Hong Kong Tax News Flash 

Legal principle was applied in the Court of Appeal judgment on Commissioner of Inland Revenue v Datatronic Limited
  
The Court of Appeal ("COA") handed down its judgment on 15 July 2009 on CIR v Datatronic Limited, a controversial case concerning a 50:50 apportionment claim under an import processing arrangement.  The COA allowed the Commissioner of Inland Revenue ("CIR")'s appeal based on the legal interpretation of the Inland Revenue Ordinance ("IRO") and overturned the earlier decisions handed down by the Board of Review ("BOR") and the Court of First Instance ("CFI").  The CFI's judgment was apparently grounded on the application of the concessionary treatment in Departmental Interpretation & Practice Notes No. 21 ("DIPN 21") to the taxpayer.
    
The case
    
The taxpayer, Datatronic Limited ("Datatronic"), was engaged in the manufacturing and sale of electronics components.  Datatronic previously entered into a contract processing arrangement with a factory in the PRC for the production of its goods.  Subsequently, Datatronic set up a manufacturing subsidiary, Datatronic (Shunde) Corporation ("DSC"), in the PRC to take over the manufacturing operations from that factory.  The arrangement entered into between Datatronic and DSC was one of import processing as DSC's licence was solely for import processing work and the transfers of materials and finished goods between the two were by way of sale and purchase.  Datatronic provided DSC with design, technical know-how, management, training and supervision of the local workforce and supplied DSC with the manufacturing plant and machinery.  The transactions between Datatronic and DSC were not at arm's length.  The price of the finished goods paid by Datatronic represented more or less the expenses incurred by DSC after offsetting the price of the raw materials supplied by Datatronic.
    
Datatronic argued that its products were mostly manufactured by way of contract processing in the PRC by DSC on its behalf as an agent.  Datatronic also argued that its profits were not derived from trading but were from the manufacturing and finishing activities both in Hong Kong and the PRC such that an apportionment of its profits on a 50:50 basis would be appropriate.
    
The CIR placed emphasis on the form and contended that Datatronic was bound by the form of trading adopted by it and DSC.  The CIR also held that there was no evidence DSC was Datatronic's agent in manufacturing the goods (i.e. DSC was named as a principal party in the contracts between Datatronic and DSC).  As such, the business operations of Datatronic and DSC were separate and there was no valid basis of treating any part of the profits derived from DSC's manufacturing business in the PRC as Datatronic's profits.
     
Accordingly, additional assessments / assessment were raised on Datatronic in the relevant years of assessment disallowing the 50:50 apportionment claim.
   
The Board of Review's decision
     
Datatronic appealed to the BOR against the profits tax additional assessments / assessment raised.  In BOR Case No. D43/06, the Board allowed Datatronic's appeal.  The Board found that there was no agency relationship between Datatronic and DSC and that the arrangement between Datatronic and DSC was one of import processing.  Notwithstanding that, on carefully considering the relevant law, the evidence and the submissions, the Board was satisfied that the taxpayer was carrying on a manufacturing business and the profits derived from its business were manufacturing profits and a certain part of its profits was sourced in the PRC.  By providing DSC with design, technical know-how, management, training and supervision of the local workforce and in supplying DSC with the manufacturing plant and machinery, the taxpayer undertook operations in the PRC which were important and attributable to the profits in question.  That part of the profits was sourced outside Hong Kong and was thus not chargeable to Hong Kong profits tax.
    
The following points are worth noting in the BOR's decision:

• The Board concluded that DSC was not an agent of Datatronic and DSC's manufacturing operations should not be considered in determining the source of profits of Datatronic.
    
• The Board however concluded that Datatronic was carrying on manufacturing operations in the PRC by providing DSC with design, technical know-how, etc and these operations were important to the profits of Datatronic.
    
• The apportionment conclusion of the Board was not based on the ground that the arrangement Datatronic had was a contract processing arrangement but was based on the general apportionment principle in section 14 of the IRO as accepted by the CIR in paragraphs 21 and 22 of DIPN 21.

The Court of First Instance's judgment
  
The CIR appealed against the BOR decision that Datatronic's profits were manufacturing profits partly sourced in the PRC of which 50:50 apportionment was applicable whereas Datatronic cross appealed against the decision that DSC was not its agent and that the transactions between it and DSC were import processing rather than contract processing.
    
The CFI held that the Board was correct in law to conclude that an apportionment of Datatronic's profits should be made on a 50:50 basis.  The CFI's judgement very much hinged on its interpretation of the phase "in cases of this nature" in paragraph 16 of DIPN 21 and the notion of "substance over form".  In the CFI's view, paragraph 16 of DIPN 21 intends to give a tax concession for cases falling within its terms without sticking strictly to the legal form of the transaction.  As such, in determining the true nature of the transactions and whether the tax concession under DIPN 21 was applicable to Datatronic, substance should prevail over form.  Taking into account Datatronic's extent of involvement in the PRC manufacturing activities, the CFI held that the Board was correct in concluding that Datatronic had undertaken manufacturing operations in the PRC and such operations were important operations and attributable to Datatronic's profits.  The CFI also concluded that the Board was incorrect in holding that DSC was not the agent of Datatronic and that the transactions between Datatronic and DSC were import processing rather than contract processing but considered that these two issues were irrelevant.
      
The Court of Appeal's judgment
      
The CIR appealed to the COA against the above CFI's decision.  The COA ruled in favour of the CIR and concluded that Datatronic's profits were onshore trading profits fully subject to Hong Kong profits tax.  Below is a summary of the key issues considered by the COA in its judgment.

• What were the profit-producing activities?
  
  
  Citing the Kwong Mile Services Ltd. v CIR case which stated that in determining the profit-producing transactions, one has to "... grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters ...", the COA held that while the Board was right in its fact finding that the products were manufactured by DSC and then sold to Datatronic, the Board failed in concentrating on the profit-making transactions of Datatronic which resulted in its wrong conclusion.
       
  In the COA's view, Datatronic's profit-making transactions consisted of purchasing goods from DSC and then reselling them at a profit and such activities took place in Hong Kong.  The technical assistance and other activities performed by Datatronic in the PRC, even though commercially essential to the operations and profitability of Datatronic's business, were merely antecedent or incidental to the transactions that generated the profits.
      
  

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• Whether the taxpayer is a manufacturer?
  
  
  Citing the ING Baring Securities (Hong Kong) Ltd. v CIR case which mandated that "commercial reality" does not dictate that the source of the profits of a group company can be ascribed to the activities of another group company, the COA held that as (1) DSC and Datatronic were two separate legal entities and (2) the Board's essential finding was that DSC was not an agent of Datatronic, the manufacturing activities carried on by DSC were not the activities of Datatronic and therefore, Datatronic was not a manufacturer.  The COA also held that, in substance, Datatronic did not make the assessable profits in question through manufacturing in the PRC but through selling the finished products bought from DSC.
      
  

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• The effect of DIPN 21
  
  
  The COA's judgment was based on the charging section for Hong Kong profits tax, that is, section 14 of the IRO.  DIPN 21 has no legal effect.  Instead of concentrating on the wording of DIPN 21 and the notion of substance over form, one should ascertain what the profit-producing transactions were and where they took place.  The COA further commented that the issue of whether effect should be given to DIPN 21 for administrative law reason was not raised in this case and hence such issue was beyond the scope of the COA's decision.  As a side comment, the COA expressed its view that the concession provided by DIPN 21 to contract processing cannot be stretched to import processing.
      
  

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PwC observations
    
While it remains to be seen whether the taxpayer will appeal against the COA's decision to the Court of Final Appeal, there are a number of issues arising from the COA's judgment that deserve further consideration.

• Profit-producing vs antecedent / incidental transactions
  
  
  While the COA concluded that the activities performed by Datatronic in the PRC were merely antecedent or incidental to the production of profits, it is not absolutely clear from the judgment on what basis it arrived at this conclusion.  Apparently, the conclusion is based on the COA's findings that Datatronic derived its profits from trading and for trading profits, the relevant transactions that give rise to the profits are the buying of goods from the suppliers and the selling of the goods to the customers.  This goes back to the fundamental question of what should be considered as the "relevant profit-producing transactions" and how such relevancy should be measured.  Determining the transactions that are relevant profit-producing transactions and the activities that are antecedent or incidental to the production of profits is a matter of judgment and the determination is highly facts-specific.
       
  In the present case, the Board and the COA held different views on what the profit-making activities of Datatronic are.  In the Board's view, the work performed by Datatronic in the PRC was significant enough to be considered as one of the profit-producing activities whereas the COA considered the work as merely antecedent or incidental.  Interestingly, the judges at the COA did not make any reference to the ING Baring case so far as determination of the profit-producing transaction was concerned.  It is therefore unable to tell from the judgment whether the judges considered the approach taken in the ING Baring case in determining the source of brokerage income derived from securities dealings (which focused on the particular activity that directly produces the profits i.e. execution of clients' orders in the context of securities dealings) can be applied to trading profits as well.
      
  

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• DIPN 21 as administrative law
  
  
  The comment made by the COA on the effect of DIPN 21 (or any DIPN in general) in its judgment raises an interesting question - can one argue that DIPN 21, although issued by the Inland Revenue Department as a guidance note and has no legal effect, should be considered or given effect by the court for the purpose of administering section 14 of the IRO (which is law binding on the court)? Unfortunately, this question was not considered by the COA in the present case as no such reason had been advanced.
      
  

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