DIPN 24

Our web site : www.ird.gov.hkInland Revenue DepartmentHong KongDEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNO. 24 (REVISED)PROFITS TAXSERVICE COMPANY “TYPE II” ARRANGEMENTSThese notes are issued for the information of taxpayers and their taxrepresentatives. They contain the Department’s interpretation and practices inrelation to the law as it stood at the date of publication. Taxpayers arereminded that their right of objection against the assessment and their right ofappeal to the Commissioner, the Board of Review or the Court are not affectedby the application of these notes.These notes replace those issued in August 1995.LAU MAK Yee-ming, AliceCommissioner of Inland RevenueJuly 2009DEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNo. 24 (REVISED)CONTENTParagraphIntroduction 1Type II arrangements 4Legal principles 6Acceptable arrangements 14Arm’s length basis 15Qualifying services 17Deduction allowable 22Returns and accounting 28Application 29Annex AINTRODUCTIONThe Financial Secretary announced in his 1994-95 Budget Speechthat the Administration proposed to take steps to deal with the tax avoidanceaspects of certain “service company arrangements”. Two types ofarrangements were identified as causing particular concern. The first (Type Icases) amount to disguised employment arrangements where the remunerationfor services rendered by a person under employment-like conditions is paid notas salary to that person, but as a consultancy fee to a service company hecontrols. The second (Type II cases) typically involve deductions beingclaimed by an unincorporated business for payments, often described asmanagement fees, which are made to a company or a trust (service company)controlled by the proprietor or partners of the business.2. Following the announcement, consultations were held with a numberof practitioners and professional groups with a view to ascertaining the mostappropriate way to address the areas of concern. Having considered theadvice received, the Administration introduced section 9A to the InlandRevenue Ordinance (“the Ordinance”) to curb Type I arrangements.Departmental Interpretation and Practice Notes No. 25 discuss the applicationof the relevant provisions which were introduced following the enactment ofthe Inland Revenue (Amendment) (No. 2) Ordinance 1995.3. With regard to Type II arrangements, it was decided that in the firstinstance legislation would not be required. Rather, the Department shouldseek to discourage abuse by both explaining in a Practice Note thecircumstances under which service company claims will be challenged byplacing greater reliance on the general anti-avoidance provisions of theOrdinance. Accordingly, the purpose of this Practice Note is to set out theDepartment’s position in relation to the application of the present terms of thelaw to Type II arrangements.TYPE II ARRANGEMENTS4. As indicated at the beginning of this Practice Note, a Type IIarrangement usually involves an agreement (service company agreement)under which management fees are paid by a firm to a service company directly2or indirectly controlled by the proprietor or partners of the firm. Asconsideration for the fees paid, the agreement generally provides for the servicecompany to supply certain operating requirements to the firm.5. It has become apparent to the Department that many arrangements ofthis kind are directed at reducing the overall incidence of tax. If the amountpaid to the service company is allowed as a deduction and exceeds the cost thatwould have been incurred if it had directly obtained the requirements inquestion, the assessable profits of the firm will be reduced. The servicecompany in turn will normally seek to avoid or minimise exposure to tax on theexcess payment by claiming deductions for tax efficient remuneration providedto connected parties (e.g. the proprietor or partners of the firm or their relatives)as employees or directors of the service company.LEGAL PRINCIPLES6. It has been accepted in other tax jurisdictions that where acommercially realistic sum is paid under a service company arrangement for aservice essential to the conduct of a firm’s business, the presumption is raisedthat the expenditure was for business purposes and is a genuine cost of earningthe firm’s income (i.e. incurred in the production of its profits). However, ithas also been recognised that the converse will apply if the expenditure isexcessive, namely that the payment was not wholly for the services provided,but for some other purpose. This thinking is considered by the Department tobe equally applicable to management fee claims under the Ordinance andaccordingly it underlies the Department’s position in relation to such claims.7. It follows that it is recognised there may be valid commercial reasonsfor the owners of an unincorporated business to make use of a service companyarrangement. However, what has caused concern to the Department in recenttimes has been the increase in the number of arrangements encountered where,having regard to the services involved, the fees paid have been well in excessof commercially realistic amounts and, therefore, by implication, are notincurred wholly in the production of chargeable profits. Equally disturbinghave been the cases where agreements have not been reduced into writing;accounts have not been properly kept; or fees have been decided on an arbitrarybasis bearing little, if any, relationship to the cost of the services provided.38. It is apparent that there is a lack of appreciation on the part of somepractitioners and taxpayers of the options open to the Department to challengeservice company arrangements where they fail to operate on a propercommercial basis. In this regard it should be noted that the decisions of theBoard of Review in Case No. D19/99 14 IRBRD 209 and D153/01 17 IRBRD189, both of which involved inflated management fees, provide clearillustrations of circumstances under which, by virtue of section 16(1) of theOrdinance, a management fee can be dissected and that part which is notattributable to the production of chargeable profits disallowed. Support forthis view can be found in the observations of the Board in D19/99 -At page 218“a. Section 16Section 16 ascertains the chargeable profits by defining whichoutgoings and expenses are deductible from the chargeable profits ofa taxpayer. Section 16(1) allows to ‘be deducted all outgoings andexpenses to the extent to which they are incurred during the basisperiod ... in the production of profits in respect of which he ischargeable to tax under this Part for any period including...’Section 16(1) then sets out those expenses which are deductible.”And at page 226“20. D61/91, IRBRD, vol 6, 457 and D32/93, IRBRD, vol 8,261 cited by the Revenue did not deal with section 61 and thequestion of artificial or fictitious transaction. Nor did Case D32/94,IRBRD, vol 9, 97 in which the taxpayer, a medical practitioner,admitted that section 61 applied to his case in order to avoid the direconsequence of the board disallowing the management fee in total asthe Board was of the view that on the evidence of that case themanagement fee was indivisible. Although the Board in D110/98,IRBRD, vol 13, 553 cited to us mentioned on the side that thewording of section 61 does not allow the Revenue to disregard a partof a transaction, we are of the view that if service companyarrangement is to be disregarded in accordance with section 61, thenit is open to the Revenue to assess the chargeable profits of a4taxpayer by totally ignoring service company and the service fees.With service company and service company arrangement out of theway (in other words, after lifting the corporate veil), it is open to theRevenue to dissect the outgoing expenses of service company as ifsuch outgoing or expenses were that of a taxpayer in the light ofwhether such outgoing or expenses were deductible to the extent towhich they are incurred in the production of a taxpayer’s chargeableprofits.”9. Taxpayers should also be mindful of the view expressed by theBoard of Review in Case No. D153/01 17 IRBRD 189 and D85/02 17 IRBRD1017 to the effect that it may be appropriate to disallow entirely an excessivemanagement fee which is not capable of being split into its component parts.In D153/01, at page 205, the Board said -“53. Whether an expense is an allowable expense is governedby sections 16 and 17 of the IRO. Section 16(1) permits deductionof all outgoings and expenses which satisfy two criteria, namely (1)they must be incurred in the production of assessable profits and (2)they must be incurred during the basis period of the year ofassessment in question. Section 17 disallows deduction of certaintypes of outgoings and expenses. If a taxpayer fails to prove that anexpense was incurred for the production of his assessable profits, thewhole of that expense will be disallowed. In the present case, if theTaxpayer is unable to prove that the management fees were incurredin the production of his assessable profits, the whole of thesemanagement fees would be disallowed. But if an expense iscapable of analysis and subdivision or where section 61 or section61A applies which allows dissection of the expenses, then thatexpense can be allowed ‘to the extent’ that it was incurred to producethe taxable profits and the balance thereof be disallowed. In thepresent case, since the management fees were made up of thoseexpenses as detailed in Company B’s profit and loss accounts plus amark-up of 5%, they are thus capable of analysis and subdivision.Accordingly, only those expenses which are proved to be incurred inproduction of the Taxpayer’s assessable profits would qualify asallowable deductions.”5And at page 206“56. We were asked by Counsel for the Taxpayer to decide onthe question of whether a minute examination of Company B’sexpenses was permissible under the circumstances. We decide thatwe should allow an examination of Company B’s expenses in detail.The amounts of management fees were calculated by reference to allthe expenses and outgoings incurred by Company B in providing therequisite services plus a mark-up of 5%. Examination of thoseexpenses and outgoings is necessary as to determine whether theywere incurred in production of the Taxpayer’s assessable profits. Inso doing, we are not lifting the corporate veil nor are we saying thatthe Taxpayer is not free to decide his own affairs but the question ofwhether an expense is deductible in law when computing thechargeable profits must be answered objectively. We must lookinto the purpose of the payments and see whether the expense wasbona fide incurred in production of the chargeable profits. Theonus is on the Taxpayer to show that each of those items of expensesin Company B’s profits and loss accounts was bona fide incurred forthe production of his assessable profits. We are not persuaded byCounsel for the Taxpayer that since Company B’s tax position wasnot in dispute, the expenses in Company B’s accounts were the leastrelevant. Nor do we accept the contention that once the Taxpayercould establish that the management fees were incurred for thepurpose of acquiring professional services from Company B, themanagement fees should be allowed in full. The matter does notstop there. The Taxpayer is still required to prove that the expenseswere bona fide incurred for production of his assessable profits.”10. The view expressed by the Board on the above occasion may well beregard as reflecting the principle stated in an earlier management fee case, “It isfor the Taxpayer to prove that the money had been used in the production ofthe profits” [D96/89 6 IRBRD 372].11. The relationship, if any, of the management fee to the servicesprovided is also clearly an important consideration in relation to the question ofwhether there is a commercial rationale for a service company arrangement.In this regard, the Board observed in Case No. D110/98 13 IRBRD 553 at page558 -6“7. In conclusion, while it is clear that some of the expensesof Company X did relate to the Taxpayer’s practice, the interposingof Company X was in reality predominantly designed to be a taxvehicle whereby a lot of the Taxpayer’s personal expenses were to bemade tax deductible and, more importantly, to enable the Taxpayerto reduce his tax liability to minuscule proportions. It was hardlynecessary nor even advantageous for the Taxpayer to engageCompany X to provide services to his practice and certainly not atthe management fee that company charged. To put it another way,if Company X was not owned by the Taxpayer and not providinghim with the benefits it did (including loans on generous terms), wewould not have thought there would be much if any possibility thatthe Taxpayer would have engaged that company. It would simplynot have been commercially acceptable. Lastly, it should be notedthat Company X acted only for the Taxpayer; it had no other clients.”12. The Board in fact held in Case No. D94/99 14 IRBRD 603 that therelationship between the taxpayer and the service company was artificial andlargely, if not totally, fictitious and therefore should be disregarded under theprovisions of section 61 of the Ordinance. In reaching its conclusion theBoard emphasised the need for the parties involved to act on an arm’s lengthbasis if a service company arrangement is to be acceptable. At page 611 theBoard stated -“24. Mr B said that it was solely a matter for the Taxpayer andCompany D as to what the fair and reasonable service would be.We accept the Revenue’s submission that the matter had to beassessed objectively. That is not to say that we are lifting thecorporate veil. Nor are we saying that the Taxpayer is not free todecide its own affairs. The Taxpayer is free to give away part of itsincome as it so wishes to a related company or to a relative orindeed to any third party. The question here is whether thatpayment is a deductible expense in law when computing thechargeable profits. This question must be answered objectively.The agreement between the Taxpayer and Company D does notpreclude us from examining whether the payment is or is not adeductible expense incurred in the production of profits.725. Such expense must have been bona fide incurred in theproduction of profits. We must look at all surroundingcircumstances. For example, the relation between the payer andthe payee is a relevant circumstance. So is the purpose or thereason of the payment. The basis and the breakdown of the amountare also important. The lack of a rational basis may lead us to theconclusion that the amount is wholly arbitrary, lacking incommercial reality, and thus not bona fide incurred.26. In this case, the Taxpayer has given us very littleinformation as to how the service fee was incurred in the productionof profits. The consultancy agreement referred to ‘firstly’ a fee$12,000 every month. There is no explanation as to how this cameto be increased to $1,391,200 for the relevant period. The minutesof Company D’s board is, quite apart from the discrepancies pointedout by the Revenue, totally silent as to the reasons for the substantialincrease. We do not accept the contention in the Taxpayer’s letterof 2 July 1996 that the fee was agreed on an arm’s length basis.There is no explanation as to how the fees were determined‘periodically’ as stated in that letter. The schedule, which isannexed hereto as Appendix B and relied upon by Mr B, showsirregular payments and is again totally unexplained. There is noinformation as to how these payments relate to services provided byCompany D. It looks more like a list of sole proprietor’s drawingsfrom his own business. There is no attempt to justify any of thesums by reference to the service provided by Company D. In thecircumstances, the Taxpayer failed to discharge his onus, we haveno hesitation in dismissing the appeal.”13. It should also be noted that apart from the possibility of applyingsection 61 where a service company arrangement is not operated on acommercial basis, the Department may also turn to section 61A if it is apparentthat the sole or dominant purpose of the arrangement is to obtain a tax benefit.In such circumstances the existence of the service company could bedisregarded and the tax benefit effectively cancelled. The decision of theBoard of Review in Case No. D153/01 17 IRBRD 189 is an example where theCommissioner has applied section 61A to a Type II service companyarrangement. The Board accepted the Commissioner’s views and stated atpage 209 -8“ As to section 61A, we also accept the Commissioner’sreasons in his determination to conclude that the Service Agreementand the Employment Agreement were entered into by the Taxpayerand Company B for the sole and dominant purpose of enabling theTaxpayer to obtain a tax benefit.”ACCEPTABLE ARRANGEMENTS14. The following paragraphs set out the minimum requirements thatmust be satisfied to support a management fee claim and also spell out the basison which the quantum of the deductible amount can generally be determined.Arm’s length basis15. There may well be circumstances which warrant a person carryingon a trade, profession or business entering into an arrangement with a properlyconstituted service company to obtain certain services and facilities which arerequired in order for the person to derive chargeable profits. However, for taxpurposes, it must be emphasised that where such an arrangement is entered into,the service company has to function as a separate business operating on anarm’s length basis in its dealings with the firm. To support and be consistentwith the separate status of each party, their respective rights and obligationsand dealings with each other should be fully documented. Suchdocumentation should include -• the agreement under which the services are provided (it shouldspecify the relevant services, the basis on which fees are to bepaid, the period covered by the agreement, etc);• minutes of meetings recording approval of the terms of theservice company agreement and any subsequent amendment;• invoices and receipts in respect of transactions between theparties;• working papers in respect of the calculation of the fees chargedby the service company;9• bank records in respect of each party; and• employment contracts in respect of persons employed by eachparty.16. In the generality of cases, where a management fee is paid to aservice company on an arm’s length basis, the amount involved should reflectthe costs of the service company which are directly attributable to the relevantservices (e.g. salary paid to a typist) plus an appropriate mark-up to provide forthe operating expenses (e.g. rent of premises occupied by the service companyitself) and reasonable profit margin of the company. These matters are furtherdiscussed in the following paragraphs.Qualifying services17. In order to determine the deductible amount, if any, in respect of amanagement fee paid by a firm, the starting point must be to examine thenature of the services received from the service company. In this regard, it isnecessary to identify what might, for convenience, be called “qualifyingservices” required by the firm in order to produce chargeable profits.18. The Department’s position is that, broadly, the term “qualifyingservices” encompasses non-professional services which are required to providethe infrastructure in which the firm operates and to cater for its day-to-dayoperations. Accordingly, it can include services such as the provision ofpremises, staff (e.g. administrative, secretarial, clerical and cleaning staff),plant and equipment and miscellaneous supplies (i.e. stationery, photocopying,medical, etc). The term does not, however, extend to the provision of anyservices to a firm by its proprietor or partners as employees of a servicecompany. In the latter regard, the position of the Department reflects the viewthat such an arrangement would in substance amount to the proprietor orpartners seeking to employ themselves and therefore, on established principles,it would not be effective for taxation purposes.19. Also excluded from the term are services performed by otherprofessional “fee-earners” who have contracts of employment with a servicecompany, whether or not they also hold positions as ordinary employees orsalaried partners with the firm. It is pertinent in this regard that where10professionals are employed by the service company instead of the firm, itwould generally be possible for the parties concerned to arrange for the servicecompany to directly charge the client for the relevant services. In thesecircumstances the deduction allowed in respect of remuneration of theprofessionals against the sum received would be limited to the amount actuallypaid. Accordingly, it is not considered that any mark-up could be justified incommercial terms in respect of the portion of a management fee relating tosuch remuneration where the firm bills the client even though the servicecompany employs the professionals.20. A reference to professionals in this context should be read asapplying to persons whose day-to-day duties require them to apply expertisethey have acquired through training or experience in the profession of the partyfor whom the duties are performed. On the other hand, the term does not referto a person who has expertise in a profession but performs onlynon-fee-earning services. For example, it should not be taken as applying toan accountant who carries out administrative functions in a medical practice orto a legally qualified person acting only as an office manager or librarian in afirm of solicitors.21. It should be noted that the Department does not accept that aprofessional can “wear two hats” so that what might be called administrativeduties are isolated from professional duties for the purpose of treating theformer as qualifying services. The position of the Department in this regard isthat, irrespective of whether the person concerned is a proprietor, partner oremployee of the firm, such administrative duties are part and parcel of therequirements of a professional position and do not warrant separateconsideration.Deduction allowable22. If a deduction is to be allowed, a firm must establish that the amountclaimed in respect of each qualifying service falls within section 16 of theOrdinance and is not excluded under section 17. To establish deductibility, itmust provide the Department with a detailed statement which lists thequalifying services obtained from the service company. The statement shouldinclude in respect of each service -11• an explanation, unless the reason is self-evident, of why theservice is required by the firm in order to produce its chargeableprofits;• the amount included in the management fee claim in respect ofthe particular service (any portion applicable to non-businessuse should be excluded); and• an explanation of why the amount should be accepted as beingcommercially realistic and deductible.23. As was mentioned in paragraph 16 above, the Department acceptsthat a commercially realistic figure for a firm to pay for qualifying services canreflect not only the costs of the service company which are directly attributableto providing the relevant services (the “cost element”), but also an appropriatemargin or “mark-up” to cover the overheads and profits of the servicecompany. It follows that to establish the deductibility of a management feepaid for qualifying services, a firm will need to provide the Department withdetails of how the amount claimed has been calculated. In this regard, theDepartment will accept that for a particular year of assessment the costelement is represented by the sum of the tax deductions, including depreciationallowances, claimable by the service company in the same year of assessmentin respect of expenditure which is directly attributable to the provision of thequalifying services. As such, it should not include any amount in respect ofexpenditure which would not have qualified for a deduction or given rise to adepreciation allowance if it had been incurred by the firm itself, instead of bythe service company, in order to obtain directly the relevant services.24. As it is not accepted that qualifying services can include any functionperformed by a proprietor or partner of a firm, expenditure on anyremuneration or benefits provided by a service company to such a person (e.g.as a director’s fee) must not be reflected in the computation of the cost elementof qualifying services. Attached as Annex A is a simple example illustratingthe adjustment required where expenditure on the provision of remuneration toa connected party is involved.25. Where a service is provided which is used partly for a qualifyingpurpose and partly for some other purpose, the cost element should be reduced12to reflect the non-business application. For example, if an item of plantprovided by a service company to a firm is only used by the latter 40% forbusiness purposes, only that percentage of any depreciation allowance andrelated expenses should be included in the cost calculation. Similarly, wherefunds are borrowed by a service company in order to provide qualifyingservices to a firm and for some other purpose (e.g. to purchase a propertyoccupied by a connected party), only that part of the interest which relates tothe provision of the qualifying services should be included in the cost element.26. In relation to the question of what is an appropriate mark-up,provided that the overall claim does not exceed the expenditure actuallyincurred, a margin not exceeding 12.5% of the cost element will generally beaccepted as being commercially realistic. It is considered that a margin of thisorder provides a reasonable approximation of those applicable in arm’s lengthbusiness operations and reflects the views expressed by the Board of Review inCase No. D94/99 14 IRBRD 603.27. Where the information provided by a taxpayer is insufficient toestablish that the deduction claimed in respect of a management fee iscommercially realistic, the presumption will arise that the fee was paid at leastin part for a purpose unrelated to the production of chargeable profits. In sucha case, a deduction will be denied to the extent to the amount in excess of acommercially realistic figure, provided that it can be ascertained or reasonablyestimated. If this is not possible, consideration will be given to disallowingthe claim in toto in accordance with the view expressed by the Board ofReview in Case No. D153/01 17 IRBRD 189.Returns and accounting28. Unless there are exceptional reasons for doing otherwise, a firm andits related service company should make up their accounts to the same date.If different dates are used, a detailed explanation of the underlying reasonsshould be provided, otherwise it may be presumed that the parties are seekingto obtain a tax benefit. It will also facilitate the assessment of a managementfee claim in respect of qualifying services, if copies of the accounts of a servicecompany and its Profits Tax computation are lodged with the Profits Tax returnof the firm.13APPLICATION29. An assessment which in the absence of this Practice Note wouldhave been regarded as final and conclusive in terms of section 70 of theOrdinance will not be reopened for the purpose of adjusting a management feeclaim to reflect this Practice Note. However, where an assessment has notbeen made for any year, including a back-year, the Department will be atliberty to apply this Practice Note.30. Moreover, it must be stressed that this Practice Note only states theDepartment’s practice in determining whether or not management fee paid byan unincorporated business is deductible. It has no application to the taxationof the service company. As confirmed by the Board of Review in Case No.D62/01 16 IRBRD 537 at page 555, “…The whole tenor of DIPN No 24 is onthe question of whether or not the management fee paid or payable by anunincorporated business to a service company can be allowed as a deduction inthe unincorporated business’ tax file. It does not deal with the chargeabilityof the management fee paid or payable, to a service company in the servicecompany’s tax file…”. Whether a sum is deductible to the taxpayer does notaffect its chargeability in the hands of the recipient.Annex AProfessional FirmProfessional Fees $5,000,000Less: Management Fee for services(i.e. office accommodation and generalclerical support) provided 4,000,000Profits per accounts $1,000,000Actual cost of providing operating requirements(i.e. office accommodation and general clericalsupport) by Service Company to ProfessionalFirm -- $3,000,000Computation of Assessable Profits of Professional FirmProfits per accounts $1,000,000Add: Management Fee adjustment(deduction restricted to $3,375,000being actual cost of $3m + 12.5%) 625,000Adjusted Assessable Profits $1,625,000Note: The 12.5% mark-up is on expenditure incurred by the Service Companyin providing services to the Professional Firm (i.e. the “cost element”).For this purpose it is only accepted as including expenditure whichwould have been deductible to the Professional Firm if it had directlyincurred the relevant expenditure (see Para. 23 of the Practice Note).iiService CompanyIncome (Management Fee) $4,000,000Less: Cost of services provided toProfessional Firm -Office Accommodation,Administrative, Secretarial &General Clerical support $3,000,000Director/Employee remuneration(connected parties) 400,000Own Operating Expenses 200,000 3,600,000Assessable Profits $400,000Note: Remuneration paid to each director/employee of the Company isdeductible if it falls within section 16 of the Ordinance and is notexcluded under section 17. The Practice Note does not seek to provideany guidelines in respect of such claims