Source of profits - clarification from the Court of Final Appeal

On 5 October 2007 the Court of Final Appeal handed down its decision in the case of ING Baring Securities (Hong Kong) Ltd v The Commissioner of Inland Revenue (the ING Baring case).

The Court of Final Appeal decision in this long running case on the source of profits is likely to have significant implications for both taxpayers and the Inland Revenue Department (IRD).

The profits involved in the ING Baring case were commission income, placement income and marketing income in respect of the trading of securities listed on global stock markets. However, the decisions of five judges in the Court of Final Appeal set out in considerable detail the relevant case law regarding the determination of source of profits. Thus, this decision will have application to the determination of the source of all types of profits including trading and manufacturing profits and service income as well as commission, placement and marketing income.

It is also likely that the decision of the Court of Final Appeal will result in the IRD revising their Departmental Interpretation and Practice Notes No. 21 on the Locality of Profits (DIPN21).

Hong Kong's tax system is territorial and only profits which have, or are deemed to have, a Hong Kong source are subject to Hong Kong Profits Tax.

As set out by Lord Bridge in the Privy Council in the case of CIR v Hang Seng Bank in order for a person or company to have a liability to Profits Tax that person or company must meet three conditions.
 

It should be noted that all three conditions must be met if a company is to have a liability to Profits Tax.

Lord Bridge further stated that it followed from the third condition set out above that,

"a distinction must fall to be made between profits arising or derived from Hong Kong (Hong Kong profits) and profits arising in or derived from a place outside Hong Kong (offshore profits) according to the nature of the different transactions by which the profits are generated".

Although the Hang Seng Bank case was concerned with the locality or source of trading profits, Lord Bridge set out a "broad guiding principle" to be applied in determining the source of profits generally namely that one has to consider "what the taxpayer has done to earn the profit in question", by reference to the nature of the particular transaction in question.

Lord Bridge also set out some examples on the determination of the source of profits other than trading profits. As for trading profits, the Privy Council in the Hang Seng Bank case held that the source of such profits was where the contracts of purchase and sale were "effected" which generally is where they were negotiated, concluded and are enforceable.

The Privy Council's decision in the Hang Seng Bank case was handed down in 1990. Since that time there have been various court decisions on source of profits, all of which have referred to Lord Bridge's "broad guiding principle". But some of the interpretations have confused the application of the broad guiding principle.

One element of this "reinterpretation" of the broad guiding principle in the Hong Kong courts has been to introduce a "totality of facts test" to determine the source of profits. Such an approach moves away from an analysis of the particular transaction which generates the relevant profit for a company, and concentrates on the background or "totality" of the company's activities. This approach has been adopted by the IRD as can clearly be seen in the current version of DIPN21 issued in March 1998.

The IRD replies on the Court of Appeal decision in Magna Industrial Company Ltd v CIR (the Magna case) in respect of trading profits at paragraph 6 of DIPN21 where the IRD state:

"Generally the determining factor, as indicated in [the Hang Seng Bank case] is the place where the contracts for purchase and sale are effected. However, as the Court of Appeal noted in [the Magna case], the totality of facts must be looked at in determining what the taxpayer did to earn the profit: '... the question where the goods were bought and sold is important. But there are other questions: For example: How were the goods procured and stored? How were the sales solicited? How were the orders processed? How were the goods shipped? How was the financing arranged? How was payment effected?' This reflected the statement by the High Court that "More often than not, it would not be the quantity of activities but the nature and quality of them that matters more. The cause and effect of such activities on the profits is the determining factor. It is what role such activities played and the relative importance of them in the making of profits that would usually tilt the scale and not the number of activities carried out at a particular place."

The IRD has used their interpretation of the decision in the Magna case as authority to raise extensive, wide ranging and broad based queries in cases concerning the locality of profits. However, the Court of Appeal decision in the Magna case was not in line with the decision of the Privy Council in the Hang Seng Bank case. This IRD practice has led to numerous disputes where taxpayers have claimed that the totality of facts test is incorrect as it does not identify the immediate source of a profit i.e. the particular transaction which gives rise to the profit as advanced by Lord Bridge, but concentrated on incidental matters. This has led to a series of court cases in Hong Kong including the ING Baring case.

The significance and importance of the Court of Final Appeal's decision in the ING Baring case is that it clarifies the importance of identifying and considering the particular transaction which gives to the profit concerned whilst specifically rejecting the totality of facts test in the determination of source of profits.

In his decision in the ING Baring case Mr Justice Ribeiro PJ noted that in the Privy Council decision in the case of CIR v HKTVB International Ltd Lord Jauncey stated:

"Lord Bridge's guiding principle could properly be expanded to read one looks to see what the taxpayer has done to earn the profit in question and where he has done it."

Referring to the decision in Kwong Mile Services Ltd v CIR, Mr Justice Ribeiro PJ noted that the Court had emphasised "the need to grasp the reality of each case focusing on effective causes without being distracted by antecedent or incidental matters."

In his decision Mr Justice Ribeiro PJ stated:

"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 [of the Inland Revenue Ordinance]."

Further at Paragraph 48 Mr Justice Ribeiro PJ stated:

"In a case like the present, source is determined by the nature and situs of the profit-producing transactions and not by where the taxpayer's business is administered or its commercial decisions taken."

He therefore rejected the approach followed by the IRD and the Board of Review in the ING Baring case and stated:

"In other words, the Board apparently believed that in order to ascertain the source of the disputed profits, it had to investigate every facet of the Taxpayer's business so that it could engage in a qualitative assessment of the relative importance of its various operations, choosing "the more important things done" towards the generation of those profits as the criteria for determining geographical source. That is not the approach mandated by the authorities and places an erroneous emphasis on matters properly regarded as antecedent or incidental to the profit-generating operations."

"Such an approach fails to focus on the transactions which proximately produce the profits and emphasises antecedent or incidental matters that whilst commercial essential, are legally irrelevant."

Instead the Court of Final Appeal said the correct approach was to concentrate on the profits arising from each transaction and to determine the source of income from each particular transaction. Lord Millet NPJ summarised the position in his judgement as follows:

"In summary (i) the place where the taxpayer's profits arise is not necessarily the place where he carries on business; (ii) where the taxpayer earns a commission for rendering a service to a client, his profit is earned in the place where the service is rendered not where the contract for commission is entered into; (iii) the transactions must be looked at separately and the profits of each transaction considered on their own; and (iv) where the taxpayer employs others to act for him in carrying out a transaction for a client, his profit is earned in the place where they carry out his instructions whether they do so as agents or principals."

The Court of Final Appeal decision in the ING Baring case therefore makes it clear that in determining the source of profits the relevant transaction which gives rise to the profit must be reviewed and each transaction must be looked at separately. Within the same company some transactions may give rise to offshore profits and some to Hong Kong profits. The antecedent or incidental activities of a company (as reviewed in the "totality of facts test") may be commercially essential to the operations of the taxpayer but they are legally irrelevant in determining the source of profits.

The clarification provided by the Court of Final Appeal's decision in the ING Baring case has implications for all taxpayers seeking to clarify the source of their profits.

Where taxpayers are currently in correspondence with the IRD regarding source of profits they should ensure that their case is re-examined in the light of the Court of Final Appeal's decision with emphasis placed on the importance of identifying the particular transactions that gives rise to the profits to determine the source of the profit rather than referring to the antecedent or incidental activities which comprise the "totality of facts test".

The Commissioner of Inland Revenue is normally very responsive to important court decisions and in view of the emphasis placed on the "totality of fact test" in the current DIPN21 as quoted above it appears likely that the IRD will take steps to review and reissue DIPN21 in the near future.

david.southwood@gthk.com.hk