Hong Kong Tax alert

25 May 2012 2012 Issue No. 7

Li & Fung (Trading) Limited – IRD will not appeal against the appellate court’s decision that sourcing commission is non-taxable offshore profit

The Inland Revenue Department (IRD) has decided not to appeal against the Court of Appeal’s decision in Li & Fung (Trading) Limited (LFT) to the Court of Final Appeal (CFA). The decision by the CA that the sourcing commission earned by LFT is non-taxable offshore profit in Hong Kong is therefore now final.

However, the IRD takes the view that, due to the approach adopted by the IRD at the tax tribunal level, namely the Board of Review (BOR), the courts did not have the opportunity to consider the entire facts of the case. The IRD is apparently of the view that had the courts been given the opportunity to consider the entire facts of the case, their decisions may have been different. Regardless, the IRD considers that the court decisions were based on the facts of the case, and those decisions do not amount a change of law or the overturning of any judicial precedents. As such, the IRD’s view is that the decisions by the courts may not have wide application to other source cases.

The significance of the LFT case is that, in upholding the BOR’s decision, the courts firmly rejected that contractual arrangements or commercial relationships with customers were relevant factors in determining the source of the commission income. Instead, the courts upheld that the relevant rules which determined the source of the income were the place where the underlying sourcing and agency services were performed. Furthermore, the courts also upheld that the underlying services can be performed either by the taxpayer itself, or by its agents, or by someone acting on its instructions. Contrary to what the IRD is apparently prepared to accept, the LFT case indicates that this more liberal approach to attributing the activities of others to a taxpayer in determining the source of commission income under an agency arrangement is of wide application.

Source of profits is nonetheless by its nature a complicated issue and clients should consult their professional tax advisors where appropriate.

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The IRD’s approach at the BOR level

In essence, the IRD’s argument before the BOR focused on what were the legal rules for determining the source of LFT’s commission income. The IRD argued that the business of LFT was that of a “supply chain management” rather than a “commission agent”. As such, the IRD contended that the relevant rules for determining the source of the income were the place where LFT maintained long-term commercial relationships and monitored the performance of the contracts that LFT had with its customers (that location presumably being Hong Kong). Under these source rules, the IRD argued that the activities of the overseas affiliates, being LFT’s subcontractors and not its agents, should be disregarded. This was in contrast to LFT’s argument that, its business being that of a “commission agent”, the relevant rules for determining the source of the income were the place where the underlying sourcing and agency services took place (i.e., outside of Hong Kong performed by each of the overseas affiliates as the agent of LFT).

Based on the facts and evidence of the case, the BOR found that the overseas affiliates acted as LFT’s agents in performing the sourcing and agency services outside of Hong Kong for LFT’s customers. In any case, applying the attribution rule formulated by Lord Millet in the ING Baring case3, the BOR held that regardless of whether the overseas affiliates were agents or subcontractors of LFT, their activities could be attributed to LFT, since the overseas affiliates acted on the instructions of LFT.

Ruling against the IRD, the BOR held that LFT was a commission agent and the relevant source rules for determining LFT’s net commission income were the place where the underlying sourcing and agency services took place (i.e., outside of Hong Kong). Thus, the IRD lost its case at the BOR.

Background facts

LFT acted as a sourcing agent for its overseas customers charging as its commission 6% of the value of goods sourced for the customers from overseas suppliers. Most of the sourcing and agency services were actually performed outside of Hong Kong by the overseas affiliates of LFT on instructions from LFT. LFT paid the overseas affiliates 4% for the services so rendered.

The BOR held that the direct profit-producing transactions generating the commission income were the sourcing and agency services performed outside of Hong Kong by the overseas affiliates and that what LFT did in Hong Kong was merely ancillary or incident activities.

The BOR therefore held that the 2% (i.e., 6% - 4%) net commission earned by LFT was non-taxable offshore income in Hong Kong. The Court of First Instance (CFI) and the Court of Appeal (CA) both upheld the BOR’s decision of the case. Now that the IRD has decided not to appeal against the CA’s decision to the CFA, the CA’s decision is therefore final.1

However, last Friday the IRD indicated on its webpage that, due to the approach adopted by the IRD at the BOR level, the courts did not have the opportunity to consider the entire facts of the case. The IRD is apparently of the view that had the courts been granted the opportunity to consider the entire facts of the case, their decisions may have been different. Regardless, the IRD considers that the court decisions were based on the facts of the case, and those decisions do not amount a change of law or the overturning of any judicial precedents. As such, the IRD’s view is that the decisions by the courts may not have wide application to other source cases.2

For more detailed analysis of the decisions of the CFI and CA, please refer to our Hong Kong Tax alert issued on 29 March 2012. The IRD’s stated views on the decisions of the CFI and CA can be found at http://www.ird.gov.hk/eng/faq/lifung.htm. Paragraph 147 of the decision ING Baring Securities (Hong Kong) Limited v. CIR [2008] 1 HKLRD 412.

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The CA however rejected the IRD’s argument for remitting the case to the BOR, noting that such an apportionment basis was not raised by the IRD at the BOR. As such, the CA saw no basis to remit the matter to the BOR so that the IRD could then advance a new case on apportionment.

As regards the evidence contained in the senior executive’s interview with the Harvard Business Review, the CA noted that this could not advance the IRD’s case as the content of the interview was not agreed nor found to be fact.

The CA then upheld the CFI’s decision, thus dismissing the IRD’s appeal.

Commentary

Under a recent ruling of the CFA, no matter how large the tax involved (more than HK$110 million in this case), any appeal to the CFA cannot be as of right, but can only be granted as a matter of discretion by the CFA. The legal advice obtained by the IRD was therefore that the CA’s decision of the case would be final unless there were issues in dispute that were of great general or public importance, or there were exceptional circumstances which necessitated the exercise of discretion to grant permission to appeal to the CFA. In the light of the legal advice, the IRD has decided not to appeal against the CA’s decision to the CFA.

The IRD however stated its views on the case last Friday on its webpage, playing down the significance of the decisions by the BOR and the courts. On its webpage, the IRD states that the case has established no new tax principles on the source rules. Furthermore, the IRD goes on to note that whether one is acting as an agent of a taxpayer, or on the instructions of a taxpayer (and therefore acting on behalf and for the account of the taxpayer) are factual matters. In this regard, the IRD has cited a contract manufacturing case where the activities of the overseas contract manufacturer, not being an agent of the taxpayer, were held not attributable to the taxpayer in determining the source of the trading profits of the taxpayer. Another case cited by the IRD related to a processing arrangement where despite the taxpayer having appointed agents for certain of its overseas operations, the relevant income was nonetheless held to be taxable onshore profits on account of the taxpayer’s other activities in Hong Kong. The IRD appeared to employ these two cited cases to illustrate that it was only due to the particular facts of the LFT case that the overseas affiliates were held to be agents of LFT, or to act on LFT’s instructions. As such, the IRD may thereby be indicating that the findings in LFT are not necessarily applicable to other source cases.

The IRD subsequently realized that its heavy reliance on the characterization of the business of LFT and its application of the relevant source rules at the BOR was such that the IRD had not gathered or presented evidence showing that some of the sourcing and agency services were arguably performed in Hong Kong by LFT itself (in addition to those performed by its overseas affiliates).

Therefore, before the IRD’s appeal was due to be heard by the CFI, the IRD applied to the CFI to remit the case back to the BOR so that the BOR could further consider and make findings of additional evidence that the IRD now wanted to rely on. The additional evidence which the IRD sought to rely on were comments made by a senior executive of LFT in an interview with the Harvard Business Review. During the interview, among other things, the senior executive referred to how 40 or so people in Hong Kong provided technical support, merchandising, raw material purchasing, quality assurance and shipping services to one of its largest customers. However, the CFI rejected the IRD’s application to remit the case back to the BOR to consider and make such additional findings of fact. Therefore, for the purpose of the appeal, the two parties only agreed that the said interview did occur, but what was reported to have been said by the senior executive in the interview was not agreed nor found to be fact.

After hearing the case, the CFI upheld the BOR’s decision. The CFI noted that there was ample evidence on which the BOR could come to the conclusion that the direct profit-producing transactions which generated LFT’s commission income were sourcing and agency services which LFT carried out through its overseas affiliates.

The decision of the Court of Appeal

At the CA, the IRD did not pursue its argument on the characterization of the business of LFT and its application of the relevant source rules. Instead, the IRD contended that the BOR had failed to consider whether any of the services under LFT’s agency agreements with customers were performed by LFT itself in Hong Kong relative to those performed outside of Hong Kong by the overseas affiliates. The IRD argued that the CA should remit the case to the BOR for the BOR to make such a finding of fact so as to apportion the gross commission of 6% as being partly onshore and partly offshore.

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While it may be true that the case has established no new legal principles on the source rules, the courts, in upholding the BOR’s decision, firmly rejected that contractual arrangements or commercial relationships with customers are relevant factors in determining the source of the commission income. This remains the case, regardless that the underlying services are sub-contracted out to be performed overseas by another person.

In upholding the BOR’s decision, the courts have clearly indicated that the relevant source rules for the commission income were the place where the underlying sourcing and agency services were performed. Furthermore, the courts also upheld that the underlying services can be performed either by the taxpayer itself, or by its agents, or by someone acting on the instructions of the taxpayer.

Contrary to what the IRD is apparently prepared to accept, the decisions of the courts in this case indicate that this liberal approach of attributing the activities of others to a taxpayer for the purpose of determining the source of income of the taxpayer is of wide application as regards agency arrangements. The cases cited by the IRD where the activities of others were not attributable to the taxpayers, or if attributable, were held not relevant to determining the source of the relevant profits, were cases where the facts were very different from arrangements involving an agent earning a commission. Therefore, arguably these cited cases would not undermine the more liberal attribution rule now reaffirmed by the courts in LFT’s case.

Source of profits is nonetheless by its nature a complicated issue and clients should consult their professional tax advisors where appropriate.