DIPN21

Our web site : www.ird.gov.hkInland Revenue DepartmentHong KongDEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNO. 21 (REVISED)LOCALITY OF PROFITSThese 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 March 1998.LAU MAK Yee-ming, AliceCommissioner of Inland RevenueDecember 2009DEPARTMENTAL INTERPRETATION AND PRACTICE NOTESNo. 21 (REVISED)CONTENTSParagraphIntroduction 1Basic tests for liability to Profits Tax 3Source concept 4The broad guiding principle 6Antecedent or incidental activities 14Principles on which locality of profits is determined 17Trading profits 18Re-invoicing centre 27Buying office 29Manufacturing profits 30Contract processing 33Import processing 39Other profits 45Apportionment of profits 46Sale or purchase commission 48iiGroup service companies 51Financial institutions 53Processing of offshore claims 55Agency 58Booked profits 60Advance Rulings 61Conclusion 62INTRODUCTIONThe territorial concept has always been fundamental to the taxationof profits in Hong Kong. Only those profits which arise in or are derived fromHong Kong are liable to tax here. However, where the territorial concept isclear, its application in particular cases at times remains a contentious issuebetween the Department and practitioners with numerous disputes beingreferred to the Board of Review and the Courts. The decisions of the PrivyCouncil in CIR v. Hang Seng Bank Limited [1991] 1 AC 306, HK-TVBInternational Limited v. CIR [1992] 2 AC 397 and CIR v. Orion CaribbeanLimited [1997] HKLRD 924 and of the Court of Final Appeal in Kwong MileServices Limited v. CIR [2004] 3 HKLRD 168, Kim Eng Securities (HongKong) Limited v. CIR [2007] 2 HKLRD 117 and ING Baring Securities (HongKong) Limited v. CIR [2008] 1 HKLRD 412, established guidelines to assist inlocating the source of profits. The broad guiding principle is that “one looks tosee what the taxpayer has done to earn the profits in question and where he hasdone it”.2. The Hang Seng Bank, HK-TVBI, Orion Caribbean, Kwong Mile,Kim Eng and ING Baring decisions do not set out rules to cover all cases wherethe locality of profits in issue, rather they clarify the general principles to befollowed in determining the locality of profits. The purpose of this note is tostate what the Department considers are the general principles laid down by thePrivy Council and the Court of Final Appeal and then give specific examplesapplying those principles. At the same time, it must be emphasised that eachcase will be determined on its own facts. As commented on in OrionCaribbean, Hang Seng Bank did not, when speaking of “profits earned ‘by theexploitation of property assets by letting property, lending money or dealing incommodities or securities’ lay down a rule of law. Rather, the case affirmedthat “no simple legal test can be employed”.BASIC TESTS FOR LIABILITY TO PROFITS TAX3. Section 14 of the Inland Revenue Ordinance (“the Ordinance”)makes it clear that only profits arising in or derived from Hong Kong arechargeable to profits tax. The residence of a taxpayer is not relevant. In Hang2Seng Bank, Lord Bridge explained the three conditions that must be satisfiedbefore a profits tax liability arises:(a) The person must carry on a trade, profession or business inHong Kong;(b) The profits to be charged must be from such trade, professionor business carried on by the person in Hong Kong; and(c) The profits must be profits arising in or derived from HongKong.This Practice Note will focus on the third condition, i.e. the locality of profits.The terms “source” and “locality” are used interchangeably in this PracticeNote.SOURCE CONCEPT4. Though the word “source” is not used in section 14, it has alwaysbeen accepted by the courts that the words “arising in or derived from” raisedthe concept of source. Cases from other common law jurisdictions withlegislation using the specific word “source” are therefore relevant and havebeen used in assisting the interpretation of the words used in section 14. InCIR v. Philips Gloeilampenfabrieken [1955] NZLR 868, Barrowclough CJ at874 said that the concept of derivation seems necessarily to imply the conceptof a source.5. “Source” is not a legal concept. In Nathan v. FCT [1918] 25 CLR183 at 189-190, Isaacs J explained:“The Legislature in using the word ‘source’ meant, not a legalconcept, but something which a practical man would regard as areal source of income. Legal concepts must, of course, enter into thequestion when we have to consider to whom a given source belongs.But the ascertainment of the actual source of a given income is apractical, hard matter of fact.”3THE BROAD GUIDING PRINCIPLE6. Lord Bridge in Hang Seng Bank has the following to say at 319Aabout the distinction of profits arising in or derived from Hong Kong and thosethat are not:“… a distinction must fall to be made between profits arising in orderived from Hong Kong (“Hong Kong profits”) and profits arisingin or derived from a place outside Hong Kong (“offshore profits”)according to the nature of the different transactions by which theprofits are generated.”7. Lord Bridge explained the “broad guiding principle” in Hang SengBank at 322H to 323A in the following terms:“But the question whether the gross profit resulting from aparticular transaction arose in or derived from one place or anotheris always in the last analysis a question of fact depending on thenature of the transaction. It is impossible to lay down precise rulesof law by which the answer to that question is to be determined. Thebroad guiding principle, attested by many authorities, is that onelooks to see what the taxpayer has done to earn the profit inquestion.”8. The “operations test” was further elaborated by Lord Jauncey in HKTVBIat 407C-D:“F. L. Smidth & Co. v. Greenwood [1921] 3 K.B. 583 was cited inHang Seng Bank case and their Lordships do not doubt that LordBridge has in mind the judgment of Atkin L. J. in that case and inparticular the passage when he said, at p. 593: “I think that thequestion is, where do the operations take place from which theprofits in substance arise?”Thus Lord Bridge’s guiding principle could properly be expanded toread “one looks to see what the taxpayer has done to earn the profitin question and where he has done it.”49. Lord Bridge exemplified his dicta in paragraph 7 above at 323A-Bas follows:“If he has rendered a service or engaged in an activity such as themanufacture of goods, the profit will have arisen or derived from theplace where the service was rendered or the profit making activitycarried on. But if the profit was earned by the exploitation ofproperty assets as by letting property, lending money or dealing incommodities or securities by buying and selling at a profit, the profitwill have arisen in or derived from the place where the property waslet, the money was lent or the contracts of purchase and sale wereeffected.”10. The examples cited by Lord Bridge in Hang Seng Bank are notmeant to be exhaustive and a careful analysis of the relevant facts need to becarried out in deciding whether a particular case falls within the examples.Lord Jauncey in HK-TVBI has warned against such an approach in thefollowing terms at 409D-E:“Their Lordships consider that it is a mistake to try and find ananalogy between the facts in this appeal and the example given byLord Bridge in the Hang Seng Bank case. The circumstances in thatcase involving, as they did, buying and selling in well definedforeign markets were very different from those in the present and theexamples were never intended to be exhaustive of all situations inwhich section 14 of the Ordinance might have to be considered. Theproper approach is to ascertain what were the operations whichproduced the relevant profits and where those operations tookplace.”11. The broad guiding principle has been followed in subsequent casesbefore the Court of Final Appeal. In Kwong Mile, Bokhary PJ summarised thebroad guiding principle at 174I to175E:“The ascertainment of the source of a profit is not hindered bytechnical rules, but is helped by the broad guiding principle that onelooks to see what the taxpayer has done to earn the profit and wherehe has done it. ……. In CIR v. Orion Caribbean Ltd [1997] HKLRD5924, Lord Nolan emphasised (at p.931F) that “[n]o simple, single,legal test can be employed” when ascertaining the source of aprofit. …... The situations in which the source of a profit has to beascertained are too many and varied for a universal judge-madetest. Apart from the words of the statute themselves, the onlyconstant is the need to grasp the reality of each case, focusing oneffective causes without being distracted by antecedent or incidentalmatters.”12. While the question of source of profits is a practical, hard matter offact, the broad guiding principle formulated in the judicial precedents hasenabled the proper and consistent application of the source concept to variousfactual situations. The broad guiding principle is not a set of rules. A ruleattaches a definite, detailed consequence to a detailed set of facts. It eitherapplies to a given situation, or it does not so apply; there is no latitude in itsapplication. A principle, relative to a rule, is broad, general and unspecific.The broad guiding principle is an authoritative starting point for assessing andreassessing, inclining towards a particular decision but not necessarilycompelling it.13. The broad guiding principle is not exhausted by any catalogue offactual circumstances. It does not expire when no judicial decision clearlycovers the present case because the value of the principle relies on the relevantoperations which produce the profits. It improves certainty even if a taxpayerfinds that some of the details of his specific case are different. He would knowhow to apply the profits tax charging provisions as he would understand theunderlying principle. By elucidating the broad guiding principle underlyingthe taxation of profits, conceptual clarity and a more coherent regime can beachieved.ANTECEDENT OR INCIDENTAL ACTIVITIES14. In ING Baring at 428, Ribeiro PJ when discussing the legal principlealso emphasised the need to grasp the reality of each case, focusing on effectivecauses without being distracted by antecedent or incidental matters. The focusis on establishing the geographical location of the taxpayer’s profit-producing6transactions as distinct from activities antecedent or incidental to thosetransactions.15. Whether an act is an antecedent or incidental activity is a question offact and would depend on the nature of the transaction. In CIR v. The HongKong & Whampoa Dock Co Ltd [1960] 1 HKTC 85, the initial business contactin Hong Kong which set in motion a chain of operations that ultimately led tothe salvaging of the vessel was rejected as the relevant operation.16. Comments in a similar vein can be found in Hang Seng Bank at320F-G:“The activities of the bank from which the income arose was thebuying and selling of this property in overseas market places andnot the decision making process in Hong Kong or any otheractivities in Hong Kong. Likewise the income arose from thetrading in property situate outside of Hong Kong and not themoneys of customers situate in Hong Kong.”PRINCIPLES ON WHICH LOCALITY OF PROFITS IS DETERMINED17. Assuming the first two conditions stated in paragraph 3 above aresatisfied, liability to profits tax will only arise if a person’s profits arise in orare derived from Hong Kong. The Department’s view is that the basicprinciples for determining the locality of profits enunciated in the decisions ofHang Seng Bank, HK-TVBI, Orion Caribbean, Kwong Mile, Kim Eng and INGBaring can be summarised as follows:(a) The question of locality of profits is a hard, practicalmatter of fact. No universal judge-made test will coverevery case. Whether profits arise in or are derived fromHong Kong depends on the nature of the profits and thetransactions giving rise to them.(b) The ascertainment of the source of profits though apractical, hard matter of fact requires an accurate legalanalysis of the transaction.7(c) The transactions must be looked at separately and theprofits of each transaction considered on their own.(d) The broad guiding principle is that one looks to see whatthe taxpayer has done to earn the profits in question andwhere he has done it. In other words, the proper approachis to ascertain what were the operations which producedthe relevant profits and where those operations took place.(e) The operations in question must be the operations of thetaxpayer.(f) The relevant operations do not comprise the whole of thetaxpayer’s activities carried out in the course of hisbusiness but only those which produce the profit inquestion. It is necessary to appreciate the reality of eachcase, focusing on effective causes for earning the profitswithout being distracted by antecedent or incidentalmatters.(g) The distinction between Hong Kong profits and offshoreprofits is made by reference to gross profits arising fromindividual transactions.(h) In certain situations, where gross profits from anindividual transaction arise in different places, they can beapportioned as arising partly in and partly outside HongKong.(i) The place where day to day investment decisions are takendoes not generally determine the locality of profits.(j) It is necessary to examine the operations of the taxpayerirrespective of the fact that the taxpayer may be acompany within a group. The source of profits must beattributed to the operations of the taxpayer which producethem and not to the operations of other members of thegroup. The operations of the group should not be looked8at on the question of source. However, in appropriatecases, if a related company is in fact acting on behalf ofthe taxpayer, then the activities of the related companywill be considered to see if appropriate weight should beaccorded thereto.(k) If an arrangement or scheme is implemented in HongKong to free transactions from overseas regulations orovercome trade barriers, this in itself does not mean thatthe profits will be sourced outside Hong Kong..(l) Identifying an agent’s acts with those of its principal,whilst imposing some unity on the law applicable tosituations where one party represents or acts for another,should not be taken to an inappropriate degree or taken tooliterally since this is not conducive to arriving at theaccurate legal analysis.(m) In brokerage business, it is not necessary that thetransaction which produced the profit was carried out bythe taxpayer or his agent in the full legal sense (i.e. onewho enters into a contract on his principal’s behalfcreating a contractual relationship between his principaland a third party). It is sufficient that the transaction wascarried out on the taxpayer’s behalf and for his account bya person acting on his instructions.(n) The absence of an overseas permanent establishment of aHong Kong business does not, of itself, mean that all ofthe profits of that business arise in or are derived fromHong Kong.(o) The place where the taxpayer’s profits arise is notnecessarily the place where he carries on business.However, in HK-TVBI Lord Jauncey said, “it can only bein rare cases that a taxpayer with a principal place ofbusiness in Hong Kong can earn profits which are notchargeable to profits tax.”9The above summary only serves to outline the important principles and doesnot mean to be exhaustive. It goes without saying that the peculiar facts of acase may call for special consideration.The following paragraphs set out the Department’s views on how the sourceof profits is to be determined with respect to various forms of businessactivities.TRADING PROFITS18. In CIR v. Magna Industrial Co Ltd [1997] HKLRD 171 at 178,Litton VP recognised that in case of a trading profit the purchase and the salewere the important factors. He further included in his deliberation all of therelevant operations and not just the purchase and sale of the products. Whenapplying the operations test, Litton VP said at 176G:“In other words, one looks to see what the taxpayer has done toearn the profits and where he has done it. Obviously the questionwhere the goods were bought and sold is important. But there areother questions: For example: How were the goods procured andstored? How were the sales solicited? How were the ordersprocessed? How were the goods shipped? How was the financingarranged? How was payment effected?”19. The obtaining of the buyer’s order in Hong Kong and the placing ofthe order with the seller from Hong Kong are the foundations of a tradingtransaction since the differential between the selling price and the buying price(i.e. the mark-up) generates the profit. In Exxon Chemical International SupplySA v. CIR 3 HKTC 57, having decided that the obtaining of the order from thebuyer and the placing of the order with the seller, took place respectively in andfrom Hong Kong, Godfrey J concluded that the profit arose in or was derivedfrom Hong Kong.20. In CIR v. Euro Tech (Far East) Limited 4 HKTC 30, Barnett Jdoubted that there should be some particular level or threshold of activity onthe part of the taxpayer in Hong Kong, such as by bringing the products intoHong Kong and re-exporting them. He observed that in many trading10companies the taxpayer was doing no more than bringing together thecomplementary needs of sellers and buyers. He said if the bringing togetherwas done in Hong Kong the trading profit was sourced in Hong Kong.21. When Lord Bridge said in Hang Seng Bank that profits from buyingand reselling of commodities were derived from the place where “the contractsof purchase and sale were effected”, he could not merely mean legally executed(as this would depend on formal legal rules of offer and acceptance). TheDepartment agrees with the approach in Magna and will contemplate all therelevant operations carried out to earn the profits, including the solicitation oforders, negotiation, conclusion, trade financing, shipment and performance ofthe contracts.22. The Department does not merely look at the place of contract todetermine the geographical source of profits. Where the contract is made byexchange of letters, by fax, or by e-mail, the application of contract law and ofprivate international law as to where the contract is made may result inconclusions that are entirely fortuitous. In Firestone Tyre and Rubber Co Ltdv. Lewellin [1957] 1 WLR 464 (HL) at 471, Lord Radcliffe said such anapproach under the conditions of international business and modern facilities ofcommunication was capable of proving a somewhat ingenuous one. Hunter Jshared the same view in Sinolink Overseas Ltd v. CIR 2 HKTC 126 at 131.23. On the basis of the various court judgments discussed in paragraphs18 to 22 above, the Department’s views which are reflected in its assessingpractice on the locality of profits derived from trading in commodities or goodsby a business carried on in Hong Kong can be summarised as follows:(a) Where both the contract of purchase and contract of sale areeffected in Hong Kong, the profits are fully taxable.(b) Where both the contract of purchase and contract of sale areeffected outside Hong Kong, no part of the profits are taxable.(c) Where either the contract of purchase or contract of sale iseffected in Hong Kong, the initial presumption will be thatthe profits are fully taxable. Matters, such as those mentioned11in paragraph 18 above, will be examined to determine theissue.(d) Where the sale is made to a Hong Kong customer (includingthe Hong Kong buying office of an overseas customer), thesale contract will usually be taken as having been effected inHong Kong.(e) Where the commodities or goods are purchased from either aHong Kong supplier or manufacturer, the purchase contractwill usually be taken as having been effected in Hong Kong.(f) Where the effecting of the purchase and sale contracts doesnot require travel outside Hong Kong but is carried out inHong Kong by telephone, fax, etc., the contracts will beconsidered as having been effected in Hong Kong.(g) The purchase and sale contracts are important factors but allthe relevant operations that produce the trading profits mustbe looked at to determine the locality of the profits.Persons who are merely trading with Hong Kong by either selling goods tocustomers in Hong Kong or buying goods from suppliers in Hong Kong willnot fall within the ambit of this paragraph. Nor will this paragraph applies to abuying office referred to in paragraph 29 below.24. Having regard to the points expressed above, it will be apparent that,in the Department’s view, the question of apportionment does not arise inrelation to trading profits. Trading profits will be either wholly taxable orwholly non-taxable. There is no room to substitute a mixed source for a HongKong source even though there might be some overseas activities.25. Cases may arise where it is claimed that contracts of purchase and ofsale have been effected wholly outside Hong Kong by employees of the HongKong business travelling abroad or by overseas agents. In this context, nooperations are carried out in Hong Kong to give effect to the tradingtransaction; and the employee or overseas agent habitually exercises a generalauthority to negotiate and conclude contracts on behalf of his principal.1226. Normally the activities of an agent and an employee are accorded thesame weight if it can be shown that the employee has full authority to concludecontracts without reference to the business in Hong Kong. In consideringclaims that contracts have been wholly effected outside Hong Kong byemployees, Assessors will, in addition to facts in paragraph 18 above, requiredetails of travelling, hotel and subsistence expenses in respect of eachindividual transaction. Where it is claimed that contracts are effected byoverseas agents, it will be necessary to provide agency agreements or otherevidence to support the claim.RE-INVOICING CENTRE27. The Department’s view is that if a profit is derived from servicesrendered in Hong Kong, the profit is clearly taxable. Commission income orprofit that accrues to a “re-invoicing centre” for services rendered is chargeableto profits tax. Profits derived from the buying and selling of goods are notservice income. The transaction involves the taking of commercial risks (e.g.product risks, inventory risks, credit risks, exchange risks, capital risks, etc.)different from those attached to a service. Confirmation of sales and issue ofpurchase orders are indications that it is a trading transaction. The source oftrading profits depends on the locality of the trading operations. Paragraphs 18to 26 are relevant.28. It is not possible to categorise the circumstances under which incomeor profit derived by a “re-invoicing centre” would be regarded as a serviceincome and not as a trading profit. In each case, the Department wouldexamine the nature of the operations and the type of risks in question todetermine whether they constitute the provision of services or trading. Thelabel “re-invoicing centre” clearly does not in itself provide the answer as it canmean different business structures.Example 1Company A, incorporated in Hong Kong, is a re-invoicing centre ofa group of companies with a holding company incorporated in theUnited States, as more particularly described below. It manages inHong Kong all foreign currency exposures from intra-company13trade, guarantees the exchange rates for future orders and managesintra-affiliate cash flows, including lead and lags of payments.Manufacturing affiliates in Mainland China sell goods to CompanyA, which in turns resells to the distribution affiliates in NorthAmerica and Europe. Company A resells at cost plus a mark-up forits services. The mark-up covers the cost of the re-invoicing centreand a reasonable return on the services provided.The profits accrue to Company A are service income derived fromHong Kong. The mark-up earned by Company A, which acts as are-invoicing centre, is chargeable to profits tax.BUYING OFFICE29. A trading company, carrying on business outside Hong Kong, mayset up a branch in Hong Kong to act as a buying office for the purpose ofpurchasing goods or merchandise or of collecting information. The activitiesof the branch are confined to the purchase of goods or merchandise or ofcollecting information in Hong Kong and it is not involved in their sale, eitherin Hong Kong or elsewhere. In such a situation, a liability to Hong Kongprofits tax would not arise. The functions of a buying office may also becarried out by a subsidiary company or by an agent (either related orunrelated). However, as for a branch, the subsidiary company or agent mustnot be involved in the sale of the goods. On the other hand, any commission orother remuneration earned by the subsidiary company or agent for performingits services in Hong Kong will be fully taxable.MANUFACTURING PROFITS30. Lord Jauncey in HK-TVBI at 410F has commented on the source ofmanufacturing profits. He explained:“If a manufacturer in Hong Kong sells his goods to a merchant inManila the payment which he receives is no doubt sourced in Manilabut his profit on the transaction arises in and is derived from hismanufacturing operation in Hong Kong.”14Where goods are manufactured in Hong Kong, the profits arising from the saleof such goods will be fully taxable because the profit making activities areconsidered to be the manufacturing operations carried out in Hong Kong,which should include the procurement of raw materials, the employment oflabour, the design of products and the use of machinery and plant, etc.31. The following examples illustrate the Department’s views on thissubject:Example 2Company B manufactures goods in Hong Kong and sells them tooverseas customers. The fact that Company B has sales staff basedoverseas does not give a part of the profits an overseas source.This is not a case for apportionment. The whole of the profits areliable to profits tax.Example 3Company C manufactures in Mainland China and sells the finishedgoods through a retailing branch in Hong Kong. The retailingbranch has sales staff and a fixed place of business, and hasregistered for business in Hong Kong.Company C is both a manufacturer and a retailer. Profits are derivedfrom the manufacturing operations in Mainland China and theretailing operations in Hong Kong. It is necessary to apportion theprofits derived by Company C. Profits attributable to the HongKong retailing branch are chargeable to profits tax.32. In Mainland China, two types of processing trade normally involveHong Kong companies: contract processing and import processing. They aretwo different forms of transaction and require an accurate legal analysis.15CONTRACT PROCESSING33. In contract processing, the document that governs the contractualrelationship among the parties is the processing agreement. It sets out therights and responsibilities of the Hong Kong company and the Mainlandprocessing enterprise. The Hong Kong company is responsible for the supplyof raw materials and machinery without consideration and to provide technicaland managerial know-how while the Mainland processing enterprise isresponsible for the provision of factory premises, utilities and labour force.34. In return for the processing service, the Hong Kong company pays asubcontracting charge to the Mainland enterprise. The legal title to the rawmaterials and finished goods remains with the Hong Kong company. In theDepartment’s view, the Hong Kong company’s operations in Mainland Chinacomplement its operations in Hong Kong. Recognising the operations of theHong Kong company in the Mainland, an apportionment of profits on a 50:50basis is usually accepted.35. In D132/99 15 IRBRD 25, the taxpayer contended that all of itsprofits were offshore in nature. The Board of Review held that its operationsin Mainland China were not dominant operations that overshadowed theactivities in Hong Kong and the operations in Hong Kong could not bedisregarded.36. In D145/99 15 IRBRD 91, the Board found that the taxpayer was notprivy to the processing agreements, which had been entered into by its fellowsubsidiaries and the taxpayer should be assessed for profits tax on 100% of itsprofits for the years of assessment after the processing agreement lapsed. TheBoard found that the taxpayer’s business was the procurement of toys to satisfysale and purchase contracts and that important operations took place insideHong Kong: the reaching of purchase agreements; the determination of price;the issue of invoices; the procurement of raw materials and the shipment offinished products.37. If the Hong Kong company has restricted involvement in theprocessing arrangement with the Mainland enterprise, the apportionment ofprofits could not be appropriate. For example, a Hong Kong company hascontracted out the assembly work to various contractors in Hong Kong and the16Mainland. The jobs are numerous, small in value and of short duration and theHong Kong company has minimal involvement in the assembly work. Giventhat the Hong Kong company does not carry out any manufacturing operationsoutside Hong Kong, its profits should be fully chargeable to profits tax withoutany apportionment.38. The apportionment contemplated in paragraph 34 above will alsoapply to cases where manufacturing activities are undertaken under a similararrangement in other places.IMPORT PROCESSING39. In import processing, the manufacturing operations are carried out bya foreign investment enterprise (FIE) related to the Hong Kong company. AnFIE is often a separate legal entity incorporated in the Mainland. The HongKong company sells raw materials to the FIE and buys back the finished goodsfrom the FIE. The Hong Kong company engages in the trading of rawmaterials and finished goods whilst the FIE manufactures the finished goods.The legal title to the raw materials and the finished goods passes to/from theFIE.40. In import processing, the gross profits arise from trading transactionswhereby the Hong Kong company purchases finished goods from an FIE andsells them for a profit. The manufacturing operations of the FIE in theMainland are not performed on behalf of, or for the account of, the Hong Kongcompany even though the Hong Kong company and the Mainland enterprisemight be within the same group of companies.41. In ING Baring, Lord Millet NPJ said that the source of profits had tobe attributed to the operations of the taxpayer which produced them and not tothe operations of other members of the group. In D36/06 21 IRBRD 694which was a typical import processing case, the Board held that the taxpayer’sprofits were fully chargeable to profits tax. It was ruled that the FIE was notpart of the taxpayer and was not an agent of the taxpayer. Hence the FIE’soperations were not relevant in determining the source of profits of thetaxpayer. The Board of Review rejected the contention of “substance over17form” and disagreed with the suggestion that a leasing agreement of productionfacilities was similar to a contract processing agreement.42. The Department holds the view that profits which accrued to theHong Kong company from “trading transactions” carried out in Hong Kongcannot be attributed to the manufacturing operations of the FIE carrying onbusiness in Mainland China. The source of the trading profits must beattributed to the operations of the Hong Kong company which produced them.In Consco Trading Co. Ltd v. CIR [2004] 2 HKLRD 818, To Deputy J said thatit was correct to consider factors such as the finance arrangements, the paymentof raw materials and processing fees, the arrangement for receipt of paymentfrom purchasers for the finished product and pre-contract negotiations and theBoard was entitled to conclude that, on the evidence, the preponderance of theactivities which earned the profits were performed in Hong Kong. The Courtof First Instance said the Board correctly excluded the processing activity ofthe Mainland Chinese entity as not being relevant to the determining of thetaxpayer’s source of profits which were derived through the sale of processedgoods.43. In CIR v. Datatronic Limited [2009] 4 HKLRD 675, where thearrangement between Datatronic and the FIE was an import processingarrangement, the Court of Appeal held that the profit-producing transactionswere the purchase of goods from the FIE by Datatronic and subsequent saleand that these activities took place in Hong Kong. Thus, the profits werederived from Hong Kong. The Court of Appeal further held that the fact thatthe FIE, although a wholly-owned subsidiary of Datatronic, is a separate legalentity and that its dealings with Datatronic were not at arm’s length would notdetract from the reality of the legal effect of the transactions. It is also worth tonote the Court of Appeal’s concurrence with the Board’s findings that themanufacturing was done by the FIE in the Mainland is substance and not formand that Datatronic’s activities (i.e. assisting the FIE in preparing the goods andsupplying them to Datatronic) in the Mainland were merely antecedent orincidental to the profit-generating activities.44. The Department has noticed that a Hong Kong company issometimes interposed between an overseas company and a Mainlandmanufacturing enterprise in order to comply with or circumvent the tradebarriers imposed by the overseas jurisdiction. In D7/08 23 IRBRD 102, the18Board of Review recognised that making the Hong Kong company a customerof the overseas company and of the Mainland enterprise freed the overseascompany from the trade barriers. Applying what the Court of Final Appealheld in the Kim Eng case on the effective cause of the production of the profitsin question, it was held that the Hong Kong company’s relevant activity inHong Kong however limited was what was done to earn the profits in questionand the Hong Kong company did it in Hong Kong.OTHER PROFITS45. Subject to specific provisions, the Department regards the locality ofthe following types of profits to be as follows:Income or Profits Locality(a) Rental income from realproperty.Location of the property.(b) Profits derived by an ownerfrom the sale of real estate.Location of the property.(c) Profits from the purchase andsale of listed shares and otherlisted securities.Location of the stockexchange where the shares orsecurities in question aretraded.Where the purchase and saletook place over-the-counter,the place where the contractsof purchase and sale areeffected.(d) Profits from the purchase andsale of unlisted shares andother unlisted securities.Place where the contracts ofpurchase and sale are effected,except financial institutions ininstances where section15(1)(l) applies.19(e) Service fee income. Place where the services areperformed which give rise tothe fees.It should be noted that in thecase of an investment adviserwhose organisation andoperations are located only inHong Kong, profits derivedin respect of the managementof the clients’ funds areconsidered to have a HongKong source. Included inchargeable sums are not onlymanagement fees andperformance fees but alsorebates, commissions anddiscounts received by theadviser from brokers locatedin Hong Kong or elsewherein respect of securitiestransactions executed onbehalf of clients.(f) Interest earned by personsother than financialinstitutions.Determined on the basis setout in DIPN No. 13 (“Profitstax - Taxation of InterestReceived”).(g) Royalties other than thosedeemed chargeable undersection 15 (1) (a), (b) or (ba).Place of acquisition andgranting of the licence orright of use.20(h) Cross-border landtransportation income.Normally the place of uplift ofthe passengers or goods.However, where the contractof carriage does notdistinguish between outwardand inward transportation,apportionment will not bepermitted.Article 8 of theComprehensive DoubleTaxation Arrangement withthe Mainland is relevant. Seerelevant paragraphs in DIPNNo. 44 (“Arrangementbetween the Mainland ofChina and the Hong KongSpecial Administrative Regionfor the Avoidance of DoubleTaxation and the Preventionof Fiscal Evasion with respectto Taxes on Income”).APPORTIONMENT OF PROFITS46. The Department accepts that, notwithstanding the absence of aspecific provision for apportionment of profits in the Inland RevenueOrdinance, there are certain situations in which an apportionment of thechargeable profits is appropriate. The example of manufacturing profits hasalready been explained above. A further example is service fee income wherethe services are performed partly in Hong Kong and partly outside. On theother hand, as has been mentioned in paragraph 24 above, the Department doesnot find an apportionment of trading profits is required.47. In contract processing cases, a 50:50 basis of apportionment isapplied as the norm, in view of the contractual conditions imposed on theparties to the arrangement. For other cases where apportionment is21appropriate, the basis applied will depend on the facts of the case; theDepartment will consider any rational basis put forward by the taxpayerconcerned. In calculating the portion of the profits derived from Hong Kong, itwill be necessary to scale down claims for general expenses of the businesswhich contribute indirectly to earning both the Hong Kong and offshore profitsfrom the transactions in question. General expenses in this context refer to allindirect expenses. In the tax computation, the taxpayer should explain clearlythe basis upon which such expenses have been scaled down. In most cases, itwill be appropriate to apportion by reference to gross profits rather than toassets. Requests to re-open previous years assessments to permitapportionment will not be entertained (section 70A - prevailing practice).Below examples explain why there should not be an apportionment of profits.Example 4Company D purchases goods from suppliers in Hong Kong. It paysa marketing company in Hong Kong to arrange the placement ofadvertisements in newspapers and magazines, which are circulatedin London and Paris. On receiving orders, Company D ships thegoods to the overseas customers and collects payment though creditcard companies.Although the goods are advertised overseas, this does not alter thefact that everything that Company D itself does is done in HongKong. The profits derived by Company D should be fullychargeable and no apportionment is required.Example 5Company E is a manufacturer in Hong Kong. It manufactures goodsin Hong Kong and sells them to the overseas customers. Every year,Company E and the customers sign master sale agreements outsideHong Kong.The master sale agreements are not determinant for the purpose ofdetermining the source of trading profits. They might be importantfor business purpose for they settle many particulars of the terms oftrade, yet they do not constitute the manufacturing or selling22operations of Company E. The taking of orders by Company E, themanufacture of the goods and the appropriation of the stock inresponse to the orders, and the shipment of the goods are the relevantoperations that generate the profits of Company E. The profitsaccrued to Company E should not be apportioned.SALE OR PURCHASE COMMISSION48. This refers to situations where commission income is earned both bysecuring buyers for a manufacturer’s products and by securing manufacturersto make products required by customers. Typically the commission income isa percentage of the invoiced value of the goods. In such cases the Departmentconsiders that the activity which gives rise to the commission income is thearrangement of the business to be transacted between principals. The sourceof the income is the place where the activities of the commission agent areperformed.49. The place where the principals are located, how they are identifiedby the commission agent and the place where incidental activities areperformed prior to or subsequent to the earning of the commission are notgenerally relevant. However, if substantial business activities are performed inHong Kong for and on behalf of a principal incorporated overseas, in particularin a no or low tax jurisdiction, the Department will examine the case morethoroughly to determine whether the principal has any profits tax liability undersection 14.50. Commission income may also arise where a business is carried on inHong Kong but the activities which give rise to the commission are not inHong Kong. In such cases, the commission is not taxable. Typical of thesesituations are the following examples -Example 6 - Sales or purchase agenciesCompany F holds the “Far East Area” sales or purchaseresponsibility for a product or group of products sold into the areaor sourced in the area by principals who are associated concerns.Company F and the associates are members of a group under the23control of a common parent organisation. Company F is appointedagent for the area, either by formally executed agreements or by adirective from the parent organisation and is remunerated by a“commission” on all sales and/or purchases in its area. Company Fmay either -(a) actively solicit orders ex-Hong Kong, on behalf of itsprincipals by sending employee representatives overseas forthe purpose or by employing sub-agents overseas; or(b) factually do nothing whatsoever, either itself or through subagents.Example 7 - Passive commissionA similar organisational set-up to the agencies in Example 6 above,but in this case Company G is given sales or purchase responsibilityfor group products in the “Far East Area” as a principal.Factually, Company G is unable to handle all or any of the grouprange of products and sales into or purchases from the area aretherefore entirely made by associated concerns. It is never intendedthat Company G will perform any purchasing or sales function.Company G receives an “infringement commission” for which itdoes nothing (except possibly the rendering of some “sales service”ex-Hong Kong).Alternatively, it may be the case that Company G sells or buys groupproducts in Hong Kong (profits thereon may, in accordance with theprinciples stated under the heading of Trading Profits, subject toHong Kong profits tax) and in addition receives “commissions” onsales or purchases by associated concerns in the “Far East Area”.These commissions are paid in pursuance of a parent organisationdirective. Company G has no formal function or contractualposition in relation to the associates’ transactions in the “Far EastArea”, i.e. it has no “area responsibility” either as principal, agentor sales representative and renders no service in respect of thecommission it receives.24GROUP SERVICE COMPANIES51. This refers to cases where a Hong Kong company, usually a memberof a multinational group, renders support services, such as marketing andtraining, to group members located throughout the Asia-Pacific region. Theservices are rendered substantially in Hong Kong. Inter-group charges aremade at an agreed mark-up of cost (typically 5% to 10%) and represent anarm’s length reward for the services provided plus a recoupment of 100% ofthe costs incurred by the Hong Kong company.52. The profits, being the mark-up, derived by the Hong Kong companyfor its services are regarded by the Department as wholly assessable. However,in some cases the inter-group charges have been grossed up to reflect theimposition of a withholding tax on the service charges by the country in whichthe group entity receiving the services is resident. In these cases theDepartment will allow the Hong Kong company to deduct, from the service feecharged, the foreign withholding tax paid. The effect is to assess the HongKong company on the net (of withholding tax) service fee received. Thisreflects the principle set out in DIPN No. 28 (“Profits Tax - Deductibility ofForeign Taxes”) concerning the deductibility of foreign taxes that are chargedon earnings, regardless of whether or not a profit is made.FINANCIAL INSTITUTIONS53. In 1986 the Department reached agreement with practitioners andtheir financial institution clients on the taxation treatment of certain interest andrelated fee income. This recognised the practical difficulties associated withdetermining the assessable profits of such institutions and provided them withadded certainty in their taxation affairs. The agreement reduced the largenumber of disputes which had arisen following the 1978 amendment to section15(1)(i) of the Inland Revenue Ordinance.54. Following the decisions in the Hang Seng Bank and OrionCaribbean, questions arose about certain aspects of this practice. However, inthe interest of maintaining certainty the Department is prepared to continuewith this agreed treatment, details of which are set out below.25Types of Income Tax Treatment1. Interest from loans(a) Offshore loans initiated, negotiated,approved and documented by anassociated party outside Hong Kong andfunded outside Hong Kong, i.e. fundsraised and loaned direct to the borrowerby a non-resident, e.g. head office,branch, or subsidiary, etc. albeit throughor in the name of the Hong Konginstitution.100% Non taxable(b) Offshore loans initiated, etc. by theHong Kong institution and funded by itin/from Hong Kong.100% Taxable(c) Offshore loans initiated, etc. by anassociated party outside Hong Kong butfunded by the Hong Kong institution.50% Taxable(d) Offshore loans initiated, etc. by a HongKong institution but funded by offshoreassociates. It is considered that thiscategory only applies to start-uppositions where the Hong Konginstitution has yet to establish a marketpresence.50% TaxableNote on ‘Funding’For claims concerning loans funded byoffshore associates, two essentialrequirements will have to be satisfied,namely -26(i) that the Hong Kong institutiondoes not have the authority to seekits own source of funds in respectof the loans; and(ii) there must be documentaryevidence to show that funds havebeen directly provided by anoffshore associate even thoughsuch funds may have been routedthrough another vehicle in HongKong. In other words, arbitraryfunding by another group vehiclein Hong Kong will not satisfy thisrequirement.Note on ‘Initiation’‘Initiation’ refers to the efforts exertedin obtaining the particular businessincluding solicitation, negotiation andstructuring of the loans. The financialinstitution must be able to substantiatethat the mandate or invitation toparticipate was secured as a direct resultof the activities of an associated partyoutside Hong Kong for an offshoreclaim to succeed.2. Interest on Certificates of Deposit (CDs)Acquisition of CDs will be treated in asimilar fashion to deposit placements. Thistreatment is predicated on the fact that theHong Kong institution operates withinpreviously approved parameters as to creditlimits and prime banks with whom it mayoperate. In other words, there is an obvious100% Taxable27distinction to be drawn between CDs andloans.3. Interest from securities other than CDsA similar approach to be adopted as forinterest from loans. If there is to be anyattribution of interest to offshoreintervention, the role of the Hong Konginstitution must be that of a mereintermediary in the purchase and sale ofsecurities with no discretion in the matter. Itis unlikely that any claim for exemption willbe entertained in instances where the HongKong institution possesses its own securitydealing capability and is active in thiscapacity.See (1) above4. Participation, Commitment, etc. feesTo follow the tax treatment accorded torelated loans.See (1) above5. Active feeTo be determined by reference to the‘Activity Test’, i.e. services performed toearn the fee.Depends on theparticular factsof the case6. Guarantee/underwriting feesA principal consideration of source is relatedto whether or not the risk under theguarantee or underwriting commitment isevaluated and is to be borne by the HongKong institution. In instances where theHong Kong institution has no discretion onthe acceptance or rejection of offshoreDepends on theparticular factsof the case28instructions, and undertakes no risk, suchfees will be accepted as merely ‘booked’ andnot assessable.PROCESSING OF OFFSHORE CLAIMS55. Not all the operations of a taxpayer are relevant in determining thesource of a profit. The process of identification of the source of profits maydiffer depending on the nature of transaction in question and the context inwhich the transaction takes place. In Kim Eng Securities (Hong Kong) Ltd v.CIR [2007] 2 HKLRD 117 at 143C, Bokhary PJ said :“I am unable to accept the Taxpayer’s argument that the Taxpayer’spresence and activities in Hong Kong go only to the existence andoperation of a Hong Kong business. If the Taxpayer disputed theexistence and operation of a Hong Kong business - which it does not- then its presence and activities in Hong Kong would probably beconclusive against it on such an issue. Of course the Taxpayer’spresence and activities in Hong Kong are far from conclusiveagainst it on the question of source. But that does not render suchpresence and activities wholly irrelevant to that question.”56. Taxpayers should be ready to prove in their returns, with supportingdocumentary evidence, that a profit from a transaction was derived outsideHong Kong. The Assessor has a statutory obligation to raise assessment and tomake enquiry. In this process, the Assessor has been given power undersection 51(4) to seek for full information in regard to any matter which mayaffect any liability, responsibility or obligation of any person. A request fordetailed information about the “operations” of a transaction in an enquirywould constitute a reasonable demand as the public interests so require. It hasto be emphasised that the information seeking power entrusted to the Assessorunder section 51(4) has not been restricted or reduced in any way after INGBaring. In most cases, the reasons why the Assessor asks for a piece ofinformation should be apparent.2957. The Department holds the view that the final step of the profitgenerating process should not necessarily be considered as determinative of thelocality of the source of profits. In the High Court of Australia, in COT v.Hillsdon Watts Ltd 57 CLR 36, Latham CJ said that income received by aperson might be the result of a whole series of operations conducted indifferent countries. In COT v. Kirk [1900] AC 588, when delivering thejudgment of the Privy Council, Lord Davey said that the fallacy of the lowercourts was to leave out of sight the initial stages and fastening their attentionexclusively on the final stage in the production of the income.AGENCY58. In ING Baring, when discussing the business of stockbrokers, LordMillet NPJ said that it was not necessary to establish that the transaction whichproduced the profit was carried out by the taxpayer or his agent in the full legalsense. It was sufficient if it was carried out on his behalf and for his account bya person acting on his instructions.59. The Department is of the view that the act of any person carried outoverseas should not be readily attributed to a taxpayer in Hong Kong. In INGBaring, Lord Millet NPJ referred to the provision of service and the earning ofa commission by completing share transactions in an overseas market. Indeed,Lord Millet NPJ agreed with Barma J and firmly rejected the proposition that“commercial reality” dictated that the source of the profits of one member of agroup of companies could be ascribed to the activities of another.BOOKED PROFITS60. As previously indicated, the existence of a business carried on inHong Kong in not decisive of a source of profits subject to profits tax.However, it will “only be in rare cases that a taxpayer with a principal place ofbusiness in Hong Kong can earn profits which are not chargeable to profits taxunder s. 14” (see HK-TVBI). The performance in Hong Kong of activitieswhich do not of themselves give rise to the profits, such as the rental of officepremises, recruitment of general staff, etc., also do not, in themselves,determine the locality of profits. Where, however, commissions, fees, profits30on sales, etc., relate to sales to, or services rendered to, Hong Kong customers,the resultant profits will generally continue to be liable to profits tax. TheDepartment takes a serious view of schemes and devices which seek to “book”Hong Kong profits offshore. It will not hesitate to apply the general antiavoidanceprovisions in such instances and, where appropriate, imposepenalties in blatant cases involving the non-disclosure of relevant facts. Theopportunity is taken to remind taxpayers and their authorised representatives ofthe need to accurately complete the return concerning transactions for or withnon-residents.ADVANCE RULINGS61. To provide certainty in this area, the Department has been providingadvance rulings on the locality of profits to businesses. This service is subjectto the payment of a fee. Further details are contained in DIPN No. 31(“Advance Rulings”).CONCLUSION62. It is considered that an update of the DIPN, particularly as regardstrading profits, might be helpful. It is hoped that this revised DIPN will furtherreduce the possibility of and the areas of dispute between taxpayers and theDepartment. It should be reiterated that the examples outlined in this DIPNrepresent simple, and straightforward situations and should be viewedaccordingly. As stated at the outset, each case needs to be considered in thelight of its own particular circumstances and facts. There is no simple legal testthat can be employed in all cases.