How DIPN 21 explains terms of manufacturing profits, contract and import processing for company incorporation HK?


In this blog we will discuss terms such as manufacturing profits and contract processing and import processing. These terms are defined properly in the Departmental Interpretation and Practice Notes 21. We will be referring to DIPN 21 throughout our discussion. In our discussion on manufacturing profits we will discuss some cases to understand thoroughly that among the manufactured goods and unprocessed or raw good the supplier of which is regarded as having source of profit. Then we will discuss the contract processing and import processing separately and clarify the differences between both of them that will be helpful while in the process of new company registration in Hong Kong.  

DIPN 21 - Manufacturing Profits

The judge Lord Jauncey commented in case of HK-TVBI on the source of manufacturing profits. It was explained by him that:

If a merchant in Manila buys the goods of a manufacturer in Hong Kong, then there is no doubt in this position that the payment which manufacturers receive is sourced in Manila but his profit on the transaction is derived or arises in from his operation of manufacturing in Hong Kong.

As long as goods are manufactured in Hong Kong, the profits arising from the sale of such manufactured goods will be taxable fully. The basic reason for this is that, the manufacturing operations are considered as profit gaining activities and these are carried out in Hong Kong. These manufacturing operations include the employment of labor, the procurement of unprocessed or raw material and the use of plant and machinery etc. The reference for this statement is taken from Para 30, DIPN 21.       

Now we will discuss an example, a company B doing business in Hong Kong manufactures goods and sells them to its overseas customers. The fact that, company B has sales staff based on its overseas customers which cannot be consider as the part of profits having an overseas source.

This is not case of division of asset. So the whole of profit that is attained as the result of selling goods are liable to profits tax.

Let’s discuss next example, Company C sells the finished goods in Hong Kong after manufacturing in Mainland China. It sells the finished goods in Hong Kong by a selling or trading branch. That selling branch consists of fixed business place, sales staff and also Hong Kong registered business.

As company C after manufacturing of goods sales it through its selling branch in Hong Kong so it was both manufacturer and a retailer at a time. Its profits are derived from the manufacturing operation in Mainland China while its retailing operations are in Hong Kong. So it is necessary to divide the profits derived by company C depending upon the manufacturing and retailing. Profits attributable to the retailing branch of Hong Kong are allowable to profits tax.

DIPN 21 - Import Processing and Contract Processing 

In Mainland China, companies doing business in Hong Kong are mainly involved in two types of processing trade: import processing and contract processing. Both of these are different methods of transactions and exact legal analysis is required by each of it. The reference for this statement is taken from Para 32, DIPN 21.

Contract Processing  

The processing agreement is the document that governs the relationship among parties in case of contract processing. Responsibilities and rights of processing Mainland companies are set out by it. The main responsibility of Hong Kong company is to supply machinery and raw material without consideration and to provide managerial and technical know-how. The provision of factory property, labor force and utilities are the responsibilities of Mainland processing enterprise. A subcontracting charge is paid by the Hong Kong company to the Mainland enterprise as a return for the processing service. The Hong Kong company holds the legal title to the finished goods and raw materials. The Inland Revenue department considers that, the operation of Hong Kong company in Mainland China complements its operations in Hong Kong. The Inland Revenue department accepts a division of profits on 50-50 basis after recognizing the operations of Hong Kong company in Mainland. The reference for this statement is taken from Para 33 and 34, DIPN 21.

In case D 132/99 T faced that, all of its revenue were offshore in nature. It was held by board of review that, its operations in Mainland China were not influential to dominate the activities in Hong Kong. It also held that operations in Hong Kong might not be ignored. The reference for this case is taken from Para 35, DIPN 21.

In case D 145/99 it was found by board of review that, T having company incorporation HK was not familiar with the processing agreements. The fellow subsidiaries of taxpayers had been entered into these agreements. The taxpayer after expiry of processing agreement should be evaluated for profits tax on 100% of its profit for the assessment years. It was found by board of review that, business of T was the procurement of toys to fulfil the sale and purchase contracts. Board also found that, necessary operations happened inside Hong Kong. These important operations include: obtaining of raw material, the determination of price, the reaching of purchase agreements, and the shipment of finished goods. The reference for this statement is taken from Para 36, DIPN 21.

The division of profits could not be suitable if in the processing agreement with the Mainland enterprise, the Hong Kong company has restricted involvement. For example, assembly work has been contracted out by a Hong Kong company to various contractors in Mainland and Hong Kong. The jobs are countless but of short duration and small in value. The involvement of Hong Kong company is minimal in the assembly work. With the observation that, manufacturing operations are not carried out by Hong Kong company outside Hong Kong, its profits without any division must be completely accountable to profits tax. The reference for this statement is taken from Para 37, DIPN 21.

The division examined above will also applicable to cases where manufacturing events are assumed in other places under a similar arrangement. The reference for this statement is taken from Para 38, DIPN 21.

Import Processing

In case of import processing, a foreign company enterprise (FIE) carried out the manufacturing operations related to the Hong Kong company. A foreign investment enterprise is incorporated in the Mainland and is a separate legal entity. The company in Hong Kong buys finished goods from the foreign investment enterprise and sell raw material to foreign investment enterprise. The foreign investment enterprises manufacture the finished goods while the company in Hong Kong involves in the trading of unprocessed or raw materials and finished goods both. The legal title to the finished goods and unprocessed or raw material passes from / to the foreign investment enterprise. The gross profit of Hong Kong company arises from the trading transaction. As the company in Hong Kong purchases finished goods from foreign investment enterprises and sells them for a profit. Even though the Mainland enterprise and the Hong Kong company may be within same group of companies but manufacturing operations of the foreign investment enterprises are not done in Mainland for the account of or on the behalf of the company in Hong Kong. The reference for this statement is taken from Para 39 and 40, DIPN 21.

In the case of ING Baring the judge Lord Millet NPG said that, the source of profits had to be qualified to the operations of members of group that did not produce them rather it had to be attributed to the operations of taxpayer having set up Hong Kong limited company that produced them. The case D 36/06 was a classic case of import-processing. In that case it was held by board of review that, the profits of T were chargeable to profits tax fully. It was considered that neither foreign investment enterprise was part of T nor an agent of T. Hence the operations of foreign investment enterprise were not appropriate in determination of the source of profits of T. The argument of ‘substance over form’ was rejected by the board of review and it also affected with the suggestion that, a contract processing agreement and leasing contract of production services are similar. The reference for this statement is taken from Para 41, DIPN 21.

The Inland Revenue department considers that, accumulated profits to set up Hong Kong limited company by ‘transactions of trading’ that is functioning in Hong Kong purely, then that profits cannot be allowed to the making and developing processes of the foreign investment enterprise having business in Mainland China. If company of Hong Kong produced the profits, then the basis of running profits must be qualified to the operations of that Hong Kong company. In case of Consco Trading Co Ltd. Deputy J said that, the consideration of facts such as processing fees, the payment of unprocessed or raw materials, the finance management, pre-contract debate and the payment receipt arrangement for the completed item or product from the purchaser, is correct. The board of review was responsible to conclude that, on the proofs, prevalence of the profits earning activities were performed in the Hong Kong. It was stated by court of first instance that, as not for the determination of source of profits of T, the board of review correctly prohibited the processing activity of the Mainland Chinese premises. These profits were obtained by T through the sale of managed goods. The reference for this statement is taken from the case of Para 42, DIPN 21.

In case of Datatronic Ltd. it was observed that arrangement between foreign investment enterprise and T was an import-processing arrangement. In that case court of appeal held that, purchase of goods by T from foreign investment enterprise and subsequent sale were the profit-producing transactions and these profits gaining activities held in Hong Kong. Due to this reason profits were obtained from the Hong Kong. It was further concluded by the court of appeal that, the fact that foreign investment enterprise although a completely owned subordinate of T, is a different legal entity. Due to this reason, dealings of foreign investment enterprise with T were not overlooked and would not diminish from the reality of the legal effect of transactions. The finding of board of review was that, manufacturing as a substance and not form was done by the foreign investment enterprise in the mainland and the activities of T in Mainland were only incidental to the profit making activities. The court of appeal was agreed with this finding of the board of review. The reference for this statement is taken from Para 43, DIPN 21.

For the reason of avoiding or to comply with the trade barriers imposed by the overseas jurisdiction a Hong Kong company is sometimes hinted between a Mainland manufacturing enterprise and an overseas company. It was recognized by the board of review in case D 7/08 that making T, a customer of the overseas company, a Hong Kong company and of the Mainland enterprise released the overseas company from the barriers of trade. Applying what the court of final appeal held in Kim Eng case, it was also held by board of review that, on the question of operative cause of the making of profits, the relevant activity of T in Hong Kong was in question to earn the profits. In regards to this, it was done by T in Hong Kong. The reference for this statement is taken from Para 44, DIPN 21.

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