News Flash Hong Kong Tax April 2012 Issue 5 Our Hong Kong Corporate Tax Team Contacts Peter Yu Partner Tel: +852 2289 3122 peter.sh.yu@hk.pwc.com Tim Leung Partner Tel: +852 2289 3055 tim.leung@hk.pwc.com Reynold Hung Partner Tel: +852 2289 3604 reynold.hung@hk.pwc.com Our Hong Kong Corporate Tax team provides a full range of integrated professional services in tax consulting and compliance. Our tax specialists provide technically robust, industry specific and pragmatic solutions to our clients on Hong Kong, PRC and international tax issues. Source rule in ING Baring upheld by the Court of Appeal in the Li & Fung case The Court of Appeal (“COA”) handed down its judgment in Li & Fung (Trading) Limited v CIR on 19 March 2012. This was an appeal lodged by the Commissioner of Inland Revenue (“CIR”) against the judgment of the Court of First Instance (“CFI”) handed down in April 2011. In that judgment, the CFI upheld the Board of Review’s decision and ruled that the commission income derived by the taxpayer from sourcing goods from overseas suppliers on behalf of its customers was offshore and not subject to Hong Kong profits tax. The COA upheld the CFI’s judgment and dismissed the CIR’s appeal. The case The taxpayer provided services to its overseas customers in connection with the sourcing of products from suppliers (manufacturers) outside Hong Kong and overseeing their manufacturing process, etc. to ensure that satisfactory goods are supplied to its customers. Both the customers and suppliers are unrelated to the taxpayer. Upon delivery of the finished goods to its customers, the taxpayer was usually paid a commission equal to 6% of the total FOB value of the customer’s export sales. In most cases, the taxpayer entered into contracts with its overseas affiliates under which the latter performed the above services for the taxpayer outside Hong Kong. The taxpayer paid its affiliates a certain percentage (say 4%) of the FOB value of the customer’s export sales in consideration for their services. The taxpayer has its headquarters in Hong Kong and entered into agency agreements with its customers as a result of the efforts of its senior staff based in Hong Kong. The taxpayer treated the commission earned on orders from overseas customers which were handled by non-Hong Kong based affiliates as foreign sourced and not chargeable to Hong Kong profits tax. In contrast, the CIR put forward different arguments before the Board and the CFI to argue that the taxpayer’s profits should be subject to Hong Kong profits tax. Before the Board, the CIR argued that the taxpayer operated a “supply chain management business” and earned the 2% net amount from managing its own activities and those of its affiliates in Hong Kong. Before the CFI, the CIR adopted a reformulated argument and claimed that the Board had erred in not apportioning the 6% gross profits of the taxpayer that were earned from activities carried out both in Hong Kong and overseas. The case is summarised in the diagram below. The decisions of the Board and the CFI Both the Board and the CFI ruled in favor of the taxpayer and held that the sourcing commission income was offshore and not taxable. For a detailed discussion of the decisions of the Board and the CFI, please refer to our Hong Kong Tax News Flash, Issue 3, May 2011 accessible through the following link: http://www.pwchk.com/home/eng/hktax_news_may2011_3.html In a nutshell, the CFI agreed with the Board’s approach of applying the principle established in ING Baring Securities (Hong Kong) Ltd. v CIR (“the ING Baring case”) in determining the source of commission income derived by the taxpayer. The CFI considered that the Board was correct in focusing on the services performed by the taxpayer’s overseas affiliates on its behalf outside Hong Kong as the relevant profit producing activities of the taxpayer. In the CFI’s view, the Board was also entitled to disregard the activities performed by the senior management in Hong Kong as “antecedent activities”. The judgment of the COA At the COA, the CIR put forward a refined version of the reformulated argument adopted before the CFI. In its refined argument, the CIR argued that since the services performed by the taxpayer in Hong Kong were expressly agreed to be part of the services giving rise to the commission income in the agency agreements between the taxpayer and its customers, those activities could not be regarded as antecedent or incidental but should be treated as part of the profit producing transactions. The counsel for the CIR argued that what the group chairman of the taxpayer had said in an interview (which suggested that some of the activities stated in the agency agreements were performed in Hong Kong) should be accepted as facts. The CIR contended that as the Board failed to apportion part of the taxpayer’s profits as attributable to the services performed in Hong Kong, the COA should remit the case to the Board for further consideration. News Flash – Hong Kong Tax 2 The COA rejected the CIR’s argument and considered that it is not a case for remission. The key points mentioned in the COA’s judgment are: 1. The refined argument was not raised before the Board at its hearing so the Board cannot be blamed for not dealing with such argument. At the Board’s hearing in 2006, the CIR contended that the taxpayer engaged in a “supply-chain management” instead of “commission agent” business and earned the 2% net commission income as its profits. As such, the whole 2% amount should be subject to tax and there was not an issue for apportionment. In the COA’s view, there is no basis to remit the case to the Board for the CIR to advance a new case on apportionment. 2. The Board’s decision contained a careful consideration of the authorities on source of profits and correctly applied the established principles in the ING Baring case, namely, one has to focus on “establishing the geographical location of the taxpayer’s profit producing transactions themselves as distinct from activities antecedent or incidental to those transactions”. 3. There is an important distinction between the taxpayer managing its business in Hong Kong and performing its profit producing activities (through the services rendered by its overseas affiliates) outside Hong Kong. Only the latter is relevant in determining the source of profits of the taxpayer. 4. Referring to the group chairman’s interview reported in the Harvard Business Review, the COA found that (1) the CFI was correct to accept the interview itself as an agreed fact but reject the CIR’s request to add the contents of the interview as agreed facts and (2) since the issue of whether the contents of the interview was agreed facts had not been taken before the Board, it would not be right to remit the case to Board to enable the CIR to raise this new point which most probably would require further evidence. Based on the above, the COA agreed with the Board and the CFI that all the profit producing activities of the taxpayer were done outside Hong Kong and dismissed the CIR’s appeal. PwC observations Commercially essential operations vs profit producing activities The COA’s judgment once again underlines the important distinction between “activities that are commercially essential to the operations and profitability of a taxpayer” and “activities that provide the legal test for ascertaining the source of profits”. In this case, it was concluded that the taxpayer derived its profits from provision of sourcing services based on the terms of the standard agency agreement between the taxpayer and its customers. Once it has been determined that the taxpayer’s income is in the nature of service fee income, the relevant activities that should be looked at in determining the source of profits are the performance of the said services. The other activities performed by the senior management of the taxpayer in Hong Kong, no matter how important they are to the taxpayer’s business operations, will be regarded as “antecedent or incidental” as far as the source of profits is concerned. Submission of facts and formulation of arguments The present case also highlights the importance of including all relevant facts and formulating the proper arguments at the early stage of a proceeding (i.e. during the hearing of the Board). It is equally important to understand the meaning of “agreed facts”. In this case, although the reporting of the group chairman’s interview is part of the agreed facts, the contents of the interview were not accepted as agreed facts. The COA rejected the CIR’s request of remitting the case to the Board for it to further consider the new facts and revised arguments raised by the CIR at the courts on the basis that they were not taken to the Board in the first place, leaving aside the question of whether those new facts and revised arguments would be helpful to the CIR’s case had they been run before the Board. Concluding remarks Given the unanimous decision of the COA and the difficulty in raising additional / new facts or arguments in a further appeal, it is expected that the IRD will unlikely lodge an appeal to the Court of Final Appeal against the COA’s decision. Taxpayers with business operations similar to those of Li & Fung and who have not lodged an offshore claim in prior years should review their tax filing position where necessary. News Flash – Hong Kong Tax 3 In the context of this News Flash, China, Mainland China or the PRC refers to the People’s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PricewaterhouseCoopers client service team or your other tax advisers. The materials contained in this publication were assembled on 19 April 2012 and were based on the law enforceable and information available at that time. 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They support the PricewaterhouseCoopers partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui Tel: +86 (10) 6533 3028 matthew.mui@cn.pwc.com Please visit PricewaterhouseCoopers websites at http://www.pwccn.com (China Home) or http://www.pwchk.com (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues. © 2012 PricewaterhouseCoopers Ltd. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.