Hong Kong Tax News Flash 

Please refer to our Hong Kong Tax News Flash, July 2009 Issue 8 for a detailed discussion of the Datatronic case.  The table on the next page summarises the decision, the legal basis and the reasoning adopted at various levels of authority of which the case was heard.

Level of authority	Decision	Legal basis	Reasoning
Board of Review	In favor of taxpayer	Section 14 of the Inland Revenue Ordinance	No agency relationship between the taxpayer and the PRC subsidiary Carrying on a manufacturing business Operations in the PRC were important and attributable to the taxpayer's profits 50% of the profits offshore and not taxable
Court of First Instance	In favor of taxpayer	Revised DIPN 21 issued in 1998	Substance over form Concession in revised DIPN 21 extended to the taxpayer's case which fell within the terms of paragraph 16 of the DIPN 50% of the profits offshore and not taxable
Court of Appeal	In favor of the IRD	Section 14 of the Inland Revenue Ordinance	A trader rather than a manufacturer Purchase and sale were the profit making transactions Activities in the PRC merely antecedent or incidental 100% of the profits onshore and taxable Revised DIPN 21 has no legal effect

  
The taxpayer originally applied for leave to appeal against the Court of Appeal ("COA") decision to the Court of Final Appeal ("CFA") but subsequently withdrew the application.  As such, the COA decision has become final and currently represents the highest authority on the source issue under an import processing arrangement.

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This is a BoR case concerning a 50:50 apportionment claim under an import processing arrangement.  The taxpayer who was engaged in manufacture and sale of goods set up a joint venture ("JV") with another party outside Hong Kong.  In legal form, the offshore JV set up by the taxpayer to take up the manufacturing operations was a separate legal entity (i.e. a subsidiary of the taxpayer) and the transfer of raw materials and finish goods between the taxpayer and the JV was by means of purchase and sale (i.e. commercial invoices were issued by the taxpayer to the JV and vice versa).  The taxpayer, however, contended that it was in substance carrying on a manufacturing processing business offshore by sending its employees to the offshore JV factory to provide management, supervision and technical support of the manufacturing operations.  The taxpayer initially relied on the concession stipulated in revised DIPN 21 issued in 1998 as the basis of claiming an apportionment and as one of its grounds of appeal but later asked the Board to look at the law and the guiding principles rather than the concession.  The IRD did not accept such contention and sought to tax the entire profits derived by the taxpayer.
  
The Board dismissed the taxpayer's appeal based on the following:

1. The activities of the employees deployed to work at the factory were performed as officers of the JV rather than as employees of the taxpayer (i.e. what they did was done on behalf of the JV rather than the taxpayer) because all of them had their titles at the JV;
      
2. The Board inferred that the activities of those employees produced the management fees shown in the audited accounts of the JV rather than the profits of the taxpayer;
      
3. As established in the CFA's decision in the ING Baring Securities (HK) Ltd v CIR, the source of the taxpayer's profits cannot be ascribed to the activities of the JV;
      
4. The taxpayer's argument on its involvement in the manufacturing operations focused on antecedent or incidental activities instead of the relevant operations which produced the profits in question;
      
5. As the taxpayer did not made any application to amend its "grounds of appeal", it was not open to the Board to contend that it was entitled to apportionment as a matter of legal entitlement; and
      
6. The purchase and sale transactions constituted the profit-producing transactions of the taxpayer and Hong Kong was the source of the taxpayer's profits.

Against the above BoR decision, the taxpayer has filed the stated case for consideration of the Court of First Instance ("CFI").  The date of hearing at the CFI has not yet been fixed at the time of writing.

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This is another BoR case concerning a 50:50 apportionment claim under an import processing arrangement.  The fact pattern of this case is similar to that of the Datatronic case.  The taxpayer described its principal business activity as manufacturing of a certain product.  The taxpayer initially entered into a typical contract processing agreement with a third party in the PRC but subsequently changed the arrangement from contract processing to import processing (as suggested by the documents in respect of the largest sale transaction in 2001 provided by the taxpayer) under which its wholly owned subsidiary in the PRC took up the manufacturing operations.  Under the import processing arrangement, a number of senior management staff employed by the taxpayer were stationed at the PRC subsidiary to monitor and manage its operations.
   
The taxpayer's case was that the applicable principles require the Board to consider its offshore activities and operations in determining its source of profits.  The taxpayer argued that while the manufacturing process was carried out by the PRC subsidiary, it was actively involved in such process and such involvement was part of the activities that generated its profits.  Accordingly, such profits arose partly in Hong Kong and partly in the PRC.  The IRD, on the other hand, contended that the taxpayer was engaged in trading and its profit-making activities consisted of purchasing goods from the PRC subsidiary and reselling them.  As such activities were carried out in Hong Kong, the entire profits in question arose from Hong Kong.
  
Contrary to the decision in D42/08, the Board in this case allowed the taxpayer's appeal and remitted the case back to the IRD to decide the appropriate apportionment.  Below are the key points of the Board's decision:

1. The proper approach is to apply the relevant charging provision of the Inland Revenue Ordinance ("IRO") (i.e. section 14) and to draw guidance from the case law instead of considering the applicability of revised DIPN 21 as the DIPN has no binding effect on the IRD;
      
2. It is wrong to classify the taxpayer's operation either as trading or manufacturing as the operation is a multi-facet one.  The precise characterisation of the operation is not important;
      
3. The practical commercial reality is that the taxpayer's participation in the production process in the PRC is part of the taxpayer's profit-producing transaction and therefore part of the profits should be offshore;
      
4. Based on the taxpayer's evidence, the Board accepted that the accounts and invoices of the PRC subsidiary were prepared to satisfy the requirements of the PRC authorities and do not reflect the reality of the taxpayer's situation; and
     
5. Plainly, part of the taxpayer's profit-producing transactions was located in the PRC and it is correct that part of its profits was sourced outside Hong Kong.

The BoR's decision is under appeal to the CFI, which is scheduled to be heard on 15 April 2010.

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The Board correctly pointed out in D51/08 that business models do not stand still but evolve over time, and regard must be made to the practical commercial reality of the operations of taxpayers in determining the source of profits.  The Board also made it clear that it is unhelpful in determining the source of profits by classifying the business operations either as trading or manufacturing.
   
The 50:50 apportionment concession was first included in DIPN 21 in 1992.  At that time, many Hong Kong manufacturers were allowed to perform their manufacturing operations in the PRC through a contract processing arrangement.  However, starting from early 2000s, there was a trend that contract processing arrangement was no longer being encouraged by the PRC government.  As a result, many Hong Kong manufacturers had to change their existing contract processing arrangement to an import processing arrangement in order to continue their manufacturing operations in the PRC.
   
Despite changing the legal form of operations from contract processing to import processing, what the Hong Kong entities do has remained the same in substance in most cases.  That is, the Hong Kong entities continue to be substantially involved in the manufacturing operations in the PRC by providing raw materials, technical know-how, management, production skills, training and supervision for local labor, and manufacturing plant and machinery, etc.  In addition, under the import processing arrangement, it is not uncommon for documents / records related to the transactions between the Hong Kong and the PRC entities (e.g. accounting invoices and PRC customs documents, etc.) to be prepared in such a form that satisfies the various regulatory requirements of the PRC authorities.  However, the form of those documents may not reflect the real economic substance of what has actually taken place between the Hong Kong entities and the PRC processors.
   
In our view, the approach adopted by the Board in the Datatronic case and D51/08 represents a more balanced and pragmatic approach in determining the source of profits under an import processing arrangement, namely, not being bound by the legal form of the transactions and observing what activities in reality were performed by taxpayers that gave rise to the profits in question.
   
In practice, the IRD appears to take a simplistic approach by categorizing cross-border processing operations into either import processing (considered as trading) and contract processing (considered as manufacturing).  This simplistic approach ignores the commercial reality that it could be essential (not antecedent or incidental) for taxpayers under an import processing arrangement to be heavily involved in monitoring and supporting the manufacturing operations that are carried out by the PRC entity in order to make their own so-called "trading" profits.  In our view, the Board in D51/08 is correct to allow an apportionment of profits.
    
As such, the source of profits and whether apportionment is appropriate under import processing should be considered on a case-by-case basis taken into account the specific facts and circumstances of each case.  Rigidly adhering to the established practice of allowing a 50:50 apportionment for contract processing but not import processing may not serve the purpose of taxing a "fair" portion of profits derived by taxpayers from an import processing arrangement.

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Putting aside the 50:50 apportionment provided for in revised DIPN 21, which is not law and does not have a binding effect, the fundamental charging provision of the IRO (i.e. section 14) itself permits an apportionment of profits, as only profits that are arising in or derived from Hong Kong are chargeable to profits tax under that section.  As established in the CIR v Hang Seng Bank, CIR v The Hong Kong and Whampoa Dock Co. Ltd. and CIR v Indosuez W I Carr Securities Limited cases, section 14 provides the legal authority for apportionment of profits notwithstanding the absence of a specific statutory provision for apportionment in the IRO.  Accordingly, apportionment of profits under an import processing arrangement should be permissible by law if some of the essential profit-generating activities of the taxpayer are performed outside Hong Kong.

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Although the latest revised DIPN 21 explicitly discusses and explains the different tax treatments adopted by the IRD for contract and import processing, it does not help resolve the difference in opinion between taxpayers/tax professionals and the IRD on the source of profits under import processing arrangements.  As shown in the BoR Cases D42/08 and 51/08, disputes between taxpayers and the IRD on this issue will continue to arise.  It remains to be seen whether an opportunity of testing the COA's approach in the Datatronic case will arise in future as and when the source issue under import processing is put under the consideration of the CFA by means of appeal lodged to the CFA.

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