Nov-11-2009 The road ahead after Datatronic

By Debby Davidson

After the Hong Kong Court of Appeal’s decision on 15 July 2009 in Commissioner of Inland Revenue v. Datatronic Limited, is it time for offshore manufacturers to raise the white flag?

In an earlier article, I addressed some of the troubling aspects of the Datatronic case from a legal perspective.  Much as it pains me, I understand that the Datatronic case will not be appealed and, at least for the time being, we may just have to accept the confines and limitations of the Datatronic case and the current DIPN 21¹ .  Whilst the Datatronic judgement has undoubtedly dealt a blow to Hong Kong manufacturers, there are certain defence strategies taxpayers can adopt in relation to offshore manufacturing profits.

Most of our suggestions below can be summarised simply: taxpayers must keep detailed documentation reflecting the nature of any transactions between a Hong Kong manufacturer and its PRC processing facility, and must ensure that the true transaction is reflected in the entire business, including invoices, purchase orders, customs declaration forms, internal procedures and payments.  With a carefully thought-out and documented strategy, it remains possible for taxpayers to substantiate a claim that not all manufacturing profits are assessable to Hong Kong tax.

Documents, documents, documents
As Section 14 of the Inland Revenue Ordinance only extends only to profits “arising in or deriving from Hong Kong”, any activity carried out by a taxpayer offshore, whether directly or through an agent, is not assessable to Hong Kong corporate tax.

Taxpayers seeking to argue that their agents conduct offshore activities should ensure that appropriate documentation is provided as evidence of such a principal-agent relationship. Whilst some comfort can be derived from Lord Millet’s statement that “it was not necessary to establish that the transaction which produced the profit was carried out by the taxpayer or his agent in the full legal sense” (ING Baring), we understand that the Inland Revenue Department holds the view that the act of any person carried out overseas should not readily be attributed to a taxpayer in Hong Kong.

Whilst each case is to be judged on an individual basis, taxpayers would be well advised to consider the following when substantiating the existence of an agency relationship:

(1)    entry into an express agency agreement between the Hong Kong taxpayer and its PRC processing facility is helpful evidence.  Further, to avoid any argument that such an agreement is a sham, the agreement should detail the procedures for the payment of agency fees, the scope of the agent’s duties and the ability of the agent to bind the principal.  The agreement should also be adhered to in the company’s day-to-day operations;

(2)    ensure that the agent has the appropriate licence to conduct the activities purported to be carried out under the agency agreement²; and

(3)    ensure that the accounts of the agent and the principal and the accounting entries for the relevant transactions reflect the provisions of the agency agreement and the principal-agent relationship.

Moreover, it is open to a Hong Kong manufacturer to claim that not only is its PRC processing facility an agent, but that each of its employers seconded to work in mainland factories, to build moulds in the factories, to supervise local staff or to undertake quality control is an agent of the taxpayer conducting operations outside of Hong Kong. However, in order to claim that the profits attributable to these operations are sourced overseas and should therefore be excluded from the profits assessable to tax, taxpayers are once again advised to keep detailed and accurate records of the offshore activities of its employees, as well as evidence of how these activities contributed to the profits in question.

Minimise Trading Profits

With regards to trading profits, the Inland Revenue Department’s view is that no question of apportionment arises.  Whilst trading profits are either wholly taxable or wholly non-taxable³, it is possible for taxpayer to argue either that (i) not all of the profits in question are trading profits, and that some of the profits are attributable to manufacturing activities or the provision of services conducted offshore, or that (ii) as all the contracts of purchase and contracts of sale are effected outside Hong Kong, none of the profits are taxable⁴  in Hong Kong.
 
A company that trades in commodities or goods may not be solely conducting trading activities.  In order to differentiate itself and provide extra value-added services to its customers, such a company may also provide know-how to PRC factories, design the products or packaging materials, conduct quality control, assist in the production of moulds and packaging, arrange for logistics and shipping, and assist in the sourcing of new products.  It may be that such activities are an integral part of its trading activities and that payment for such activities is included in the mark-up to the commodities and goods sold.  However, if structured differently, such activities may be a separate service provided to the customer, ancillary to but ultimately independent of the commodities or goods being traded.  Provided that a taxpayer has the requisite documents and accounts to evidence such transactions, it is open for a taxpayer to claim that whilst the profits on the commodities sold are trading profits and are assessable to Hong Kong tax, the commission or charge for services provided offshore is not part of the trading profits and, since it is conducted offshore, is therefore not taxable by the Inland Revenue Department.

In addition, any trading profit attributable to contracts of purchase and contracts of sale effected offshore is not subject to Hong Kong tax.  It is important to note that effecting a contract does not merely mean legally executing such contract⁵, but also includes all relevant operations carried out to earn the profits, including the solicitation of orders, negotiation, conclusion, trade financing, shipment and performance of the contracts.  To evidence the performance of such activities overseas, taxpayers should keep details of any travel, hotel and subsistence expenses in respect of each individual transaction in support of the overseas element.

Manufacturing Profits

Regardless of my personal view that the categorisation of processing trade as “contract processing” or “import processing” is unfortunate, artificial and divorced from the realities or complexities of modern business, manufacturers with processing facilities in the PRC must show that the transaction is for contract processing in order to benefit from apportionment.  Any Hong Kong manufacturer would be well advised to put in place some or all of the following in order to ensure that its processing activities are correctly categorised:

(1)    enter into an appropriate processing agreement that stipulates that the PRC processing facility acts as a subcontractor providing factory premises, utilities and a labour force, and that legal title to the commodities or goods remains with the Hong Kong manufacturer.  Further, to avoid any argument that such processing agreements are “internal matters which did not affect the true nature” of the business, taxpayers should ensure that whatever procedures are provided for in the processing agreement as to payment, supply of raw materials, know-how and machinery and timing are strictly adhered to;

(2)    the transfer of raw materials and finished products between the Hong Kong manufacturer and PRC processing facility should not be recorded by way of sales and purchases, and invoices and customs declarations should not record such transfer on a sales and purchases basis; and

(3)    as mentioned above, the PRC processing facility’s licence should be one of import processing.

Conclusion
It is our understanding that a revised DIPN21 is in the pipeline, although no prescribed date has been set for its release.  However, taxpayers with contract processing facilities in the PRC should take steps now to adopt a well documented defensive position.  If they do not,  they may well find that, contrary to the true commercial realities, their operations become categorised as “import processing”, or that manufacturing profits are reclassified as trading profits or offshore profits, and thus attract Hong Kong tax unless the appropriate agency agreements, licences, accounts, invoices and custom declarations are in place to substantiate the true nature of the operation. 
 

¹  One should be mindful, however, that the actual effect of DIPN21 has been left in considerable doubt, as the Court of Appeal held in its judgement on Datatronic that DIPN 21 does not have any legal effect.
²  In Datatronic, it was held by the Board of Review that the taxpayer’s mainland subsidiary was not conducting contract processing activities as an agent, on the basis that the business licence granted to it was an import processing licence.
³  Paragraph 11 DIPN 21.
⁴  Paragraph 8(c) DIPN 21.
⁵  Lord Bridge in CIR v Hang Seng Bank.

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