Hong Kong Tax System & CIR v Li & Fung (Trading) Limited
Hong Kong Tax System & CIR v Li & Fung (Trading) Limited
Is the Hong Kong tax system straightforward and/or simple?
A discussion negatively re-confirmed in CIR v Li & Fung (Trading) Limited
In a recent ‘Wordwide Tax Daily’ article from Taxanalysts, it was stated that the tax system in Hong Kong is exceptionally simple! Of course, the article is right in as much that the current Hong Kong Inland Revenue Ordinance does not contain many pages, at least not when compared to the tax provisions of many other jurisdictions. Whether the Hong Kong tax system is also a straightforward system is up for debate.
Take the charging provision for the territory scope of profits, article 14 of the Inland Revenue Ordinance, as an example says in article 14(1) that ‘…profits tax shall be charged … on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong … from such trade, profession or business …’. Unfortunately the Inland Revenue Ordinance does not explain these words in much detail, so that even the most straightforward cases are actually made complex and much is left to the tax advisers/lawyers and the Courts. Of course, some Departmental Interpretation and Practice Notes have been issued by the Hong Kong Inland Revenue on these subject matters, along with some published Advanced Rulings, such as Case No 44 regarding a Hong Kong data center and Case No 45 regarding a Hong Kong IP provider, but these are of limited use and cannot be considered as law as such.
In general, this means that article 14 of the Inland Revenue Ordinance is only applicable when there is a trade, business or profession in Hong Kong that produces a profit arising in or derived from Hong Kong. In other words, the profits must have a source in Hong Kong.
Over the years Hong Kong case law has established general principles and rules in order to determine the source of profits. In CIR v Hang Seng Bank Limited  3 HKTC 351 it was said that ‘one looks to see what the taxpayer has done to earn the profit.’ This statement was further refined in CIR v HK-TVB International Limited  3 HKTC 468, which said that ‘one looks to see what the taxpayer has done to earn the profits in question and where he has done it’. The Hang Seng Bank case also considered particular types of profits and general rules were laid down for the determination of the source of such profits. For example, some of these general rules established that the source of trading profits is where the contracts for purchase and sale are affected (see the Magna case below). It also indicates that service fee income is sourced where the services are performed and that profits from lending arise at the place where the money is lent.
In CIR v Magna Industrial Company Limited  3 HKC 210 it was said that for trading profits the ‘totality of facts must be looked at’ in determining what the taxpayer did to earn the profit. Generally there was much reliance in the past on the above-mentioned established general rules for certain types of profits.
Recent Court cases, however, seem to have deviated from this practice. See for example ING Baring Securities (Hong Kong) Ltd v CIR  10 HKCFAR 417, Ngai Lik Electronics Co Ltd v CIR  12 HKCFAR 296, CIR v Datatronic  4 HKLRD 675, CIR v C G. Lighting Limited (CACV 119/2010) and Li & Fung (Trading) Limited v CIR (HCIA 3/2010). As the Li & Fung (Trading) Limited case makes reference to all the other cases mentioned herein, only the Li & Fung case is briefly discussed as follows.
The Li & Fung (Trading) Limited case was regarded as an agency case, whereby the Hong Kong agent (principal) provided services to its non-related customers in connection with the manufacture, sale and purchase of goods. Such services included finding suppliers to manufacture the goods, which would then be sold by these non-related manufacturers to the Hong Kong agent’s customers. Many of the Hong Kong agent`s services were carried out by its offshore affiliates, and the Hong Kong agent’s activities were ‘restricted’ to managing the sourcing and manufacturing process to ensure that satisfactory goods were supplied to its customers. The Hong Kong agent usually received a commission of 6% from its customers, of which 4% was passed on to the Hong Kong agent’s affiliates. The Commissioner for Inland Revenue argued in front of the Board of Review that all of the 6% commission was taxable in Hong Kong, as it suggested that the Hong Kong agent operated a ‘supply-management businesses. The Court reformulated the Commissioner’s case so that it no longer pressed the submission that there was a ‘supply-management business’ but that the commission should be apportioned, with 4% attributable to the offshore activities of the Hong Kong agent’s affiliates and the remaining 2% attributable to the Hong Kong agent’s activities in Hong Kong. In short, the High Court, in agreeance with the Board of Review’s decision, came to the following conclusions:
1. “In ING Baring, the Court of Final Appeal criticised an approach to profits tax which fixed the geographical location of a taxpayer’s profits by reference to ‘activities antecedent or incidental’ to those transactions: Ribeiro PJ commented (at para.38): “Such antecedent activities will often be commercially essential to the operations and profitability of the taxpayer’s business, but they do not provide the legal test for ascertaining the geographical source of profits for the purpose of section 14””;
2. “In ING Baring it was stressed by the Court of Final Appeal that to determine the source of a profit, one must first identify the transaction which directly gives rise to the profit”;
3. “Ribeiro PJ said in ING Baring that “use of a ‘brain’ analogy or the place of administration of the business as criteria for ascertaining the geographical source of profits is plainly inconsistent with the decisions [… ] in Hang Seng Bank. In a case like the present, source is determined by the nature and situs of the profit-producing transaction and not by where the taxpayer’s business is administered or its commercial decisions is taken”” (NB: NO management and control test);
4. “The Hong Kong agent’s affiliates assisted the Hong Kong agent’s customers in placing orders with offshore sellers, supervised the manufacturer by those sellers of goods to the specifications of the Hong Kong agent’s customers, and arranged for the shipment of the finished goods from the sellers to the Hong Kong agent’s customers. It was those activities which directly led to the payment of the 6% commission which took place outside of Hong Kong”; and
5. “It is true that the Hong Kong agent maintained back-up or support services for its affiliates at its Hong Kong headquarters. But it was allowed to disregard these as merely antecedent activities which although commercially essential to the operations and profitability of the Hong Kong agent’s business they do not provide the legal test for ascertaining the geographical source of profits”.
The above shows that the approach of the Courts is now more a `totality of facts` approach and is not limited to contractual matters. Also, section 14 of the Hong Kong Inland Revenue Ordinance is only applicable when the profit producing transaction is in Hong Kong. Nevertheless, determining the source as Hong Kong is not a straightforward and easy exercise and is often confused with antecedent or incidental activities.