NEWS
Jul-29-2009 Datatronic Limited – Court of Appeal
The Court of Appeal handed down its judgement in the case of Commissioner of Inland Revenue v Datatronic Limited on 15th July 2009 in favour of The Commissioner of Inland Revenue.
The case evolved around whether Datatronic Limited (‘the Taxpayer’), was entitled to have part of its profits excluded from tax, having a source located outside Hong Kong; in this case a manufacturing facility in Guangzhou, Mainland China.
The Taxpayer established a wholly owned foreign enterprise in Guangzhou, Datatronic (Shunde) Corporation (‘DSC’), in September 1993. DSC commenced manufacturing on behalf of the Taxpayer in the same year. The Taxpayer and DSC entered into processing and supplemental agreements whereby the Taxpayer supplied raw materials, training, supervision of labour, design, technical know how, product specification and quality control standards, and training of local staff. The Taxpayer located three of its senior staff permanently at DSC’s factory and provided DSC’s Deputy General Manager who spent the majority of his time at the factory. All four individuals were only on the payroll of the Taxpayer.
The supply of raw material from the Taxpayer was in the form of a sale and the finished product manufactured by DSC was invoiced to the Taxpayer at a price being, “more or less the expenses incurred by DSC after offsetting the price of raw materials supplied by the Taxpayer to DSC, the transactions between them were not at arms length.”
The Board of Review had agreed that the nature of the agreement was one of an import processing contract and that the purchase of the raw materials and the sale of the finished product were structured in this manner to comply with the import license granted by the Guangzhou Government.
The Board of Review concluded that the Taxpayer was carrying on the business of manufacturing in Guangzhou and that a proportion of its profits were sourced in the PRC. The rationale for this was that;
“In providing DSC with design, technical know how management, training and supervision for the local work force and in supplying DSC with the manufacturing plant and machinery, the Taxpayer also had operations in the PRC and those operations were important operations and attributable to the profits in question. Since that part of profits was sourced outside Hong Kong, the same is thus not chargeable to tax”.
The Board of Review then permitted a 50/50 apportionment of the Taxpayer’s profits in line with the Inland Revenue Departmental Interpretation and Practice Note No.21 (“DIPN 21”) that seeks to allow such an apportionment for offshore manufacturing undertaken in Mainland China under a contract processing agreement. Whilst The Inland Revenue Ordinance is drafted in a way to permit apportionment no specific provisions apply hence the adoption of the concession in DIPN 21 as a practical solution to this issue.
The case was originally appealed to the Court of First Instance by both the Commissioner and the Taxpayer. The grounds for appeal by the Commissioner were that;
a) The Board of Review was incorrect in determining that the Taxpayer’s profits were derived from manufacturing and its profits were sourced in the PRC.
b) The Board of Review was incorrect in determining that the Taxpayer had undertaken manufacturing operations in the PRC.
c) That the Board of Review was incorrect in law in apportioning the profits on a 50/50 basis.
The Taxpayer appealed on the basis that;
a) The Board of Review was incorrect in determining that the nature of the manufacturing agreement between the Taxpayer and DSC was that of import processing.
b) The Board of Review was incorrect in determining that DSC was not the agent of the Taxpayer.
Chung J, the Judge in the Court of First Instance, found that the Board of Review was correct in finding on the facts of the case that the profits were derived from manufacturing, that a substantial proportion of the Taxpayer’s profits was sourced outside Hong Kong, that the Taxpayer did have substantial operations in Mainland China and that the Board of Review was correct to apportion the Taxpayer’s profits on a 50/50 basis. With regard to the Taxpayer’s objections Chung J found in the negative. The Commissioner appealed the decision to the Court of Appeal.
The Court of Appeal in reaching its decision referred to the ‘Leading Authority on Section 14’ - Kwong Mile Services Ltd v Commissioner of Inland Revenue (2004) 7 HKCFAR 275, and to Ribeiro PJ’s summary of the principles expressed in that case in his judgement in ING Baring Securities (Hong Kong) Ltd v CIR [2007] 10 HKCFAR 417.
“In Kwong Mile Services Ltd v Commissioner of Inland Revenue applying the above mentioned authorities, the Court noted the absence of a universal test but emphasised ‘the need to grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters’. The focus is therefore on establishing the geographical location of the Taxpayer’s profit-producing transactions themselves as distinct from activities antecedent or incidental to those transactions. Such antecedent activities will often be commercially essential to the operations and profitability of the Taxpayer’s business, but they do not provide the legal test for ascertaining the geographical source of profits for the purposes of Section 14.”
The Court of Appeal agreed, with the Counsel for the Commissioner, that the learned judge in the High Court had concentrated on the words of DIPN 21 and the notion of substance over form.
The Court of Appeal was of the view that the Board of Review had failed to look at the profit making transactions and that there was an import processing agreement under which purchase and sales contracts had been concluded between the Taxpayer and DSC which could not be said to have been undertaken purely for PRC Customs Duty purposes. Furthermore, the Inland Revenue Departmental Interpretation and Practice Notes had no legal effect.
The Court of Appeal concluded that the Taxpayer could not be said to be manufacturing in the PRC and that the Taxpayer’s profits were derived from selling products purchased from DSC. All the technical assistance provided to DSC by the Taxpayer was, “merely antecedent or incidental to the profit generating activities. As the Taxpayer purchased and sold its products from Hong Kong all the profits earned were Hong Kong sourced and hence chargeable to Hong Kong Profits Tax under Section 14 IRO.”
Read why Roddy thinks this is a cause of concern.