How fees are derived by non-financial institutions and some important ‘source of profits’ cases experienced by the taxpayers having company incorporation HK


11 Dec

In this blog we will throw light on some of the important ‘source of profits’ cases that are experienced by the taxpayers doing business in Hong Kong. These are the cases of taxpayers as individual or group of the people in the form of company. We will thoroughly analyze the decisions of Inland Revenue department, court of appeal and board of review etc.


Fees for Underwriting/Guarantee Derived by Non-Financial Institutions

As described in the departmental interpretation and purchase notes 21 (DIPN 21), the source for underwriting/guarantee fees that are received by financial institutions is decided by viewing at whether the applicable risk is assessed and carried by the institution of Hong Kong. However, from the DIPN21 (revised) it is not clear that, whether source of guarantee fees obtained by the non-financial institutions is determined in a same way or not. In accordance with the minutes of annual meeting that held between Inland Revenue department and HKICPA in year 2011, it was indicated by Inland Revenue department that:

  • The basic source of profits is a question of actuality.
  • If the non-financial institutes drill the same risk and were operated under the similar scenarios as that of other financial institutions, the source rule same as on guarantee fees for financial institutions could also be applicable to the non-financial institutions.
  • In the generalization of cases, the undertaking and evaluation of risk for the determination of underwriting fees or source of guarantee by the taxpayer would be taken into account by the Inland Revenue department. But in some uttermost cases such as in the case of Kwong Mile Services it was observed that, profit arose from the marketing activities and it did not arise from the underwriting arrangement. To focus on the relevant principles was the proper approach while it is not proper approach to formulate the rules on the ‘relevant profit-generating activities’ for a specific type of profit or income. The reference for this statement is taken from the Bulletin of tax 21.

The discussion done below gives a summary of some ‘source of profits’ court cases related to companies having Hong Kong incorporation:

Case of Whampoa Dock Co Ltd.

The business of ship repairing was carried on by the Hong Kong & Whampoa Dock Co Ltd. only in Hong Kong. A ship was wrecked accidently outside Hong Kong in the open ocean. The owners of the ship called for help. A tug was sent by company and it pulled the wrecked ship for repair to Hong Kong. The cost contract was signed outside the Hong Kong on the wrecked ship. It was held that no division should be made even though the last three miles of the cost journey back to the Hong Kong was in the waters of Hong Kong. The origin of profit was completely outside Hong Kong as the profit was obtained from the operations that were carried out considerably outside Hong Kong by the taxpayer having offshore company incorporation. The operation test of the case of Smidth & Greenwood was applied.


Case of Seng Bank Ltd.       

Hang Seng was doing business in Hong Kong. It had no foreign branches. From the investors & withdrawers in Hong Kong that bank obtained a large quantity of overseas currency. These funds were used by it to sell and purchase the bonds, securities like gilt edged and some other securities in Singapore and London. The foreign exchange department in Hong Kong for that bank made all the decisions to sell and buy. It was argued by the CIR that, as business was carried out at nowhere else other than Hong Kong, the decision was made in Hong Kong and fund came from its business in Hong Kong, the profits should be allowed to tax. It was found by board of review that, as the sales and purchase contracts were affected by the foreign brokers outside Hong Kong, so profits were also obtained outside the Hong Kong. Preferably, the profits arose outside Hong Kong from the use of its fund. The decision of board of review was supported by the Privy Council. The case of Mehta ITR 521 was followed. The two conditional demands of Section 14 of Hong Kong tax law were ignored by the argument of the CIR. The subjection of profits to tax is not only dependent on the carrying business in Hong Kong. The profits will be covered now by the Section 15 (1) 1 of Hong Kong tax law doubtlessly that was approved after the assessment year to which this case was related.

Case of HK-TVB International Ltd.

HK-TVB had a secondary company named as HK-TVB international Ltd. That company acquired or made the videos or films in Chinese language. In many countries, the company HK-TVB had the copyright to these films. The rights were given to TVBI by HK-TVB to use these outside the Hong Kong. These rights included the complete rights to sub-license its allocation. To send the indicatives abroad for the purpose of requesting the business and arranging the matters with customers was the general business way of TVBI. In the Hong Kong that sub-license was prepared and later it was sent to the customer to be signed. Infrequently, the signing was carried out in foreign. The payment in the form of sub-license fee was made in Hong Kong. The high court initiate for the CIR. The much condemned comments were made by the judge in the direction of judgement. The judgement was that; the profit could not be offshore as long as a profit-generating operation is not established outside Hong Kong by the taxpayer having offshore company incorporation. It was found by the court of appeal for taxpayer on the basis that, as the profit making activities were taken place outside Hong Kong and copyrights were also exercised outside the Hong Kong. As other possibility, the profit arose in the place where advantages in the form of assets were located and these profits were earned by the misuse of property. It was found and concluded for the CIR by Privy Council that:

  • The basic approach is to determine that which operations produced the relevant operations and at which place those operations took place.
  • The court of appeal was not right and the reason for this was that, the profit-making activities were carried out outside Hong Kong by sub-licensees and were not carried out by TVBI. These activities include exhibition of films and exploitation.
  • By adopting this point of view that, what appears is that TVBI, a company based in Hong Kong carrying on business in Hong Kong, obtained the rights of exhibition thence and also used those rights by awarding sub-licenses to foreign customers. The usage of rights of film that were exercisable overseas, was the relevant business of TVBI. This business was carried out in Hong Kong.
  • It could be only infrequent case that, a taxpayer with a basic place of business can earn the profits that are not chargeable to the Hong Kong profits tax. The reference for this statement is taken from the cases of Hang Seng Bank and Whampoa Dock. However, the judge of court was not right in saying that, a profit generation operation must be established by the taxpayer outside Hong Kong but in case if he is to have accepted profits as offshore.
  • This fact was not important in the non-presence of any financial interest in the succeeding exercise of the rights by sub-licensee that, relevant copyrights were located outside the Hong Kong.     

The decision of Privy Council is reasonable on the basis that; rights were obtained by the TVBI from HK-TVBI in Hong Kong and TVBI granted some of the sub-licenses to its customers outside Hong Kong (compared with the goods purchasing in Hong Kong). Other than that, there is one censure of its decision. It was held by the Privy Council that; profits were taxable due to the reason that business was carried out by TVBI outside Hong Kong. One more time, the fact that Section 14 of Hong Kong tax law requires two conditions appears to have been disregarded. Conceivably, by referring to ‘business’, the ‘operations’ that actually produced the profits were meant. There is a risk that, uncertainty may have created by its confusion of reason as to the profit’s source of question that had been a very disputable issue.

Case of Magna Industrial Company Ltd.

The business in engineering products was carried on by the taxpayer having Hong Kong incorporation. It purchased all the products from its completely owned secondary company named as A Ltd. The manufacturers that would supply the products were sourced by the A Ltd. Before the products were marketed by the taxpayer, A Ltd. would try out these products. He was also held responsible to ensure the both quantity and quality of the products. Profit was made by the A Ltd. on the sale of product to that taxpayer who exported his products to distributors around the globe. An ‘export manager’ was appointed by taxpayer in each region where it sold its products. These export managers were the non-dependent agents that were contracted by it. The finding of appropriate persons to be distributor and sell the products to these distributors was the major role of export managers. Sales were resulted outside the Hong Kong.

The taxpayer lost in the High Court but won at the board of review. It was ruled out by high court that, for the determination of whether profits of taxpayer arose in Hong Kong from the clashing factors of the case, it is actual to carry out a considerable exercise. Due to this reason, the practice of departmental interpretation and practice notes 21, to tax the complete profits if either the sale or purchase contract is effected in Hong Kong must not be true. However, A Ltd. was only the ‘pawn’ of Magna. According to the application of weighing exercise the source of profit was Hong Kong. It was followed by the Sinolink. The decision of the board of review was restored by the Court of Appeal. By also looking into the totality of facts not only the place where the goods were sold out and purchased the approach of board of review was accepted by it. The factors given below was also relevant:

  • Where the sales were requested?
  • How the goods were exported?
  • Where the goods were acquired and stored?
  • How the payments were effected?
  • How it was arranged the financing?
  • How the orders were exercised?

This case was of type borderline. But the most exceptional features in this case was that, the sales were undoubtedly of less-value products, in large numbers and was affected in foreign by a network of foreign independent contractors. The activities in Hong Kong like shipping, collecting payments and invoicing were additional and not the valid source of the profit. The view of High court that company A Ltd. was an only ‘marionette’ of Magna could never be supported. The reason behind this non-supporting behavior was that this was never the case of Commissioner.

Case of Kwong Mile Services Ltd.  

Profits were obtained by T from underwriting the sale of actual property in Mainland China to buyers in Hong Kong. Under that underwriting agreement, the profits of T consisted of the differences between individual unit’s sale prices and the amount paid by T to the developers of actual properties. For the purpose of selling and marketing the units in Hong Kong, another company was incorporated in Hong Kong and appointed by T as its absolute agent. It was held by the majority of board of review that, the profits derived or arose in were from the consideration of an underwritten chance that was outside Hong Kong and as offshore. It was considered by the court of final appeal that; T did not earn any fee, premium or other payment by the assumption of the risk. The profits were taxable on the basis that, underwriting profits arose from the marketing activities of T in Hong Kong.

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