NEWS
Oct-08-2009 Import Processing Arrangements – a legal critique of the Datatronic Limited judgment
By Debby Davidson
Much has been written in recent months about the Hong Kong Court of Appeal’s decision on 15 July 2009 in Commissioner of Inland Revenue v. Datatronic Limited, in which the Court of Appeal dismissed the taxpayer’s claim for apportionment of profits on the basis that Datatronic’s arrangement with its PRC subsidiary (“Datatronic (Shunde) Corporation” or “DSC”) constituted an import processing arrangement, and therefore such taxpayer operated a trading (as opposed to a manufacturing) business.
The facts of the case have been previously summarised on our website. It is our view that the Court of Appeal’s judgment failed to take into account the complexities of the business models utilized by Hong Kong manufacturers and has left the current law on apportionment in a contradictory state.
Of particular concern is the Court of Appeal’s reluctance to accept, despite a wealth of evidence, that Datatronic conducted manufacturing activities in the PRC through DSC as its agent. In our view, the basis upon which the Court of Appeal held that DSC was not Datatronic’s agent was flawed, and rested upon a gross simplification of the law. Further, the Court of Appeal’s conclusion that the taxpayer’s profit-producing transactions arose strictly from its trading activities rested on the categorization of DSC’s arrangement with Datatronic as an import processing arrangement, which we believe is the conceptual equivalent of fitting a square peg in a round hole.
Agency
As Hong Kong’s taxation system is territorial based, the taxpayer sought to argue that its profits were derived from the manufacturing and finishing activities undertaken by DSC (in its capacity as agent of Datatronic) in the PRC. As the taxpayer’s profits were derived from both PRC (through its agent) and Hong Kong, an apportionment of its profits was appropriate.
The Board of Review found that DSC was not an agent of the taxpayer, on the basis that the two companies were two separate legal and commercial entities: Datatronic and DSC had separate business operations and kept and maintained separate books of accounts and workforce. In the view of the Board of Review, as the processing fees of DSC were maintained at a level whereby substantial profits tax would not be payable, the profits of DSC were treated as its own and not that of Datatronic’s. Thus, the Board of Review concluded that the agency test set out by Alkinson J in Smith Stone & Knight Limited v Birmingham Corporation was not fulfilled. Further, due to the general principle of law that a person cannot do by means of an agent what he cannot do himself, the Board of Review reasoned that DSC could not have been an agent of the taxpayer as only DSC, and not the taxpayer, had a license to carry out processing works in the PRC.
The Court of First Instance concluded that the Board of Review was incorrect in holding that DSC was not an agent of Datatronic. This finding, albeit obiter dicta and therefore not legally binding, was not followed on appeal by the Court of Appeal. However, the Court of Appeal did not consider the point in detail as the issue of agency was not considered by the Court of First Instance to be relevant as to the applicability of Departmental Interpretation & Practice Notes No. 21 (“DIPN 21”).
This is unfortunate as the Court of Appeal also held that DIPN 21 does not have any legal effect, which leaves the question 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.
The basic question to be determined in each case is whether there are profits arising in or deriving from Hong Kong which are chargeable to profits tax pursuant to section 14 of the Inland Revenue Ordinance. With respect to the Court of First Instance, it is our view that the question of agency will become crucial in the future to the question of whether profits ‘arise in or derive from Hong Kong’, as an offshore branch or subsidiary may act on the behalf of a taxpayer in performing activities which generate profits.
We agree with the Court of First Instance in its judgment that DSC was an agent of Datatronic. Unfortunately the Court of First Instance did not go into details in its judgment on the agency issue but in our view, the Board of Review erred in holding that profits of DSC being kept artificially low was determinative of DSC not being an agent. Instead, the Board of Review should have considered the totality of all the evidence before it. Further, when considering the profit-generating activities of an agent, it should be noted that ‘In considering the sources of profits… it is not necessary for the taxpayer to establish that the transaction which produced the profit was carried out by him or his agent in the full legal sense. It is sufficient that it was carried out on his behalf and for his account by a person acting on his instructions’ (ING Baring Securities (Hong Kong) Ltd v CIR.
Further, in our view, the fact that Datatronic did not have a processing license in the PRC does not in itself preclude it from conducting contract processing activities in the PRC through a duly licensed agent. To argue that Datatronic could not have been conducing contract processing activities in the PRC through an agent on the basis that it did not have the requisite licenses plainly, in our view, ignores the commercial realities of the current case. The general principle of law that ‘a person cannot do by means of an agent what he cannot do himself’ should not be applied indiscriminately in every situation. An exception provided by statutory law is that a principal can only conduct share dealing activities (a regulated activity) through a duly licensed securities broker, and there is little doubt that in doing so, the securities broker acts as an agent of the principal. The current case is another exception to the general principle.
In the future, instead of arguing that the PRC processing factory is an agent, a better argument would be for taxpayers to claim that the act of seconding their employers to work in mainland factories, building moulds in the factories, supervising local staff, and undertaking quality control constitutes conducting operations outside of Hong Kong. As such, the profits attributable to these operations are sourced overseas and need to be excluded from the profits assessable to tax. The reasons given by the Court of Appeal’s in holding that no agency existed in the Datatronic case, namely that Datatronic and DSC were separate legal entities, had separate accounts (and hence profits) and workforce, would be rendered irrelevant. Unfortunately, this alternative argument was not put before the Board of Review.
Manufacturing vs Trading and Contract Processing vs Import Processing
In its decision, the Court of Appeal overturned the Court of First Instance’s judgment and concluded that the profits in question were trading profits and that the business transacted between Datatronic and DSC was in the nature of ‘import processing’. In reaching this decision, the Court of Appeal considered the focus when determining the location and taxability of profits should be on ‘establishing the geographical location of the taxpayer’s profit-producing transactions’ (Kwong Mile Services Ltd v Commissioner of Inland Revenue).
The Court of Appeal considered that Datatronic’s profit making transactions consisted of purchasing goods from DSC and re-selling them at a profit, and that works undertaken by Datatronic in the manufacturing process, ‘though commercially essential to the operations and profitability’ of Datatronic, were merely antecedent or incidental to the transactions generating the profits. We find the Court of Appeal’s judgment on this point to be contradictory. How is it possible that a process that in the Court of Appeal’s own words was ‘commercially essential to the operations and profitability’ of a company be ‘antecedent or incidental’ to the profit generating transaction?
In support of its decision, the Court of Appeal held that the Court of First Instance had erred in concentrating on the notion of substance over form. In our view, 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 this documentary form, whilst other documentary evidence favorable to the taxpayer was disregarded: crucially, no mention was made of 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.
The Court of Appeal stressed throughout its judgment that the crucial determination to be made in considering the source of profits was to ascertain ‘what were the profits’ producing transactions and where they took place’. However, having stated the determinative question, the Court of Appeal disregarded the facts found by the Board of Review, namely, that that Datatronic controlled the manufacturing process, was responsible for design, product testing and prototype production, trained the PRC factory staff, supplied the manufacturing plant and machinery and monitored and managed the operations of DSC. The categorization of the work undertaken by Datatronic as merely providing ‘technical assistance’ was in complete defiance of the fact findings of the lower courts.
Conclusion
It remains to be seen whether Datatronic will further appeal the case to the Court of Final Appeal. However, for the time being, the Court of Appeal’s decision in Datatronic remains binding. As the law currently stands, the legal effect of DIPN 21 is uncertain and 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.
The only certainty is that the circumstances in which a Hong Kong manufacturer would be able to claim that operations are conducted offshore through an agent are severely limited and any Hong Kong manufacturer with agents offshore should review their accounting and bookkeeping system, licenses and inter-group operations in light of the Datatronic judgment. Taxpayers with contract processing facilities in the PRC may well find that, contrary to the true commercial realities, their operations risk being categorised as ‘import processing’ unless the appropriate licenses, accounts, invoices and custom declarations reflect the contract processing nature of the operation.