What are the findings of board of review in the ‘source of profits’ cases about taxpayers having well established or start up company Hong Kong?

In this blog we will discuss some cases of individual taxpayers and taxpayer companies in Hong Kong. We will attempt to explore the findings of the board of review related to these cases. These cases would be specific to the ‘source of profits’ of taxpayers both in Hong Kong and in foreign. A taxpayer should have an idea about legal technicalities before company formation HK and this blog will be a guide for it.

Case of Dataronic Ltd.

A contract processing agreement was held between T and a factory in the PRC for the manufacturing of new product in a start up company Hong Kong. This contract was for the production of electronic components for sale. For the purpose of taking over the manufacturing actions from that factory a subsidiary was setup by T in the PRC. The license of DSC was simply for the purpose of import-processing work. The finished items and transfer of materials between the two parties were by the way of purchase and sale. The DCS was provided by T with:

• The developing of machinery and plant; and
• Technical understanding, training, local workforce’s supervision, design and management.  

The price of the finished items paid to DSC by T represented approximately the expenses included by DSC after counterbalancing the price of raw material provided by T.

It was argued by the T that:

• Trading was not the source for driving its profits as its profits were obtained from the finishing and manufacturing activities in PRC and Hong Kong, such that division of its profits on a fifty: fifty bases would be reasonable; and
• DSC mostly manufactured its products by the way of contract processing in the PRC. That was manufactured on the behalf of DSC as an agent.

The decision of court of first instance was overturned by the court of appeal and it held that:

• DSC was not the agent of T;
• The profits were trading profits and not the manufacturing profits;
• The conclusion drawn by the board of review that, a division of profits should be made on 50: 50 bases was wrong.
• The deal between DSC and the taxpayer was not the contract processing but import processing.
• The board of review was not right to find that operation of T in the PRC that were mandatory operations and contributed to the in question profits.
• 
  

Case of C G Lighting Ltd an offshore incorporations HK limited

A factory was involved by T in its business previously to manufacture the goods under an agreement of contract processing. The Inland Revenue department agreed firstly that only 50 % of net profits of T from the sales of products which manufactured in Mainland were subjected to profits tax. Eventually, a completely owned Mainland subsidiary located outside the Mainland, CGED were under an agreement of import processing where the goods sold by T. The profits of T were taxed from the sales of goods in full. Technical understanding, management staff, unprocessed material, skills of production, product designs, skillful labor, training, computer related software, manufacturing machinery and plant and supervision was provided by T to CGES at zero cost.

The related parts of operation of T that were found by the board of review were as given below:

• For the purpose of managing and monitoring the operations of T, many members of senior management staff who were employed by T, were also stationed in subsidiary.
• Unprocessed materials that were required necessarily for the manufacturing of finished items were acquired by T in Hong Kong. Then it transferred to its secondary branch in the Mainland China according to the set production schedule in Hong Kong.
• It was the responsibility of T to perform designing, testing of product and production of prototype (this work was partly carried out at CGES in Mainland China and partly in Hong Kong).
• T concluded the purchases from the third parties. T prepared the orders of production and orders of sale work in Hong Kong while faxed to its secondary company CGES.
• The secondary branch gave the place and staff for the manufacturing of products like lighting fixtures for a monthly fees which was given by T. This fees was not greater than the coat incurred on the secondary branch overheads cost.
• Staff for production control and engineers responsible for quality assurance were employed and stationed in the secondary branch to update and train the staff of subsidiary this was according to the directions by T.

Documents were supplied to the CIR by T. Part of these supplied documents in respect of typical transaction were the CGES’s documents. It was suggested by these documents that, the items that it produced were sold to T. However, this type of sale was not agreed by T. It was the stance of T that documents did not reproduce the reality. And he further stated that, these documents were prepared to satisfy the authorities of Mainland. The appeal of Board of Review was allowed by T and this was concluded by it that, part of profits of T were generated outside Hong Kong and on these bases it was not chargeable to profits tax in Hong Kong. The question as to the suitable division of profits to be taxed was addressed to the CIR by the Board of Review. The CIR appealed to the court of final instance.    

It was considered by the court of final instance that, the CGES’s operation was not the operation of T and the activities of T in Mainland were incidental to that transactions. Although, there was zero sale of the finished products to T by CGES. This remains the fact that, finished goods are not manufactured by the T and T only had them to deport to it following to the subcontracting agreements between CGES and it. The transactions of T that were producing profits consisted of the accession of the finalized products from CGES, for which a processing fee was paid by T under subcontracting or processing agreement according to the producer of goods from CGES, and on bargaining of the goods to its customers. The transactions that produced the profits in goods for T were the finished goods’ sales to its customers. As those sales were accomplished in Hong Kong so the profits should be completely taxable. The following decision was given by the Court of Appeal in Datatonic:

The appeal of T to the court of appeal was abandoned. The leave to appeal application made by T was rejected by the appeal court.

Case of Li & Fung (Trading) Ltd.

A company named as T (LFT) was setting up sole proprietorship in Hong Kong. That company was completely owned by Li & FUNG (B.V.I) Limited (LFBVI). Li & FUNG Limited was a company incorporated in the British Virgin Islands. Li & Fung Limited completely owned the LFBVI. That company was listed on the stock exchange of Hong Kong. A business was carried on by LFT in Hong Kong. The head quarter of LFT was in Hong Kong and many of its senior most staff based here.

For the purpose of allowances of services, LFT ordinarily entered into contracts with customers. The customers of LFT were department stores, importers, and chain stores located in the foreign. Services are provided to these customers by LFT. For these shops that were located in foreign for which LFT was paid typically with 6 % of the goods’ FOB value which was supplied to these type of customers. In turn LFT entered into agreements of service with its foreign associates. As a practice, many of the services provided by LFT to its customers were carried out by its foreign associates outside Hong Kong. 4 % on the FOB value of the stock was paid by LFT to its associates in consideration for the services rendered. An agreement took place between LFBVI and LFT. Under that agreement, LFT agreed on that to pay the 2 % of FOB value to LFBVI for all export sales made for the services rendered by LFT. It was contended by LFT that; the profits related to the goods sourced from the suppliers was offshore if suppliers were located in the places except Mainland China, Hong Kong and Macau. As profit was offshore hence not taxable although the company was based in Hong Kong and was not offshore incorporations HK limited.

It was claimed by the CIR before the board of review that, a ‘supply-chain management businesses were operated by LFT. The profit of LFT was the difference within 6 %. This difference was received by it from its customers. And it also paid 4 % to its associates. As a result of managing its own activities and activities of its associates in Hong Kong, LFT earned the 2 %. On the other side, it was claimed by the LFT that, under Section 16 (1) of Hong Kong tax law, the fees paid to LFBVI were deductible. The anti-avoidance allowances in Section 61 and 61A were not appropriate to these type of deductions.

After a period of about 3.5 years after the hearing, the decision of board of review was passed on by it. The board of review:

• Deduced that, the agents of LFT were the foreign sourcing associates. The complete profits of LFT were grossed in the place where the foreign sourcing associates carried out its commands;
• Held in the favor of CIR on the Section 61 A of Hong Kong tax law issue and favor of LFT on the issue of source;
• Dismissed the proposal that LFT operated at ‘supply-chain business management’ and held that LFT was a ‘commission agent’; and
• Decided that, the under discussion profits had source outside the Hong Kong and question of division did not matter. Both of the parties applied to the court of first instance.      

An application was filed by CIR for the purpose of an amendment of the described case to incur the extra facts to demonstrate that the operation done in Hong Kong by LFT did generate a profit break to LFT. In accordance with the consideration of court for the Section 61 A of Hong Kong tax law issue, it was postponed the pending advantage of specific matters to the board of review.

In response to the appeal on the issue of source by CIR, the decision of court of final instance was upheld by the decision of board of review. It held that, there were enough proofs on which the board of review could deduce the conclusion and it did the same.

The court of appeal was appealed by CIR. The soul of the case of CIR in the court of appeal was that the, company formation HK operations and economic activities performed in Hong Kong by LFT were agreed clearly under the conformity with customers. And these were carried out in Hong Kong by the LFT while performing the phrases of agreements. These activities or operations that were capable of generating the profit which should had happen in Hong Kong.

The court of appeal rejected this appeal and held that:

• There were no grounds to cancel the case back to the board of review to enable the CIR to proceed a new case on division or to build more findings of facts.
• The facts found by the board of review justified the judgement of court of final instance freehandedly.  
• The material finding of facts had been made by the board of review and had given enough reasons, and the delay of board of review in passing on its decision would not provide the unsafe decision.
• The board of review did not deal with the argument of CIR raised in court of appeal and it cannot be blamed for that.
• On the question of source of profits, the relevant legal principals were applied. These principals were the wide guiding principles laid down in case of HK-TVB International Ltd., to earn the in question profit and the reputation on focusing the effectual reasons to profit-generating transactions as well defined from other incidental or antecedent activities to that transactions.