The Court of Appeal upheld the lower court’s decision that the sourcing commission earned by Li & Fung (Trading) Limited was non-taxable offshore income.
Last week, the Court of Appeal (CA) upheld that the buying agency commission of Li & Fung (Trading) Limited (LFT) was non-taxable offshore income. The commission in question was earned by LFT through services rendered outside Hong Kong on its behalf by its overseas affiliate companies.
Brief facts of the case
LFT provided services to its customers as their buying agents. LFT had its headquarters in Hong Kong with many of its most senior staff based in Hong Kong. LFT entered into agency agreements with its customers as a result of the efforts undertaken by its senior staff in Hong Kong.
Typically, the services to be provided by LFT to its customers as specified in the agency agreements included:
- Locating suppliers, arranging manufacturing of the relevant merchandise by the suppliers, placing orders in the territory of the suppliers on behalf of its customers
- Monitoring suppliers’ production schedules
- Maintaining quality control on the relevant merchandise
- Arranging shipment and assisting suppliers with the preparation of all relevant export documentation
- Attempting to settle possible merchandise claims on behalf of its customers
- Keeping customers informed of new developments in the suppliers’ markets
- Signing or countersigning contracts/purchase orders/ commitments on the customers’ behalf
Upon the suppliers delivering the finished goods to its customers, LFT would usually receive a commission from the customers of 6% of the total FOB value of the merchandise.
Where both the customers and suppliers were located outside Hong Kong, LFT would ask its overseas affiliate companies to perform many of the above services. The overseas affiliates performed these services to customers on behalf of LFT under separate service agreements between LFT and the affiliates. In consideration for the services provided by the affiliates, LFT would pay them, for example, 4% of the FOB value of the merchandise.
LFT claimed that its net commission income of 2% (i.e., 6% - 4%) derived from the above mode of operations was offshore sourced and, therefore, not chargeable to tax in Hong Kong1. The Commissioner of Inland Revenue (CIR) however rejected LFT’s claims, determining that the net commission was onshore income chargeable to tax in Hong Kong.
Not satisfied with the CIR’s determination of its case, LFT appealed to the tax tribunal, the Board of Review (BOR).
Taxpayers would generally welcome this as a favorable decision, properly applying the case-law principles for determining the source of a profit by focusing on the direct profit-producing transactions, rather than various other antecedent or incidental business activities.
The decision indicates that under appropriate circumstances the activities of a sub-agent or subcontracted service provider can be attributed to the agent or principal service provider for the purposes of determining the source of the profits of the agent or principal service provider in Hong Kong.
At this stage it is however not known whether the CIR would further appeal the CA’s decision to the Court of Final Appeal (CFA), and, if so, whether the CA or CFA would grant the CIR’s leave for the appeal on the grounds that the issue involved is of great public interest.
Source of profits is by its nature a complicated issue and clients should consult their professional tax advisors where appropriate.
1 This tax alert only explains and discusses the decision as regards LFT’s offshore claims for its net commission income. The other issue of dispute in the case related to LFT’s claims for tax deductions for the payment of marketing commissions. This second issue is not addressed here, consideration of the same being deferred by the Courts pending remittal of certain matters to the BOR.