APAC Tax Matters: November 2012

Hong Kong

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  • Income booked in Hong Kong not necessarily subject to tax in Hong Kong

Taxability of income booked in Hong Kong

Following the 2007 decision of the Court of Final Appeal (CFA) in Kim Eng1, there has been a concern that any income booked in Hong Kong could be charged to tax in Hong Kong, despite the underlying transactions taking place outside Hong Kong.

However, in the recent tax tribunal decision D31/11, the Board of Review (BOR) indicated that where profits are only booked in Hong Kong for tax reasons and not to achieve any specific commercial purpose, those profits might not be subject to tax in Hong Kong.

Brief facts

The facts of the case are simplified and depicted in the diagram below.

Taxpayer and Company G were beneficially owned by the same principal. Taxpayer was a company incorporated in Hong Kong and Company G was an overseas company operating in Country E.

Aside from maintaining a registered address in Hong Kong in compliance with the requirements of the Hong Kong Companies Ordinance, Taxpayer did not maintain any office nor employ any staff in Hong Kong. The activities undertaken by Taxpayer in Hong Kong were essentially limited to maintaining a bank account and instructing a presumably independent accounting firm to prepare accounts for it.

The instructions for operating the bank account, and preparing the accounts, were all given by a director of Taxpayer residing in Country E.

Despite Company G manufacturing the goods in Country E and making sales of the same to customers also located in Country E, the sales of the goods and the related cost of sales were, by way of certain internal agreements, reflected in the accounts of Taxpayer. The apparent effect of these internal agreements was to treat Company G as the manufacturing and sales agent of Taxpayer in Country E, with Company G receiving only a fee for the agency services.

Taxpayer claimed that the arrangement was only to book the profits from the manufacturing and sales of the goods in the accounts of Taxpayer as part of a strategy to legitimately reduce the tax burden of Company G in Country E. Taxpayer argued that it was not carrying on a business in Hong Kong and the booked profits were therefore not chargeable to tax in Hong Kong.

The Commissioner of Inland Revenue (CIR) disallowed Taxpayer's claim and charged the relevant profits to tax in Hong Kong. Taxpayer appealed to the BOR.


Decision of the BOR

The CIR did not challenge that the relevant manufacturing and trading activities were carried out in Country E. Instead, the CIR argued that the internal agreements by which the sales were booked in the accounts of Taxpayer were “a dressing up arrangement”, apparently referring to the Kim Eng case in support of his argument.

In Kim Eng, commission income of a Singapore stockbroker for executing securities trades for its clients was booked in the account of a related Hong Kong stockbroker, despite the underlying trades being executed by the Singapore broker on the Stock Exchange of Singapore. The commercial reason for booking the commission income in the accounts of the Hong Kong stockbroker was to circumvent certain trading restrictions or rules of the Singapore Stock Exchange.

One of the judges of the CFA considered that the arrangement by which the relevant clients were regarded as clients of the Hong Kong stockbroker was “a dressing-up arrangement”, and the clients were in fact the clients of the Singapore stockbroker. As such, the judge considered that the Hong Kong stockbroker did not actually earn the commission for executing the trades for the clients (through the Singapore stockbroker).

Instead, the Hong Kong stockbroker earned its share of the commission income for participating in the “dressing-up arrangement” so as to circumvent the trading restrictions or rules of the Singapore Stock Exchange for the benefit of all the parties concerned.

The judge went on to say that since the “dressing-up arrangement” for which the Hong Kong stockbroker earned its commission was orchestrated and implemented in Hong Kong, the commission income was sourced in Hong Kong and therefore chargeable to tax in Hong Kong. This is despite the underlying securities trades being executed by the Singapore stockbroker in Singapore “on behalf of” the Hong Kong stockbroker.

In D31/11, however, the BOR rejected the “dressing-up arrangement” argument of the CIR. Based on the evidence, the BOR held that Taxpayer did not carry on business in Hong Kong and the profits derived from its business in Country E could not in any way be considered to be sourced in Hong Kong. Thus, the income booked in the accounts of Taxpayer was not chargeable to tax in Hong Kong.

Commentary

After the 2007 decision of the CFA in Kim Eng, there has been a concern that any income booked in Hong Kong could be charged to tax in Hong Kong, despite the underlying transactions taking place outside Hong Kong. The decision in D31/11 indicates that this is not necessarily the case.

Following D31/11, if income is booked in Hong Kong only for tax reasons, and not to achieve any other specific commercial purpose as in the Kim Eng case, then it may be possible to argue that the said income is not assessable to tax in Hong Kong.

Furthermore, while the threshold may be very low, there are nonetheless circumstances such as those arising in D31/11 where certain minimal activities can be carried out in Hong Kong by a taxpayer without causing the taxpayer to be regarded as carrying on business in Hong Kong.

Nonetheless, determining whether a business is carried on in Hong Kong, and whether the profits arising from that business are sourced in Hong Kong, are by their nature complicated matters. Clients should seek professional tax advice where appropriate.


1 Kim Eng Securities (Hong Kong) Ltd v CIR [2007] 2 HKLRD 117

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