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| Nov 2008, Issue 2 |
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The Commissioner won another anti-avoidance case
During last two years, there were a few court cases (i.e. Tai Hing Cotton Mill (Development) Ltd v CIR; CIR v HIT Finance Ltd & Hong Kong International Terminals Ltd and Shui On Credit Co Ltd v CIR) in which the Commissioner of Inland Revenue successfully used the anti-avoidance provision, section 61A of the Inland Revenue Ordinance ("IRO"), to challenge taxpayers' arrangements. Adding to the list is the recent judgement handed down by the Court of Appeal ("COA") on 15 October 2008 in Ngai Lik Electronics Co Ltd v CIR. The COA's judgement upheld the one handed down by the Court of First Instance ("CFI") in December 2007 and the Board of Review's decision (BOR Case No. D83/06) in February 2007.
The case: Ngai Lik Electronics Co Ltd v CIR
Ngai Lik Electronics Co Ltd ("NLE"), the taxpayer in this case, is a company incorporated in Hong Kong and is part of the Ngai Lik group whose principal activities are design, manufacturing and trading of audio equipment and products. Prior to 1990/91, NLE offered all its profits, both manufacturing and trading profits, for profits tax despite the fact that the production was subcontracted to two group companies in the Mainland. Following a re-organisation scheme ("the scheme") in 1991/92, three new BVI companies were set up as NLE's subsidiaries (i.e. Din Wai, Shing Wai and Ngai Wai) to take over the production operations in the mainland. Under the scheme, customers typically placed orders for audio equipment with NLE in Hong Kong and NLE would in turn order the equipment from Din Wai. Din Wai would then order the necessary components for the equipment from Mainland manufacturers, in particular Shing Wai and Ngai Wai, and assembled the components purchased in its Mainland plant to produce the equipment ordered by NLE. After the implementation of the scheme, NLE continued its substantial involvement in the manufacturing process as it did before.
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The sale price of the goods sold by Din Wai to NLE was not set at the times of sales but was subsequently determined by the group's accounting department annually. In addition, bulk sale discounts would be determined annually on an arbitrary basis to spread the profits between Din Wai, Shing Wai and Ngai Wai. These pricing mechanisms allowed the group to split the overall group profits among NLE and its subsidiaries on an ex post basis. While the profits of NLE were still subject to Hong Kong profits tax, the profits recorded in the accounts of the other three companies could likely be claimed offshore.
Under the intra-group master agreement relating to services, NLE was also entitled to charge 5% of the expenses incurred as remuneration for services provided to its subsidiaries. However, little or no management fees were actually paid to NLE by its subsidiaries.
The dispute
Considering the scheme as a "transaction" having the effect of conferring a tax benefit on NLE, the assessor raised five additional profits tax assessments from 1991/92 to 1995/96 on NLE to include the profits of the three BVI companies as NLE's assessable profits under section 61A of the IRO. For the purpose of protecting the government's interest, five assessments were raised by the assessor on each of the three BVI subsidiaries of NLE as alternatives. After re-considering the case, the Commissioner decided to reduce the profits under challenge by a half in her determination. NLE lodged an appeal against the Commissioner's determinations on the five additional profits tax assessments raised on it.
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The main thrust of NLE's argument is that no tax benefit was conferred by the scheme. NLE contended that the scheme involved profits from manufacturing as well as trading businesses. In respect of the manufacturing profits, the scheme could not be a "transaction" within section 61A having the effect of reducing its tax liability because: (1) the group's production facilities were relocated to the mainland and its manufacturing process had been exclusively carried out in the mainland long before the re-organisation, profits from such manufacturing activities would simply not be taxable in Hong Kong; and (2) NLE had never been the group's holding company nor did they own the group's manufacturing entities so profits made by those manufacturing entities could never be considered as NLE's assessable profits. In respect of the trading profits, NLE argued that should the purchase costs be inflated due to the price setting mechanism, the Commissioner should disallow part of the deductions claimed instead of taxing part of the group's manufacturing profits derived entirely offshore. Furthermore, NLE stressed that there was no actual evidence to establish or quantify overcharging by its subsidiaries.
The Board's decision and Courts' judgements
The Board identified the scheme as the relevant "transaction" under section 61A and concluded that the scheme had the effect of conferring a tax benefit on NLE by reducing the amount of tax as a result of the profits allocation. The Board found that the price-setting system coupled with the arbitrary additional discounts and insubstantial management fees for services rendered were the key constituents of the scheme whereby NLE's assessable profits (and therefore its liability to tax) would be reduced.
On the basis that there was a tax benefit, the Board then considered each of the seven matters specified in section 61A(1) individually, looked at the matters globally and arrived at an overall conclusion that the dominant purpose of the scheme was to enable NLE to obtain a tax benefit. It followed that the five additional assessments on NLE were confirmed. The 15 assessments on the three BVI subsidiaries, which were protective alternative assessments (in case the assessments on NLE were set aside) were annulled.
The CFI upheld the Board's decision and dismissed NLE's appeal on the basis that the Board was not perverse or unreasonable, in its consideration of the seven matters under section 61A(1), to conclude that the curious pricing mechanism was a means of obtaining tax benefit for NLE.
The recent judgement of the COA unanimously upheld the Board's decision and the CFI's judgement. Furthermore, the COA clarified the following points in the application of section 61A:
- Section 61A assessments are distinct and different from section 14 assessments
The central issue of the appeal is whether section 61A can extend the territorial ambit of the IRO to assess profits from offshore businesses that are otherwise not chargeable under section 14, rather than whether the profits in question are chargeable under section 14. In the COA's view, so far as a scheme falls within the scope of section 61A, such assessments are lawful under section 61A(2) as they are directed at counteracting the perceived tax benefit conferred by the scheme. The section 61A assessments in this case were raised for anti-avoidance purposes to tax what would be NLE's assessable profits should the tax benefit obtained by NLE be counteracted, rather than to tax the offshore profits of the BVI subsidiaries. Close
- Existence, but not quantification, of a tax benefit is necessary for the application of section 61A
The COA's judgement confirms that section 61A can be applied when the sole or dominant purpose of a transaction is to confer 3 a tax benefit. It is therefore sufficient to show that the scheme has the ability to confer a tax benefit and quantification of the tax benefit is not a pre-requisite to the application of section 61A. Close
- What is considered as sole or dominant purpose is a matter of fact.
On the question of the sole or dominant purpose of the scheme, the COA held that the Board's conclusion that the dominant purpose of the scheme was to confer a tax benefit on NLE was not perverse and therefore cannot be disturbed by the appellant court. Close
PwC observations
The taxpayer failed in its appeal in the present case mainly because it could not persuade the Board and the Courts that the dominant purpose of entering into the scheme was not to obtain a tax benefit. In the COA's view, there was not a rational explanation for the adoption and application of the transfer pricing policy (which enabled the taxpayer's net profits to be manipulated and shifted offshore) and the non-arm's length features of the scheme cannot be explained except as a means of minimizing the taxpayer's assessable profits. NLE has appealed against the COA's judgement to the Court of Final Appeal but the hearing date of the appeal has not yet been confirmed.
Taking into consideration the judgements in the recent cases related to the application of section 61A, we can come to the following conclusions:
- To determine whether a tax benefit is conferred by a transaction (or a scheme) requires a comparison.
The key is to determine what to compare. It is clear from the judgement in the Tai Hing case that the appropriate comparison is NOT between the taxpayer's position before and after the transaction, but between the effects of the transaction and the effects of some other appropriate alternatives. In the Ngai Lik case, the comparison is not between the taxpayer's position with and without the arbitrary pricing mechanism but between the effects of such arbitrary pricing mechanism and the effects of an alternative appropriate pricing mechanism. Close
- Existence of a tax benefit as the sole or dominant purpose of a transaction is sufficient for section 61A to apply.
For section 61A to apply, it is sufficient to establish that a transaction has or would have had the effect of conferring a tax benefit without the need of quantifying the tax benefit (i.e. a quality test as opposed to a quantity test applies). Close
- There is a LIMIT on the power of the Commissioner to counteract tax benefit.
Counteracting a tax benefit in applying section 61A, however, still requires the Commissioner to quantify the tax benefit. The CFA's decision in the Tai Hing case indicates that the Commissioner should consider the tax benefit by comparing the consequence of the most likely alternative transaction with the result of the actual transaction that took place. Although this point was not explicitly mentioned in the COA's decision in the Ngai Lik case, the additional assessments raised by the Commissioner in the case imply that the Commissioner considered that under the most likely alternative, 50% of the profits recorded in the accounts of the BVI subsidiaries would be those of NLE, and that represents the consequence of the transaction if the pricing mechanisms were of arm's length. Close
No doubt that the recent COA's judgement in the Ngai Lik case, together with the decisions in the Tai Hing, HIT Finance and Shui On Credit cases, indicate not only the power of section 61A but also a trend for the Commissioner to combat non-commercially driven activities carried out solely or dominantly for the purpose of avoiding tax. It is, however, still possible for companies to organise their transactions or activities with justifiable commercial objectives in the most tax efficient manner. |
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Download our Hong Kong Tax News Flash (Nov 2008, Issue 2) (pdf file, 102KB) for your reference. |
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