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The HK Court Cases  Review and Learn

 As Hong Kong adopts a territorial source principle of taxation. Only profits which have a source in Hong Kong are taxable here.
Profits sourced elsewhere are not subject to Hong Kong Profits Tax. That mean tax is possible exempt.) Company can claim offshore income with provide enough evidence proof. The principle itself is very clear but its application in particular cases can be, at times, contentious. To clarify the operation of the principle, we have prepared this simple guide on the territorial source principle of taxation. It gives a brief explanation of how the principle operates and provides simple examples for illustrative purposes of the tests applied to different types of businesses. If you wish to explore the subject in greater depth, we recommend that you consult your professional advisers.

 

CIR v The Hong Kong Whampoa Dock Co .Ltd.

This case concerns the profit derived by a Hong Kong ship-building company from a ship-salvage operation performed in waters outside Hong Kong's boundary. The company argued that because the operation was done outside Hong Kong, the profit was not taxab1e. The Board allowed the company's appeal.

CIR appealed to the court. The court upheld the Board's decision and held that the payment of services is of no importance in deciding the issue and because almost the entire services performed, which gave rise to the profits, were performed outside Hong Kong, the profit did not arise in or derive from Hong Kong. ~

CIR v Euro Tech (Far East) Ltd.

The taxpayer was incorporated in Hong Kong. It was a subsidiary of a UK public company. Its business comprised of marketing and trading of e1ectronic equipments. The equipments were bought from the UK parent company as well as from within the group companies. It entered into a distributorship agreement with a Korean company and a Singaporean company. Having received orders from these two companies, the taxpayer sent orders to its UK parent or group companies. Then, the equipments were shipped directly from UK to the two companies. The profit earned by the taxpayer was assessed to Profits Tax. The taxpayer appealed to the Board who al1owed the appeal. Then, CIR appealed to the High Court and got the Board's decision reversed. The court ru1ed that it was the bridging operations done by the taxpayer between the UK companies and the two overseas buyer companies in Hong Kong that gave rise to the profit..

The court said: “If. taxpayer has a principal place of business in Hong Kong, it is likely that it is in Hong Kong that he earns his profits. It will be difficult for such taxpayer to demonstrate that the profits were earned outside Hong Kong and therefore not chargeable to tax."

CIR v International Wood Products Ltd.

The company acted as agent for two overseas principals for sale of 1ogs. It appointed sub-agents outside Hong Kong for the sale. Orders and payments were sent directly to its principals. The company received commission and passed on sub--commission to the sub--agents. Profits Tax assessments were raised to assess the amount retained by the company. The Board annulled the assessments because the work giving rise to the commission was found outside Hong Kong. This decision was upheld by the court saying that the source of the commission income was the place where the services were rendered to earn the income and the source in the case was outside Hong Kong ------ the services done by the sub--agents outside Hong Kong--- even though the company did some ancil1ary services in Hong Kong.

CIR v Karsten Larssen & Co.(H.K.)Ltd.

The case also concerned commission involving overseas services but the commission was held to be taxable. In the case, the commission was earned by a ship broker for seeking chatterers and concluding charter agreements. Although some services were carried out overseas by an agent appointed by the taxpayer, the profit retained by the Hong Kong company was held to be derived from Hong Kong ---based on the fact that there was an agreement identifying the taxpayer and the overseas agent and their share of the commission.

Sinolink Overseas Ltd. V CIR

The company bought plywood for sale in Hong Kong and main1and China. The company did not have an office in China but had one in Wanchai.

Its sales to China were concluded in China by a director who had full power to sign contract on behalf of the company. After conclusion of the sales, the company sent purchase orders to overseas manufacturers. The company argued that it had carried on two businesses: one in Hong Kong and the other in China. Both arguments were rejected by the court. Applying the operations test, the judge Hunter J ruled that it was the activities of the Hong Kong office that produced the profits. The reasoning is as follows:

(1 )The setting for business and the 1ogistics for the purchase and sale were all done in Hong Kong.

(2)The purchases were managed and arranged in Hong Kong.

(3)The China sales were conc1uded in China. But the company's profits should be regarded as from both the purchase and sale. This factor could not alone make the profit from China sales non-taxable. -

(4) The post--contract activities and management work were done in Hong Kong. On a totality of the above factors, the judge conc1uded that all the profits ---Whether from Hong Kong sales or China sales --- were taxable. The decision in Sinolink case is controversial. Its importance has been falling, especially after the recent case CIR v. Magna Industrial Company Ltd.

CIR v. HK-TVB International Ltd.

The taxpayer (hereinafter called TVBI) carried on the business of 1icensing films that had been produced by its parent company HK-TVB Ltd (hereinafter called TVB). Pursuant to agreements between the taxpayer and TVB, the taxpayer was granted the exclusive right to broadcast and export TVB's television films and programs outside Hong Kong and to grant sub-licenses to others. The negotiations between the taxpayer and its customers usually took place outside Hong Kong. The business contracts signed by the overseas customers were sent to the taxpayer in Hong Kong for conclusion. The taxpayer objected to the profits tax assessment on the grounds that the profits were outside Hong Kong. The Board agreed to the taxpayer's arguments. The case final1y went to Privy Counci1.

It was held that the profits were assessab1e because the operations producing the profits ---the acquisition of the exclusive rights of granting sub-1icenses together with the relevant films and the grant of those sub-licenses together with the provision of the film by contracts with individual customers --- were carried out in Hong Kong.

CIR v Emerson Radio Corporation

The taxpayer is an American corporation manufacturing and sel1ing e1ectronic equipments. It was the registered owner of a trade mark "E". It had a wholly owned subsidiary in Hong Kong. The Hong Kong subsidiary contracted with manufacturers in various Asian countries, inc1uding Hong Kong, for the manufacture of electronic equipment to be sold main1y in US. No goods were sold in Hong Kong. Profits tax was paid by the Hong Kong subsidiary in respect of its trading profits arising from its course of business in Hong Kong. The Hong Kong subsidiary had entered into a royalty agreement with the taxpayer under which the Hong Kong subsidiary was allowed to use the trade mark on goods sold by the Hong Kong subsidiary to the US. CIR assessed the taxpayer to profits tax on its royalty income under Section 15(1 ) (b). The taxpayer appealed to the Board on the grounds that the trade mark was not used in Hong Kong. The Board dismissed the taxpayer's appeal and ruled that the royalty income was indivisible sum --- it could not be apportioned between goods manufactured in Hong Kong and goods manufactured outside Hong Kong. The taxpayer appealed to Court of First Instance. It was held that only the royalty income attributable to the goods manufactured in Hong Kong is taxable and the income attributable to the goods manufactured outside Hong Kong is not taxab1e. Therefore, apportionment of income could be made. The ruling of the Court of First Instance was uphe1d by the Court of Final Appeal.

Bank of India v CIR The Bank was carrying on business in Hong Kong and was active in trade financing through discounting of foreign bills. The bi1ls originated from international trade. The drawers of the bills, companies of Hong Kong, were suppliers of goods. The drawees were importers of goods residing outside Hong Kong. The Bank was the payee. On application of the customers, the Bank discounted the bills and paid the proceeds to the customers in Hong Kong while the collection of the value of the bills on maturity was performed overseas by the Bank's agent.

The Bank made profits from the difference between the costs of the bills and proceeds on the maturity of the bills. The profits were assessed to Profits Tax. The Bank appealed to the Board who decided in favor of CIR. The Bank appealed to the High Court. CIR won. It was held that the operations from Which the profits arose took place in Hong Kong.

Board of Review case Dl4/96The company was a travel agent se1ling outbound tours through its retai1 outlets in Hong Kong. It claimed that the outbound tour income should not be assessable because such income arose main1y from activities outside Hong Kong. The Revenue disallowed the claim and the company appealed to the Board of Review. The Revenue contended that the income was derived from the buying and selling of tour packages and all such activities were done in Hong Kong. In fact, the company had a number of retail outlets in Hong Kong. It also purchased al1 airline tickets for its tours in Hong Kong. The Board's approach was to analyze the case by identifying the company’s activities concerning the issue. It found that the company's relevant activities consisted of:

1. the marketing and sale of the tours through its retail outlets

2. the purchase and sale of airline tickets

3. the discharging of the obligations of the company and its agents for the tour services No doubt, the first and second type of activities were done in Hong Kong. As for the third activity, the Board found that it took place mainly outside Hong Kong. In this activity, although no formal agency agreement was entered into by the company with its 1and operators in each tour destination, the 1and operators acted on behalf of the company to perform the various activities which the company had contracted to provide for the tour. The relationship between the company and the land operators was based on trust and the land operators should be regarded as agents of the company and their activities were also relevant to the earning of the profits. The Board considered whether the profits should be apportioned between the three activities. However, the Board found this question problematic because neither the company nor the CIR admitted the possibility of apportionment. The Board said:

“Presumably this was on the basis that the profit was on inseparab1e Whole obtained as the indiscriminate result of the entirety of operations.” So, the Board adopted the principle of the Whampoa Dock case: where apportionment was not possib1e, the 1ocality where the profits arise must be determined by considerations which fasten upon the acts more immediately responsib1e for the receipt of the profit. Having considered all the relevant facts, the Board took the view that the first and second activities namely marketing and sale of the outbound tour in Hong Kong was more immediately responsib1e for the receipt of the profit. The Board therefore held that he profit arose in Hong Kong and was taxab1e.

Exxon Chemical International Supply SA v CIR

The taxpayer was the wholly--owned subsidiary of a multi-national corporation in the USA. It carried on business in Hong Kong and the Bahamas. In the course of business in Hong Kong, it purchased goods from one affiliate within the group and sold them to another at a profit. The taxpayer invoked Section 70 A to correct a profits tax assessment on the argument that all services (for example shipping of goods) were performed outside Hong Kong. After his claim rejected by CIR, the taxpayer appealed to the Board which upheld the CIR's determination. The taxpayer then appealed to High Court and his appeal was dismissed

In the Exxon case, the court said: "ECIS submits that before deciding Where a profit is derived (or, I suppose, Where it arises) it is necessary first to determine how the profit is derived and then (and then on1y) secondly to determine where it is derived. I am content for the purposes of the present case to accept this; having already demonstrated how the profit on the transaction in question was derived 1 can satisfy myself that it was derived from a “mark-up" on sales (as ECIS itse1f submitted) and I can go on to consider where it was derived. I ask myself Where did ECIS obtain the buyer's order for the goods? The answer is that it obtained that order in Hong Kong. I ask myse1f:Where did ECIS p1ace its order with the seller for the goods to meet the buyer's requirement?

The answer is that it placed that order from Hong Kong. These acts, the obtaining of the buyer's order in Hong Kong and the placing of the order with the seller from Hong Kong, are the foundations of the transaction; for it is the differential between the selling price and the buying price ("the mark--up" ) which generates, indeed represents, the profit... In my judgment (and on this I agree with the Board), on the facts ECIS derived its profit from what it did in Hong Kong. The income which arose from the "mark--up" taken by ECIS arose where the mark--up was taken; that is to say, in Hong Kong. No doubt, income arose on the de1ivery of the goods to the buyer, but that was the income of those responsible for getting the goods from Houston to Singapore. The on1y income of ECIS was its "turn" between the se11ing and buying prices. ECIS does not operate, outside Hong Kong, any activity with a view to profit. It is in my view immaterial that the subject of the transaction, effected in this case by the acceptance of ECIS of the order from the buyer and matched (at a profit) by its own order p1aced with the seller, was a load of lube oil additive destined for transshipment from the USA to Singapore. The business was transacted in Hong Kong." ~

CIR v. Magna Industrial Company Ltd.

The taxpayer was a limited company carrying on business in Hong Kong. It acquired industrial products from its wholly-owned subsidiary and so1d them to overseas customers. The subsidiary acquired the products from overseas supp1iers and warehoused them in its name in Hong Kong. The taxpayer set up a sales network comprised of independent contractors in their own countries. The independent contractors were to find suitable distributors, to train and supervise them and to promote the sale of the taxpayer's products. The independent contractors were authorized to enter into sales orders. The independent contractors sent the sales orders to taxpayer in Hong Kong for processing. Then, the taxpayer bought the goods from its subsidiary and shipped the goods to the customers and collected the sales money. The profit made by the taxpayer on the sale of the goods was assessed to Profits Tax. The taxpayer appealed to the Board successfully. It was held that the activities in the purchase of products were those of the wholly--owned subsidiary, and not the taxpayer, and the sales of products were effected by a network of overseas independent contractors who had the authority to bind the taxpayer to specific orders. Therefore, the profits were derived outside Hong Kong.

CIR appealed to the High Court. The High Court allowed CIR’s appeal based on the findings that the subsidiary was the taxpayer’s agent in its purchase activities in Hong Kong. The taxpayer appealed to Court of Appeal. This time, the taxpayer won and the Board's findings and decision were restored.

Note the following court comments :"More often than not, it wou1d not be the quantity of activities but the nature and quality of them that matters more. The cause and effect of such activities on the profits is the determining factor. It is what role such activities p1ayed and the relative importance of them in the making of profits that would usually tilt the scale and not the number of activities carried out at a particular place…''' This is a case of trading profit and the purchase and the sale are the important factors. We p1ace on record that we have inc1uded in our deliberations al1 of the relevant facts and not just the purchase and sale of the products. C1early everything must be weighed by a Board when reaching its factual decision as to the true source of the profit. We must look at the totality of the facts and find out what the Taxpayer did to earn the profit... Obviously the question where the goods were bought and so1d is important. But there are other questions : For example: How were the goods procured and stored? How were the sales solicited? How were the orders processed? How were the goods shipped? How was the financing arranged? How was payment effected?"

It is noteworthy that different judges have different decisions on the same issue in the same case. This reflects the practical difficulty in identifying what is the immediate operation to earn the profit in question. The reality is: If the IRD disallows an off-shore claim, the taxpayer has to appeal to the Board or even the court and then to bear all the costs involved and the uncertainty of the judgment. Therefore, a prudent taxpayer must endeavor to put forward all the relevant facts as  early as possible to convince the IRD to accept his claim

Wardley Investment Services (Hong Kong Limited) v CIR Taxpayer was a company incorporated in Hong Kong and carried on business as investment adviser. In the course of business, it arranged for sale and purchase of overseas securities on behalf of its c1ients; and from such activities it earned rebate from overseas stock--brokers. The rebate was assessed but the taxpayer appealed to the Board against such assessment. In its decision, the Board of Review ruled that the rebate was not assessable. The ruling was based on the 'operation test' and its findings that the 'operations' giving rise to the profits were done outside Hong Kong.

The Board's findings and decision were overturned by the High Court. The taxpayer appealed to Court of Appeal. It was held by majority that the profits were taxable because the taxpayer did nothing outside Hong Kong to earn the profits. Author's comment: In my experience, it is hard to convince the Revenue to accept the offshore c1aim where the taxpayer's activities outside Hong Kong were minimal. It should be noted in this case that the overseas operations giving rise to the profits were not done by the taxpayer but by the overseas stock--brokers.

Commissioner of Inland Revenue v. Hang Seng Bank Ltd.

This case concerned the investment activities of a Hong Kong bank in the purchase and sale of certificates of deposit, bonds and gi1t edged securities. Both the purchase and sale of these financial instruments (that gave the profits) took place outside Hong Kong (in London and Singapore). It was he1d that the relevant profits were made as a result of activities that took p1ace outside Hong Kong even though the decision to buy or sell the instruments in question was made in Hong Kong. Accordingly, the profit was not taxable. It should be noted that after this case the relevant law was amended, vide section 15(1 ) (l), so that such income of a Hong Kong fincancial institution, wherever it took place, was deemed to be chargeable income.

It was held that there were three conditions for a charge to arise:

(1 ) the taxpayer must carry on a trade, profession or business in Hong Kong;

(2) the profits to be charged must be "from such trade, profession or business" carried on in Hong Kong;

(3) the profits must be "profits arising in or derived from" Hong Kong." The principle derived from this case is: "one looks to see what the taxpayer has done to earn the profit in question." To summarize, Lord Bridge of Harwich made the following comments : "It is not enough for the purposes of section 14(1) mere1y to find the existence of profits which have been made by a business carried on in Hong Kong. It does not follow that such profits arose in or were derived from Hong Kong. Thus, for example, the fact that a company carries on business in Hong Kong (as many Hong Kong companies do) does not mean automahcal1y that a1l its profits become liab1e to profits tax. One must go further to inquire whether the relevant profits actual1y arose in or were derived from Hong Kong. These are the very words found in section l4(1) as we1l as other re1ated parts of the Ordinance such as section15 and also rule 2A of the In1and Revenue Rules…

The three conditions must be satisfied before a charge to tax can arise under section l4:

(l ) the taxpayer must carry on a trade, profession or business in Hong Kong;

(2) the profits to be charged must be 'from such trade, profession or business,' Which their Lordships construe to mean from the trade, profession or business carried on by the taxpayer in Hong Kong;

(3) the profits must be 'profits arising in or derived from' Hong Kong. Thus the structure of the section presupposes that the profits of a business carried on in Hong Kong may accrue from different sources, some located within Hong Kong, others overseas. The former are taxable, the 1atter are not. The determination of whether or not profits arise in or are derived from Hong Kong is ultimately a question of fact depending on the nature of the relevant transactions:-see 322H(4).However, the "broad guiding principle" is that one must 1ook to see what the taxpayer has done to earn the relevant profits. Section 14(1 ) also requires that the relevant profits must have arisen from activities or operations carried on by the taxpayer in Hong Kong. This 1ast requirement follows from the words in section l4(l), "assessab1e profits arising in or deriving from Hong Kong".

Kwong Mile Services Limited v CIR

The taxpayer carried on business in Hong Kong. It got profit from a property development in mainland China. Such profit was assessed to Profits Tax. In fact, the profit was from its underwriting of the sale of the property in Hong Kong. The underwriting contract was a two--page document and contained six short c1auses. The taxpayer agreed to underwrite the sale of the units in the building in the sum of $84,314,015. The underwriting period was up to 30 June 1992. If on or before that day, the total price the developer received from the sale of the building exceeded $84,314,015, then the developer would pay the difference to the taxpayer. If the amount was 1ess than the underwritten amount, the taxpayer would have to pay the difference to the deve1oper and take up the unso1d units. To implement the underwriting, the taxpayer advertised the property development in Hong Kong and secured contracts of sale for the units with purchasers in Hong Kong.

The purchasers had to sign in Hong Kong a "pre--contract provisional agreement" with the deve1oper.The taxpayer arranged for these purchasers to go to Main1and to sign a pre-contract formal agreement" with the developer.

The taxpayer was not a party to these agreements. The sale was a big success. The amount from the sale exceeded the underwritten sum of $84,314.015. The taxpayer received the agreed difference from the deve1oper. The taxpayer appealed to the Board against the Profits Tax assessment. The Board allowed the taxpayer's appeal. Then, CIR appealed to High Court and CIR won. Then, the taxpayer appealed to Court of Appeal and again, CIR won. The court ru1ed that it was the underwriting of the sale that gave rise to the profit and because the underwriting was substantially carried out in Hong Kong, the profit derived from Hong Kong and therefore taxable

CIR v Orion Caribbean Ltd.

This case concerns source of interest income. In this case, the company received deposits from its ho1ding company outside Hong Kong. Then, it lend the money to a person outside Hong Kong. The CIR argued that by accepting the deposits the company was a financial institution under section l5(1 ) (i) and therefore the interest income is taxable. This argument was rejected by the court. The following court's comments are noteworthy. "There are three difficulties inherent in this proposition. The first is that it attributes to Lord Bridge's words, even if they are taken in isolation, a rather broader meaning than that which they naturally bear. Lord Bridge speaks of profit earned' by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities'. The reference to' property assets' in relation to the letting of property or the lending of money may have been intended to refer simply to the exploitation of property or money owned by the taxpayer. 1f ORPL lent its own money to a borrower in, say, New York, then other things being equal there might be 1itue difficulty in saying that the 1ocation of the source of the interest on the 1oan was New York. If on the other hand, Lord Bridge was intending to cover, by his examp1es, a case such as that of OCL where they money has to be borrowed before it can be lent-1ike the commodities which have to be bought before they can be reso1d – it would be surprising if he were suggesting that regard should be had solely to the place of lending, to the exclusion of the p1ace of borrowing.

Secondly, and more generally, the proposition that Lord Bridge was laying down a rule of law to the effect that, in the case of a loan of money, the source of income was always 1ocated in the p1ace where the money was lent, is one that cannot stand with the opening words of Lord Bridge quoted above, nor with the explanation of his remarks by Lord Jauncey in the HK-TVB case, nor with the who1e range of authority starting from the judgment of Atkin LJ in F.L. Smidth & Co v Greenwood onwards, to the effect that the ascertaining of the actual source of income is a ‘practical hard matter of fact', to use words employed, again by Lord Atkin, in Liquidator, Rhodesia Metals Ltd v Commissioner of Taxes [ l940] AC 774 at page 789. No simp1e, single, 1egal test can be emp1oyed..."

In general, the HK IRD will adopt the "provision of credit" test to decide the source of interest income. However, because of the above court comments, other tests may be used if the "provision of credit" has apparently been used as a trick to avoid tax.

 

 



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