at the accurate legal analysis.
  • The place where a business is carried on by the taxpayer is not necessarily the place where the profit of taxpayer arises. However, it was stated by the judge Lord Jauncey in case of HK-TVBI that ‘it can only be happen in some rare cases that, profits that are not chargeable to profits tax were earned by the taxpayer with a principal place of business in Hong Kong’.          
  • It is not meant by the absence of a foreign permanent establishment of a Hong Kong business that, all of the profits of the business are derived or arise in Hong Kong.

These 15 principals described above are not to be all inclusive, as the weird fact of a case may require special consideration but one should be familiar with these before setting up a business in HK. 

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