Jan-11-2010 Uncertainty Over the Source of Profits of Hong Kong Manufacturers is Damaging to Hong Kong

The Court of Appeal’s decision in the Commission of Inland Revenue and Datatronic Limited may have been in favour of Inland Revenue, but there are compelling reasons why the Government of the Hong Kong Special Administrative Region should act proactively to resolve the uncertainty over apportionment, the source of profits relating to Hong Kong manufacturers with processing facilities in the PRC and the applicability of DIPN 21.  The failure to do so will be damaging to Hong Kong’s competitiveness.

The Decision in Datatronic

The taxpayer, Datatronic Limited (“Datatronic” or “Taxpayer”), is a manufacturer of electronics with processing facilities operated by a wholly owned subsidiary in the PRC. Datatonic’s subsidiary (“DSC”) was unable to obtain a contract processing certificate, and instead, DSC operated under an import processing licence.  Regardless of the strict legal form of the arrangements between Datatronic and DSC, Datatronic was primarily responsible for providing the design, technical know-how, management, training, machinery and equipment to DSC.

Datatronic sought to argue that its activities should be treated as those of a manufacturer that had entered into a contract processing arrangement with a PRC entity, and accordingly, that 50% of its profits should be apportioned pursuant to the Departmental Interpretation and Practice Notes No. 21 (“DIPN 21”).  The Court of Appeal dismissed the taxpayer’s claim for apportionment of profits on the basis that Datatronic’s arrangement with DSC constituted an import processing arrangement.  Further, the Court of Appeal held that the Taxpayer’s “profit-producing transactions” were not manufacturing activities, which were carried on by DSC, but the purchase of the finished electronics from DSC and the subsequent sale of the same by the Taxpayer.  Essentially the Court of Appeal held that the Taxpayer operated a trading (as opposed to a manufacturing) business and that as the “profit-producing activities” were conducted in Hong Kong, the whole of the profits of the Taxpayer were chargeable to Hong Kong profits tax.

A legal critique of Datatronic

 Substitution by the Court of Appeal of its own finding of fact over that of the Board of Review

Initially, the Board of Review found for the Taxpayer and held that an apportionment of profits on a 50:50 basis was appropriate as the Taxpayer had undertaken operations in the PRC that were important and attributable to the profits in question, and that such profits, being sourced outside of Hong Kong, were not chargeable to tax.

Pursuant to section 69 of the Inland Revenue Ordinance, appeals to the Court of First Instance may only be made on a question of law.  The Board of Review is the only finder of fact and the courts would only interfere with a conclusion drawn from the primary facts or with a conclusion drawn from a combination of primary facts and inference, if the true and only reasonable inference or conclusion was not the one reached by the Board of Review1.

In our view, the Court of Appeal’s judgment overturning that of the Board of Review and the Court of First Instance was based not on questions of law but rather questions of fact, contrary to the Inland Revenue Ordinance.  The Board of Review correctly summarised the guiding principles regarding the source of profits as 2:

“One looks to see what the taxpayer had done to earn the profit in question and where he has done it.”

“The proper approach is to ascertain what were the operations which produced the relevant profits and where those operations took place.3”

Further, the Board of Review also understood that in determining the profit-producing transactions, it is the activities of the Taxpayer that are relevant, and it is wrong to focus on the activities of other subsidiaries or associates.

The Board of Review found the following facts 4:

(1) the Taxpayer was carrying on a manufacturing business;
(2) the Taxpayer was involved in the manufacturing business in the following manner:

1. the Taxpayer was primarily responsible for design, product testing and prototype production;
2. machinery, equipment, raw materials and technical know-how all originated from the Taxpayer;
3. purchases from third parties were concluded by the Taxpayer;
4. raw materials were purchased in Hong Kong and then transferred to DSC in accordance with the production schedule;
5. quality assurance engineers and production control staff from the Taxpayer visited DSC to train the staff there;
6. the Taxpayer seconded a deputy general manager, production manager, production engineer at DSC to monitor and manager its operation;

(3) part of the profits from the business had been sourced in the PRC because the Taxpayer had undertaken the operations there.

The Court of First Instance wisely agreed with the Board of Review with regard to the finding that part of the profits of Datatronic were sourced outside of Hong Kong and that Datatronic carried on a manufacturing business.

At the Court of Appeal, however, Hon. Tang VP substituted his own finding of facts over that of the Board of Review, and worse, inaccurately reformulated what the Board of Review had said.  In his judgment, Hon. Tang VP said that “The Board had found that DSC manufactured the products which were sold to the Taxpayer.  This is a finding of fact.”  In fact, the Board of Review found no such thing as the Board of Review never held that DSC “manufactured the products”.  The Board of Review correctly focused on what the Taxpayer, not its subsidiary, did, and found that the Taxpayer had undertaken important operations in the PRC that were attributable to the profits in question.

The source of profits is a “question of fact”, and in our view, is a question that only the Board of Review had the jurisdiction and authority to determine.  It is well established that in determining the source of profits, the following should be considered:  

(1) The ascertainment of the actual source of a given income is a practical hard matter of fact 5; and
(2) Judging the matter of sources as one of practical reality does not involve disregarding the accurate legal analysis of transactions 6, but on the other hand, it is not a technical matter but a commercial one 7.

Given that the Board of Review had found that, in providing DSC with design, technical know-how, management, training, supervision of the local staff, manufacturing plant and machinery, the Taxpayer had undertaken manufacturing operations in the PRC that were important operations contributing to the profits in questions, it is difficult to see how the Court of Appeal could justify substituting its own finding of facts over that of the Board of Review.  The Court of Appeal’s finding of fact that work undertaken by the Taxpayer “even though commercially essential to the operations and profitability of the buyer’s business, are merely antecedent or incident to the transactions which generated profits” is not only divorced from reality, it is outside the remit and jurisdiction of the Court of Appeal.  As noted above, unless the finding of fact is such that a reasonable lower court could not have so inferred or concluded, a higher court has no jurisdiction to interfere with the finding of fact of a lower court.

Form over substance

Although obiter dicta, Hon Tang VP criticised the Court of First Instance and the Board of Review for concentrating on the notion of substance over form.  The debate of substance vs form was considered to be important by both the Board of Appeal and Court of First Instance in determining two questions: (a) firstly, whether DSC was an agent of the Taxpayer in conducting manufacturing activities in the PRC, and (b) secondly, whether the arrangements between DSC and the Taxpayer were that of contract processing or import processing.  The Court of Appeal’s preference for the legal form over the substance of the underlying transaction is problematic for the reasons set out below.

The Court of Appeal placed undue gravity on the documentary form of the transaction (and the legal consequence flowing from such form) between DSC and Datatronic in holding that sale and purchase invoices and custom declarations containing the terms “CIF” and “FOB” were determinative of the “import processing” relationship.  This is most unsatisfactory as no explanation was given as to why such importance was placed on the sale and purchase invoices and the custom declaration forms, whilst other documentary evidence favorable to the Taxpayer was disregarded.  If the Court of Appeal was genuinely concerned about the documentary form of the transaction, why did it conveniently ignore (i) the processing agreement pursuant to which DSC and Datatronic agreed that all the inventories were to be owned by Datatronic at all times and which evidenced the contract processing relationship, (ii) the audited accounts of the Taxpayer that showed that the title to the raw material and finished products remained with the Taxpayer at all times 8 and (iii) contemporaneous faxes showing processing fees calculated and paid?

The second point to note regarding the Court of Appeal’s emphasis on the form over substance is that the Court of Appeal saw the Court of First Instance as having been led astray by its concentration on the substance over form.  In actuality, the Court of First Instance recognised that whether DSC was an agent of the Taxpayer and whether the arrangements between the parties constituted contract processing or import processing were largely redundant and irrelevant questions, as both the Board of Review and Court of Appeal agreed that the Taxpayer conducted offshore activities attributing to the profits in question.  

Other pending cases

Despite initially applying for leave to appeal to the Court of Final Appeal, Datatronic has subsequently withdrawn the right to appeal.  Hence, for the time being, the Court of Appeal’s decision in Datatronic remains binding, leaving the legal effect of DIPN 21 and the law on apportionment and the source of profits uncertain.  Each case involving Hong Kong manufacturers and PRC processing facilities will have to be judged on a case-by-case basis to determine whether profits arise in or are derived from Hong Kong.

Currently, there are two appeals from the Board of Review involving Hong Kong manufacturers with processing facilities in the PRC.  The first is Case No. D42/08 9, where the Board of Review found for the Inland Revenue Commissioner on the basis that the activities of the Hong Kong concerned (“Taxpayer A”) were held to be incidental and ancillary to the manufacturing activities conducted overseas.  In this case, the Board of Review grossly oversimplified the operations of Taxpayer A in holding that, as the number of employees of Taxpayer A was only 22 compared to the 2105 employees employed by the PRC processing facility, the work done by the Taxpayer A could not be important operations attributing to the manufacturing profits.  This simple arithmetic plainly ignores the valued-added of the management team of Taxpayer A compared to that of the menial workers in the PRC.  The second difficulty raised by this case is that the Board of Review preferred the financial accounts of the PRC processing facility to those of Taxpayer A, the latter of which were audited and prepared in accordance with the general accepted accounting practice of Hong Kong.  The second case is Case No. D51/08 10, where the Board of Review found for the Hong Kong taxpayer (“Taxpayer B”) on the basis that its participation in the production process was an integral part of the profit-producing transactions and that as part of its profit-producing activities were conducted offshore, an apportionment was appropriate.   

In the case of Taxpayer B, compared to Taxpayer A and Datatronic, the Board of Review was astute to the commercial realities of modern business.  The Board of Review refused to categorise the Taxpayer B as a trader or a manufacturer, as “the precise characterization of the Taxpayer’s operations is not important 11” and “where operation is a multi-faceted one, the Board must have regard to the practical commercial reality 12”.  Taxpayer B’s business model was not dissimilar to that of Datatronic or Taxpayer A, but several factors could be distinguished:

1. Taxpayer B retained ownership of the raw materials, plant and machinery and the finished goods,
2. the Company’s book of accounts did not show any transaction of sale between Taxpayer B and its PRC subsidiary,
3. Taxpayer B was paid a processing fee,
4. all staff seconded to the PRC subsidiary remained staff of Taxpayer B 13 and
5. the Board of Review preferred the audited financial accounts of Taxpayer B over the documents of its PRC subsidiary, the later of which were “prepared in such a way to satisfy the requirements of the Mainland authorities 14”.

Problems faced by taxpayers after Datatronic

The cases of Taxpayer A and Taxpayer B illustrate the considerable hurdles currently faced by Hong Kong manufacturers.

(a) A taxpayer has no choice but to devote considerable time and resources in appealing a tax assessment

At the moment, each case must be determined in accordance with principles of case law.  A taxpayer disputing an assessment by the Inland Revenue is currently left with no choice but to devote considerable resources in bringing his or her case to court.  Further, as Taxpayer B has found to his detriment, even if the Board of Review finds in his favour, he must be prepared to bring the case (if necessary) all the way Court of Final Appeal as the Commissioner has no hesitation in appealing an unfavourable Board of Review decision post-Datatronic.

(b) What is the status of DIPN 21?

The current status of DIPN 21 is unclear following the Court of Appeal’s obiter dicta in Datatronics that it has no legal effect.  The question is left open as to whether in the future the Inland Revenue Department will be able to disregard its own practice notes at will.  If DIPN 21 indeed has no force of law, then further cases must be determined on a case-by-case basis based on fundamental principles of law.  In both Case No. 42/08, Case No. 51/08 and Datatronic, the relevant counsel appearing for the taxpayer accepted that reliance may not be placed on DIPN 21 as the Inland Revenue’s concession therein has no legal effect.

Aside from the argument that allowing the Inland Revenue to deviate retrospectively at will from its own practice notes is against the rule of law, the current difficulty for taxpayers is formulating what the legal basis is or apportionment.  As explained by the Court of First Instance in Datatronic, DIPN 21 is a convenient concession by the Inland Revenue in cases where the profits tax might have been fully assessable for tax if section 14 (1) of the Inland Revenue Ordinance had been adhered to strictly.

Taxpayers are left with no choice but to go back to first principles, and argue that their profits (or a portion thereof) are not assessable to tax under section 14 of the IRO in the first place as they are not Hong Kong sourced profits.  Taxpayers who would otherwise have been guided by DIPN 21 will have to review their tax affairs, internal arrangement and structures in order to assess their tax risks.  On the other hand, taxpayers previously disbarred from claiming apportionment under DIPN 21 on the basis of them entering into import processing arrangements or where they are conducting trading (as opposed to manufacturing) activities should re-assess their profits profit to see whether an offshore claim is possible after all.

(c) Preference of PRC documents over HK audited financial accounts

The Board of Review accepted and preferred Taxpayer B’s audited accounts, whilst the Court of Appeal in Datatronics and the Board of Review in the case of Taxpayer A relied upon the financial accounts and documents of the PRC processing facility.

The later approach defies the judgment of Lord Millet NPJ in CIR v Secan Ltd., where it was held that there is no basis on which a taxpayer could challenge a tax assessment based on “its own financial statements, so long as these are prepared in accordance with ordinary accounting principles, show a true and fair view of its affairs and are not inconsistent with a provision of the Ordinance.”  It remains to be seen whether Lord Millet’s statement applies equally to the Hong Kong Courts or the Board of Review to preclude a challenge to a taxpayer’s tax assessment which is based upon the financial statements of a taxpayer’s offshore subsidiary.

(d) Are there really any distinguishing factors between the cases?

At the end of the day, what exactly distinguishes one Hong Kong manufacturer from another?  Many of the facts found by the Board of Review in Taxpayer B’s case were also put forward by Datatronic or Taxpayer A, though the Board of Review did not accept those appellants’ propositions in the later cases.  Are there legal or technical issues that distinguish one case from another, or is the credibility of the taxpayer and strength of evidence the only things that separate Taxpayer B from the rest?  The cases of both Taxpayer A and Taxpayer B are being appealed at the moment, but in the meantime, a Hong Kong manufacturer planning and structuring its tax affairs has very little guidance to go on.

The way forward

The current state of the law is clearly detrimental to Hong Kong’s manufacturing and trading industries.  Given the uncertainty surrounding the application of DIPN 21, Hong Kong manufacturers have precious little guidance as to the potential tax liabilities of their Hong Kong operations and their PRC processing facilities.  If they are to dispute an assessment of the Inland Revenue, they will have to be prepared to be dragged through the courts, with no assurance that any finality would result unless their case reaches the Court of Final Appeal.  The Hong Kong Government is strongly urged to take definitive steps to resolve and provide some guidance on this case.

 

 

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