Inland Revenue Department

The Government of the Hong Kong Special Administrative Region

of the People's Republic of China

DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

NO. 21 (REVISED)

LOCALITY OF PROFITS

These notes are issued for the information of taxpayers and their tax
representatives. They contain the Department’s interpretation and practices in
relation to the law as it stood at the date of publication. Taxpayers are
reminded that their right of objection against the assessment and their right of
appeal to the Commissioner, the Board of Review or the Court are not affected
by the application of these notes.

These notes replace those issued in December 2009.

CHU Yam-yuen
Commissioner of Inland Revenue

July 2012

Our web site : www.ird.gov.hk

 DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

No. 21 (REVISED)

CONTENT

Paragraph

Introduction 1

Basic tests for liability to Profits Tax 3

Source concept 4

The broad guiding principle 6

Antecedent or incidental activities 14

Principles on which locality of profits is determined 17

Trading profits 18

Re-invoicing centre 27

Buying office 29

Manufacturing profits 30

Contract processing 33

Import processing 39

Other profits 45

Apportionment of profits 46

Sale or purchase commission 48

Group service companies 51

Financial institutions 53

Processing of offshore claims 55

Agency 58

Booked profits 60

Advance Rulings 61

Conclusion 62

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INTRODUCTION

The territorial concept has always been fundamental to the taxation

of profits in Hong Kong. Only those profits which arise in or are derived from
Hong Kong are liable to tax here. However, where the territorial concept is
clear, its application in particular cases at times remains a contentious issue
between the Department and practitioners with numerous disputes being
referred to the Board of Review and the Courts. The decisions of the Privy
Council in CIR v. Hang Seng Bank Limited [1991] 1 AC 306, HK-TVB
International Limited v. CIR [1992] 2 AC 397 and CIR v. Orion Caribbean
Limited [1997] HKLRD 924 and of the Court of Final Appeal in Kwong Mile
Services Limited v. CIR [2004] 3 HKLRD 168, Kim Eng Securities (Hong
Kong) Limited v. CIR [2007] 2 HKLRD 117 and ING Baring Securities (Hong
Kong) Limited v. CIR [2008] 1 HKLRD 412, established guidelines to assist in
locating the source of profits. The broad guiding principle is that “one looks to
see what the taxpayer has done to earn the profits in question and where he has
done 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 where
the locality of profits in issue, rather they clarify the general principles to be
followed in determining the locality of profits. The purpose of this note is to
state what the Department considers are the general principles laid down by the
Privy Council and the Court of Final Appeal and then give specific examples
applying those principles. At the same time, it must be emphasised that each
case will be determined on its own facts. As commented on in Orion
Caribbean, Hang Seng Bank did not, when speaking of “profits earned ‘by the
exploitation of property assets by letting property, lending money or dealing in
commodities or securities’ lay down a rule of law. Rather, the case affirmed
that “no simple legal test can be employed”.

BASIC TESTS FOR LIABILITY TO PROFITS TAX

3. Section 14 of the Inland Revenue Ordinance (“the Ordinance”)

makes it clear that only profits arising in or derived from Hong Kong are
chargeable to profits tax. The residence of a taxpayer is not relevant. In Hang
Seng Bank, Lord Bridge explained the three conditions that must be satisfied
before a profits tax liability arises:

(a) The person must carry on a trade, profession or business in

Hong Kong;

(b) The profits to be charged must be from such trade, profession

or business carried on by the person in Hong Kong; and

(c) The profits must be profits arising in or derived from Hong

Kong.

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 Practice
Note.

SOURCE CONCEPT

4. Though the word “source” is not used in section 14, it has always
been accepted by the courts that the words “arising in or derived from” raised
the concept of source. Cases from other common law jurisdictions with
legislation using the specific word “source” are therefore relevant and have
been used in assisting the interpretation of the words used in section 14. In
CIR v. Philips Gloeilampenfabrieken [1955] NZLR 868, Barrowclough CJ at
874 said that the concept of derivation seems necessarily to imply the concept
of a source.

5. “Source” is not a legal concept. In Nathan v. FCT [1918] 25 CLR

183 at 189-190, Isaacs J explained:

“The Legislature in using the word ‘source’ meant, not a legal

concept, but something which a practical man would regard as a
real source of income. Legal concepts must, of course, enter into the
question when we have to consider to whom a given source belongs.
But the ascertainment of the actual source of a given income is a
practical, hard matter of fact.”

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THE BROAD GUIDING PRINCIPLE

6. Lord Bridge in Hang Seng Bank has the following to say at 319A
about the distinction of profits arising in or derived from Hong Kong and those
that are not:

“… a distinction must fall to be made between profits arising in or

derived from Hong Kong (“Hong Kong profits”) and profits arising
in or derived from a place outside Hong Kong (“offshore profits”)
according to the nature of the different transactions by which the
profits are generated.”

7. Lord Bridge explained the “broad guiding principle” in Hang Seng

Bank at 322H to 323A in the following terms:

“But the question whether the gross profit resulting from a

particular transaction arose in or derived from one place or another
is always in the last analysis a question of fact depending on the
nature of the transaction. It is impossible to lay down precise rules
of law by which the answer to that question is to be determined. The
broad guiding principle, attested by many authorities, is that one
looks to see what the taxpayer has done to earn the profit in
question.”

8. The “operations test” was further elaborated by Lord Jauncey in HK-

TVBI at 407C-D:

“F. L. Smidth & Co. v. Greenwood [1921] 3 K.B. 583 was cited in
Hang Seng Bank case and their Lordships do not doubt that Lord
Bridge has in mind the judgment of Atkin L. J. in that case and in
particular the passage when he said, at p. 593: “I think that the
question is, where do the operations take place from which the
profits in substance arise?”

Thus Lord Bridge’s guiding principle could properly be expanded to

read “one looks to see what the taxpayer has done to earn the profit
in question and where he has done it.”

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9. Lord Bridge exemplified his dicta in paragraph 7 above at 323A-B
as follows:

“If he has rendered a service or engaged in an activity such as the

manufacture of goods, the profit will have arisen or derived from the
place where the service was rendered or the profit making activity
carried on. But if the profit was earned by the exploitation of
property assets as by letting property, lending money or dealing in
commodities or securities by buying and selling at a profit, the profit
will have arisen in or derived from the place where the property was
let, the money was lent or the contracts of purchase and sale were
effected.”

10. The examples cited by Lord Bridge in Hang Seng Bank are not
meant to be exhaustive and a careful analysis of the relevant facts need to be
carried out in deciding whether a particular case falls within the examples.
Lord Jauncey in HK-TVBI has warned against such an approach in the
following terms at 409D-E:

“Their Lordships consider that it is a mistake to try and find an

analogy between the facts in this appeal and the example given by
Lord Bridge in the Hang Seng Bank case. The circumstances in that
case involving, as they did, buying and selling in well defined
foreign markets were very different from those in the present and the
examples were never intended to be exhaustive of all situations in
which section 14 of the Ordinance might have to be considered. The
proper approach is to ascertain what were the operations which
produced the relevant profits and where those operations took
place.”

11. The broad guiding principle has been followed in subsequent cases
before the Court of Final Appeal. In Kwong Mile, Bokhary PJ summarised the
broad guiding principle at 174I to175E:

“The ascertainment of the source of a profit is not hindered by

technical rules, but is helped by the broad guiding principle that one
looks to see what the taxpayer has done to earn the profit and where
he has done it. ……. In CIR v. Orion Caribbean Ltd [1997] HKLRD

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 924, Lord Nolan emphasised (at p.931F) that “[n]o simple, single,
legal test can be employed” when ascertaining the source of a
profit. …... The situations in which the source of a profit has to be
ascertained are too many and varied for a universal judge-made
test. Apart from the words of the statute themselves, the only
constant is the need to grasp the reality of each case, focusing on
effective causes without being distracted by antecedent or incidental
matters.”

12. While the question of source of profits is a practical, hard matter of

fact, the broad guiding principle formulated in the judicial precedents has
enabled the proper and consistent application of the source concept to various
factual situations. The broad guiding principle is not a set of rules. A rule
attaches a definite, detailed consequence to a detailed set of facts. It either
applies to a given situation, or it does not so apply; there is no latitude in its
application. A principle, relative to a rule, is broad, general and unspecific.
The broad guiding principle is an authoritative starting point for assessing and
reassessing, inclining towards a particular decision but not necessarily
compelling it.

13. The broad guiding principle is not exhausted by any catalogue of

factual circumstances. It does not expire when no judicial decision clearly
covers the present case because the value of the principle relies on the relevant
operations which produce the profits. It improves certainty even if a taxpayer
finds that some of the details of his specific case are different. He would know
how to apply the profits tax charging provisions as he would understand the
underlying principle. By elucidating the broad guiding principle underlying
the taxation of profits, conceptual clarity and a more coherent regime can be
achieved.

ANTECEDENT OR INCIDENTAL ACTIVITIES

14. In ING Baring at 428, Ribeiro PJ when discussing the legal principle
also emphasised the need to grasp the reality of each case, focusing on effective
causes without being distracted by antecedent or incidental matters. The focus
is on establishing the geographical location of the taxpayer’s profit-producing

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transactions as distinct from activities antecedent or incidental to those
transactions.

15. Whether an act is an antecedent or incidental activity is a question of

fact and would depend on the nature of the transaction. In CIR v. The Hong
Kong & Whampoa Dock Co Ltd [1960] 1 HKTC 85, the initial business contact
in Hong Kong which set in motion a chain of operations that ultimately led to
the salvaging of the vessel was rejected as the relevant operation.

16. Comments in a similar vein can be found in Hang Seng Bank at

320F-G:

“The activities of the bank from which the income arose was the
buying and selling of this property in overseas market places and
not the decision making process in Hong Kong or any other
activities in Hong Kong. Likewise the income arose from the
trading in property situate outside of Hong Kong and not the
moneys of customers situate in Hong Kong.”

PRINCIPLES ON WHICH LOCALITY OF PROFITS IS DETERMINED

17. Assuming the first two conditions stated in paragraph 3 above are
satisfied, liability to profits tax will only arise if a person’s profits arise in or
are derived from Hong Kong. The Department’s view is that the basic
principles for determining the locality of profits enunciated in the decisions of
Hang Seng Bank, HK-TVBI, Orion Caribbean, Kwong Mile, Kim Eng and ING
Baring can be summarised as follows:

(a) The question of locality of profits is a hard, practical

matter of fact. No universal judge-made test will cover
every case. Whether profits arise in or are derived from
Hong Kong depends on the nature of the profits and the
transactions giving rise to them.

(b) The ascertainment of the source of profits though a

practical, hard matter of fact requires an accurate legal
analysis of the transaction.

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(c) The transactions must be looked at separately and the
profits of each transaction considered on their own.

(d) The broad guiding principle is that one looks to see what
the taxpayer has done to earn the profits in question and
where he has done it. In other words, the proper approach
is to ascertain what were the operations which produced
the relevant profits and where those operations took place.

(e) The operations in question must be the operations of the

taxpayer.

(f) The relevant operations do not comprise the whole of the

taxpayer’s activities carried out in the course of his
business but only those which produce the profit in
question. It is necessary to appreciate the reality of each
case, focusing on effective causes for earning the profits
without being distracted by antecedent or incidental
matters.

(g) The distinction between Hong Kong profits and offshore

profits is made by reference to gross profits arising from
individual transactions.

(h) In certain situations, where gross profits from an

individual transaction arise in different places, they can be
apportioned as arising partly in and partly outside Hong
Kong.

(i) The place where day to day investment decisions are taken
does not generally determine the locality of profits.

(j) It is necessary to examine the operations of the taxpayer

irrespective of the fact that the taxpayer may be a
company within a group. The source of profits must be
attributed to the operations of the taxpayer which produce
them and not to the operations of other members of the
group. The operations of the group should not be looked

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 at on the question of source. However, in appropriate
cases, if a related company is in fact acting on behalf of
the taxpayer, then the activities of the related company
will be considered to see if appropriate weight should be
accorded thereto.

(k) If an arrangement or scheme is implemented in Hong

Kong to free transactions from overseas regulations or
overcome trade barriers, this in itself does not mean that
the 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 to
situations where one party represents or acts for another,
should not be taken to an inappropriate degree or taken too
literally since this is not conducive to arriving at the
accurate legal analysis.

(m) In brokerage business, it is not necessary that the

transaction which produced the profit was carried out by
the taxpayer or his agent in the full legal sense (i.e. one
who enters into a contract on his principal’s behalf
creating a contractual relationship between his principal
and a third party). It is sufficient that the transaction was
carried out on the taxpayer’s behalf and for his account by
a person acting on his instructions.

(n) The absence of an overseas permanent establishment of a

Hong Kong business does not, of itself, mean that all of
the profits of that business arise in or are derived from
Hong Kong.

(o) The place where the taxpayer’s profits arise is not

necessarily the place where he carries on business.
However, in HK-TVBI Lord Jauncey said, “it can only be
in rare cases that a taxpayer with a principal place of
business in Hong Kong can earn profits which are not
chargeable to profits tax.”

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The above summary only serves to outline the important principles and does
not mean to be exhaustive. It goes without saying that the peculiar facts of a
case may call for special consideration.

The following paragraphs set out the Department’s views on how the source
of profits is to be determined with respect to various forms of business
activities.

TRADING PROFITS

18. 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 sale
were the important factors. He further included in his deliberation all of the
relevant operations and not just the purchase and sale of the products. When
applying the operations test, Litton VP said at 176G:

“In other words, one looks to see what the taxpayer has done to
earn the profits and where he has done it. Obviously the question
where the goods were bought and sold is important. But there are
other questions: For example: How were the goods procured and
stored? How were the sales solicited? How were the orders
processed? How were the goods shipped? How was the financing
arranged? How was payment effected?”

19. The obtaining of the buyer’s order in Hong Kong and the placing of
the order with the seller from Hong Kong are the foundations of a trading
transaction since the differential between the selling price and the buying price
(i.e. the mark-up) generates the profit. In Exxon Chemical International Supply
SA v. CIR 3 HKTC 57, having decided that the obtaining of the order from the
buyer and the placing of the order with the seller, took place respectively in and
from Hong Kong, Godfrey J concluded that the profit arose in or was derived
from Hong Kong.

20. In CIR v. Euro Tech (Far East) Limited 4 HKTC 30, Barnett J
doubted that there should be some particular level or threshold of activity on
the part of the taxpayer in Hong Kong, such as by bringing the products into
Hong Kong and re-exporting them. He observed that in many trading

9
companies the taxpayer was doing no more than bringing together the
complementary needs of sellers and buyers. He said if the bringing together
was done in Hong Kong the trading profit was sourced in Hong Kong.

21. When Lord Bridge said in Hang Seng Bank that profits from buying
and reselling of commodities were derived from the place where “the contracts
of purchase and sale were effected”, he could not merely mean legally executed
(as this would depend on formal legal rules of offer and acceptance). The
Department agrees with the approach in Magna and will contemplate all the
relevant operations carried out to earn the profits, including the solicitation of
orders, negotiation, conclusion, trade financing, shipment and performance of
the contracts.

22. The Department does not merely look at the place of contract to
determine the geographical source of profits. Where the contract is made by
exchange of letters, by fax, or by e-mail, the application of contract law and of
private international law as to where the contract is made may result in
conclusions that are entirely fortuitous. In Firestone Tyre and Rubber Co Ltd
v. Lewellin [1957] 1 WLR 464 (HL) at 471, Lord Radcliffe said such an
approach under the conditions of international business and modern facilities of
communication was capable of proving a somewhat ingenuous one. Hunter J
shared 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 paragraphs

18 to 22 above, the Department’s views which are reflected in its assessing
practice on the locality of profits derived from trading in commodities or goods
by a business carried on in Hong Kong can be summarised as follows:

(a) Where both the contract of purchase and contract of sale are
effected in Hong Kong, the profits are fully taxable.

(b) Where both the contract of purchase and contract of sale are
effected outside Hong Kong, no part of the profits are taxable.

(c) Where either the contract of purchase or contract of sale is

effected in Hong Kong, the initial presumption will be that
the profits are fully taxable. Matters, such as those

10
 mentioned in paragraph 18 above, will be examined to
determine the issue.

(d) Where the sale is made to a Hong Kong customer (including

the Hong Kong buying office of an overseas customer), the
sale contract will usually be taken as having been effected in
Hong Kong.

(e) Where the commodities or goods are purchased from either a

Hong Kong supplier or manufacturer, the purchase contract
will usually be taken as having been effected in Hong Kong.

(f) Where the effecting of the purchase and sale contracts does
not require travel outside Hong Kong but is carried out in
Hong Kong by telephone, fax, etc., the contracts will be
considered as having been effected in Hong Kong.

(g) The purchase and sale contracts are important factors but all
the relevant operations that produce the trading profits must
be looked at to determine the locality of the profits.

Persons who are merely trading with Hong Kong by either selling goods to
customers in Hong Kong or buying goods from suppliers in Hong Kong will
not fall within the ambit of this paragraph. Nor will this paragraph applies to a
buying 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 in
relation to trading profits. Trading profits will be either wholly taxable or
wholly non-taxable. There is no room to substitute a mixed source for a Hong
Kong source even though there might be some overseas activities.

25. Cases may arise where it is claimed that contracts of purchase and of
sale have been effected wholly outside Hong Kong by employees of the Hong
Kong business travelling abroad or by overseas agents. In this context, no
operations are carried out in Hong Kong to give effect to the trading
transaction; and the employee or overseas agent habitually exercises a general
authority to negotiate and conclude contracts on behalf of his principal.

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26. Normally the activities of an agent and an employee are accorded the
same weight if it can be shown that the employee has full authority to conclude
contracts without reference to the business in Hong Kong. In considering
claims that contracts have been wholly effected outside Hong Kong by
employees, Assessors will, in addition to facts in paragraph 18 above, require
details of travelling, hotel and subsistence expenses in respect of each
individual transaction. Where it is claimed that contracts are effected by
overseas agents, it will be necessary to provide agency agreements or other
evidence to support the claim.

RE-INVOICING CENTRE

27. The Department’s view is that if a profit is derived from services

rendered in Hong Kong, the profit is clearly taxable. Commission income or
profit that accrues to a “re-invoicing centre” for services rendered is chargeable
to profits tax. Profits derived from the buying and selling of goods are not
service 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 of
purchase orders are indications that it is a trading transaction. The source of
trading profits depends on the locality of the trading operations. Paragraphs 18
to 26 are relevant.

28. It is not possible to categorise the circumstances under which income

or profit derived by a “re-invoicing centre” would be regarded as a service
income and not as a trading profit. In each case, the Department would
examine the nature of the operations and the type of risks in question to
determine whether they constitute the provision of services or trading. The
label “re-invoicing centre” clearly does not in itself provide the answer as it can
mean different business structures.

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 Example 1

Company A, incorporated in Hong Kong, is a re-invoicing centre of

a group of companies with a holding company incorporated in the
United States, as more particularly described below. It manages in
Hong Kong all foreign currency exposures from intra-company
trade, guarantees the exchange rates for future orders and manages
intra-affiliate cash flows, including lead and lags of payments.
Manufacturing affiliates in Mainland China sell goods to Company
A, which in turns resells to the distribution affiliates in North
America and Europe. Company A resells at cost plus a mark-up for
its services. The mark-up covers the cost of the re-invoicing centre
and a reasonable return on the services provided.

The profits accrue to Company A are service income derived from

Hong Kong. The mark-up earned by Company A, which acts as a
re-invoicing centre, is chargeable to profits tax.

BUYING OFFICE

29. A trading company, carrying on business outside Hong Kong, may

set up a branch in Hong Kong to act as a buying office for the purpose of
purchasing goods or merchandise or of collecting information. The activities
of the branch are confined to the purchase of goods or merchandise or of
collecting information in Hong Kong and it is not involved in their sale, either
in Hong Kong or elsewhere. In such a situation, a liability to Hong Kong
profits tax would not arise. The functions of a buying office may also be
carried out by a subsidiary company or by an agent (either related or
unrelated). However, as for a branch, the subsidiary company or agent must
not be involved in the sale of the goods. On the other hand, any commission or
other remuneration earned by the subsidiary company or agent for performing
its services in Hong Kong will be fully taxable.

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MANUFACTURING PROFITS

30. Lord Jauncey in HK-TVBI at 410F has commented on the source of

manufacturing profits. He explained:

“If a manufacturer in Hong Kong sells his goods to a merchant in

Manila the payment which he receives is no doubt sourced in Manila
but his profit on the transaction arises in and is derived from his
manufacturing operation in Hong Kong.”

Where goods are manufactured in Hong Kong, the profits arising from the sale
of such goods will be fully taxable because the profit making activities are
considered to be the manufacturing operations carried out in Hong Kong,
which should include the procurement of raw materials, the employment of
labour, the design of products and the use of machinery and plant, etc.

31. The following examples illustrate the Department’s views on this

subject:

Example 2

Company B manufactures goods in Hong Kong and sells them to

overseas customers. The fact that Company B has sales staff based
overseas does not give a part of the profits an overseas source.

This is not a case for apportionment. The whole of the profits are
liable to profits tax.

Example 3

Company C manufactures in Mainland China and sells the finished

goods through a retailing branch in Hong Kong. The retailing
branch has sales staff and a fixed place of business, and has
registered for business in Hong Kong.

Company C is both a manufacturer and a retailer. Profits are derived

from the manufacturing operations in Mainland China and the
retailing operations in Hong Kong. It is necessary to apportion the

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 profits derived by Company C. Profits attributable to the Hong
Kong retailing branch are chargeable to profits tax.

32. In Mainland China, two types of processing trade normally involve

Hong Kong companies: contract processing and import processing. They are
two different forms of transaction and require an accurate legal analysis.

CONTRACT PROCESSING

33. In contract processing, the document that governs the contractual

relationship among the parties is the processing agreement. It sets out the
rights and responsibilities of the Hong Kong company and the Mainland
processing enterprise. The Hong Kong company is responsible for the supply
of raw materials and machinery without consideration and to provide technical
and managerial know-how while the Mainland processing enterprise is
responsible for the provision of factory premises, utilities and labour force.

34. In return for the processing service, the Hong Kong company pays a
subcontracting charge to the Mainland enterprise. The legal title to the raw
materials and finished goods remains with the Hong Kong company. In the
Department’s view, the Hong Kong company’s operations in Mainland China
complement its operations in Hong Kong. Recognising the operations of the
Hong Kong company in the Mainland, an apportionment of profits on a 50:50
basis is usually accepted.

35. In D132/99 15 IRBRD 25, the taxpayer contended that all of its
profits were offshore in nature. The Board of Review held that its operations
in Mainland China were not dominant operations that overshadowed the
activities in Hong Kong and the operations in Hong Kong could not be
disregarded.

36. In D145/99 15 IRBRD 91, the Board found that the taxpayer was not
privy to the processing agreements, which had been entered into by its fellow
subsidiaries and the taxpayer should be assessed for profits tax on 100% of its
profits for the years of assessment after the processing agreement lapsed. The
Board found that the taxpayer’s business was the procurement of toys to satisfy
sale and purchase contracts and that important operations took place inside

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Hong Kong: the reaching of purchase agreements; the determination of price;
the issue of invoices; the procurement of raw materials and the shipment of
finished products.

37. If the Hong Kong company has restricted involvement in the

processing arrangement with the Mainland enterprise, the apportionment of
profits could not be appropriate. For example, a Hong Kong company has
contracted out the assembly work to various contractors in Hong Kong and the
Mainland. The jobs are numerous, small in value and of short duration and the
Hong Kong company has minimal involvement in the assembly work. Given
that the Hong Kong company does not carry out any manufacturing operations
outside Hong Kong, its profits should be fully chargeable to profits tax without
any apportionment.

38. The apportionment contemplated in paragraph 34 above will also

apply to cases where manufacturing activities are undertaken under a similar
arrangement in other places.

IMPORT PROCESSING

39. In import processing, the manufacturing operations are carried out by

a foreign investment enterprise (FIE) related to the Hong Kong company. An
FIE is often a separate legal entity incorporated in the Mainland. The Hong
Kong company sells raw materials to the FIE and buys back the finished goods
from the FIE. The Hong Kong company engages in the trading of raw
materials and finished goods whilst the FIE manufactures the finished goods.
The legal title to the raw materials and the finished goods passes to/from the
FIE.

40. In import processing, the gross profits arise from trading transactions
whereby the Hong Kong company purchases finished goods from an FIE and
sells them for a profit. The manufacturing operations of the FIE in the
Mainland are not performed on behalf of, or for the account of, the Hong Kong
company even though the Hong Kong company and the Mainland enterprise
might be within the same group of companies.

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41. In ING Baring, Lord Millet NPJ said that the source of profits had to
be attributed to the operations of the taxpayer which produced them and not to
the operations of other members of the group. In D36/06 21 IRBRD 694
which was a typical import processing case, the Board held that the taxpayer’s
profits were fully chargeable to profits tax. It was ruled that the FIE was not
part of the taxpayer and was not an agent of the taxpayer. Hence the FIE’s
operations were not relevant in determining the source of profits of the
taxpayer. The Board of Review rejected the contention of “substance over
form” and disagreed with the suggestion that a leasing agreement of production
facilities was similar to a contract processing agreement.

42. The Department holds the view that profits which accrued to the
Hong Kong company from “trading transactions” carried out in Hong Kong
cannot be attributed to the manufacturing operations of the FIE carrying on
business in Mainland China. The source of the trading profits must be
attributed 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 that
it was correct to consider factors such as the finance arrangements, the payment
of raw materials and processing fees, the arrangement for receipt of payment
from purchasers for the finished product and pre-contract negotiations and the
Board was entitled to conclude that, on the evidence, the preponderance of the
activities which earned the profits were performed in Hong Kong. The Court
of First Instance said the Board correctly excluded the processing activity of
the Mainland Chinese entity as not being relevant to the determining of the
taxpayer’s source of profits which were derived through the sale of processed
goods.

43. In CIR v. Datatronic Limited [2009] 4 HKLRD 675, where the

arrangement between Datatronic and the FIE was an import processing
arrangement, the Court of Appeal held that the profit-producing transactions
were the purchase of goods from the FIE by Datatronic and subsequent sale
and that these activities took place in Hong Kong. Thus, the profits were
derived from Hong Kong. The Court of Appeal further held that the fact that
the FIE, although a wholly-owned subsidiary of Datatronic, is a separate legal
entity and that its dealings with Datatronic were not at arm’s length would not
detract from the reality of the legal effect of the transactions. It is also worth to
note the Court of Appeal’s concurrence with the Board’s findings that the
manufacturing was done by the FIE in the Mainland is substance and not form
and that Datatronic’s activities (i.e. assisting the FIE in preparing the goods and

17
supplying them to Datatronic) in the Mainland were merely antecedent or
incidental to the profit-generating activities.

44. The Department has noticed that a Hong Kong company is

sometimes interposed between an overseas company and a Mainland
manufacturing enterprise in order to comply with or circumvent the trade
barriers imposed by the overseas jurisdiction. In D7/08 23 IRBRD 102, the
Board of Review recognised that making the Hong Kong company a customer
of the overseas company and of the Mainland enterprise freed the overseas
company from the trade barriers. Applying what the Court of Final Appeal
held in the Kim Eng case on the effective cause of the production of the profits
in question, it was held that the Hong Kong company’s relevant activity in
Hong Kong however limited was what was done to earn the profits in question
and the Hong Kong company did it in Hong Kong.

OTHER PROFITS

45. Subject to specific provisions, the Department regards the locality of

the following types of profits to be as follows:

Income or Profits Locality

(a) Rental income from real Location of the property.

property.

(b) Profits derived by an owner Location of the property.

from the sale of real estate.

(c) Profits from the purchase and Location of the stock

sale of listed shares and other exchange where the shares or
listed securities. securities in question are
traded.

Where the purchase and sale

took place over-the-counter,
the place where the contracts
of purchase and sale are
effected.

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(d) Profits from the purchase and Place where the contracts of
sale of unlisted shares and purchase and sale are effected,
other unlisted securities. except financial institutions in
instances where section
15(1)(l) applies.

(e) Service fee income. Place where the services are

performed which give rise to
the fees.

It should be noted that in the

case of an investment adviser
whose organisation and
operations are located only in
Hong Kong, profits derived
in respect of the management
of the clients’ funds are
considered to have a Hong
Kong source. Included in
chargeable sums are not only
management fees and
performance fees but also
rebates, commissions and
discounts received by the
adviser from brokers located
in Hong Kong or elsewhere
in respect of securities
transactions executed on
behalf of clients.

(f) Interest earned by persons Determined on the basis set

other than financial out in DIPN No. 13 (“Profits
institutions. tax - Taxation of Interest
Received”).

(g) Royalties other than those Place of acquisition and

deemed chargeable under granting of the licence or
section 15 (1) (a), (b) or (ba). right of use. Please refer to
Departmental Interpretation &
Practice Notes No. 49, Part B.

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 (h) Cross-border land Normally the place of uplift of
transportation income. the passengers or goods.
However, where the contract
of carriage does not
distinguish between outward
and inward transportation,
apportionment will not be
permitted.

Article 8 of the
Comprehensive Double
Taxation Arrangement with
the Mainland is relevant. See
relevant paragraphs in DIPN
No. 44 (“Arrangement
between the Mainland of
China and the Hong Kong
Special Administrative Region
for the Avoidance of Double
Taxation and the Prevention
of Fiscal Evasion with respect
to Taxes on Income”).

APPORTIONMENT OF PROFITS

46. The Department accepts that, notwithstanding the absence of a

specific provision for apportionment of profits in the Inland Revenue
Ordinance, there are certain situations in which an apportionment of the
chargeable profits is appropriate. The example of manufacturing profits has
already been explained above. A further example is service fee income where
the services are performed partly in Hong Kong and partly outside. On the
other hand, as has been mentioned in paragraph 24 above, the Department does
not find an apportionment of trading profits is required.

47. In contract processing cases, a 50:50 basis of apportionment is

applied as the norm, in view of the contractual conditions imposed on the
parties to the arrangement. For other cases where apportionment is

20
appropriate, the basis applied will depend on the facts of the case; the
Department will consider any rational basis put forward by the taxpayer
concerned. In calculating the portion of the profits derived from Hong Kong, it
will be necessary to scale down claims for general expenses of the business
which contribute indirectly to earning both the Hong Kong and offshore profits
from the transactions in question. General expenses in this context refer to all
indirect expenses. In the tax computation, the taxpayer should explain clearly
the basis upon which such expenses have been scaled down. In most cases, it
will be appropriate to apportion by reference to gross profits rather than to
assets. Requests to re-open previous years assessments to permit
apportionment will not be entertained (section 70A - prevailing practice).
Below examples explain why there should not be an apportionment of profits.

Example 4

Company D purchases goods from suppliers in Hong Kong. It pays

a marketing company in Hong Kong to arrange the placement of
advertisements in newspapers and magazines, which are circulated
in London and Paris. On receiving orders, Company D ships the
goods to the overseas customers and collects payment though credit
card companies.

Although the goods are advertised overseas, this does not alter the
fact that everything that Company D itself does is done in Hong
Kong. The profits derived by Company D should be fully
chargeable and no apportionment is required.

Example 5

Company E is a manufacturer in Hong Kong. It manufactures goods

in Hong Kong and sells them to the overseas customers. Every year,
Company E and the customers sign master sale agreements outside
Hong Kong.

The master sale agreements are not determinant for the purpose of
determining the source of trading profits. They might be important
for business purpose for they settle many particulars of the terms of
trade, yet they do not constitute the manufacturing or selling

21
 operations of Company E. The taking of orders by Company E, the
manufacture of the goods and the appropriation of the stock in
response to the orders, and the shipment of the goods are the relevant
operations that generate the profits of Company E. The profits
accrued to Company E should not be apportioned.

SALE OR PURCHASE COMMISSION

48. This refers to situations where commission income is earned both by

securing buyers for a manufacturer’s products and by securing manufacturers
to make products required by customers. Typically the commission income is
a percentage of the invoiced value of the goods. In such cases the Department
considers that the activity which gives rise to the commission income is the
arrangement of the business to be transacted between principals. The source
of the income is the place where the activities of the commission agent are
performed.

49. The place where the principals are located, how they are identified
by the commission agent and the place where incidental activities are
performed prior to or subsequent to the earning of the commission are not
generally relevant. However, if substantial business activities are performed in
Hong Kong for and on behalf of a principal incorporated overseas, in particular
in a no or low tax jurisdiction, the Department will examine the case more
thoroughly to determine whether the principal has any profits tax liability under
section 14.

50. Commission income may also arise where a business is carried on in

Hong Kong but the activities which give rise to the commission are not in
Hong Kong. In such cases, the commission is not taxable. Typical of these
situations are the following examples -

Example 6 - Sales or purchase agencies

Company F holds the “Far East Area” sales or purchase

responsibility for a product or group of products sold into the area
or sourced in the area by principals who are associated concerns.
Company F and the associates are members of a group under the

22
control of a common parent organisation. Company F is appointed
agent for the area, either by formally executed agreements or by a
directive from the parent organisation and is remunerated by a
“commission” on all sales and/or purchases in its area. Company F
may either -

(a) actively solicit orders ex-Hong Kong, on behalf of its

principals by sending employee representatives overseas for
the purpose or by employing sub-agents overseas; or

(b) factually do nothing whatsoever, either itself or through sub-

agents.

Example 7 - Passive commission

A similar organisational set-up to the agencies in Example 6 above,

but in this case Company G is given sales or purchase responsibility
for group products in the “Far East Area” as a principal.
Factually, Company G is unable to handle all or any of the group
range of products and sales into or purchases from the area are
therefore entirely made by associated concerns. It is never intended
that Company G will perform any purchasing or sales function.
Company G receives an “infringement commission” for which it
does nothing (except possibly the rendering of some “sales service”
ex-Hong Kong).

Alternatively, it may be the case that Company G sells or buys group

products in Hong Kong (profits thereon may, in accordance with the
principles stated under the heading of Trading Profits, subject to
Hong Kong profits tax) and in addition receives “commissions” on
sales or purchases by associated concerns in the “Far East Area”.
These commissions are paid in pursuance of a parent organisation
directive. Company G has no formal function or contractual
position in relation to the associates’ transactions in the “Far East
Area”, i.e. it has no “area responsibility” either as principal, agent
or sales representative and renders no service in respect of the
commission it receives.

23
GROUP SERVICE COMPANIES

51. This refers to cases where a Hong Kong company, usually a member
of a multinational group, renders support services, such as marketing and
training, to group members located throughout the Asia-Pacific region. The
services are rendered substantially in Hong Kong. Inter-group charges are
made at an agreed mark-up of cost (typically 5% to 10%) and represent an
arm’s length reward for the services provided plus a recoupment of 100% of
the costs incurred by the Hong Kong company.

52. The profits, being the mark-up, derived by the Hong Kong company
for its services are regarded by the Department as wholly assessable. However,
in some cases the inter-group charges have been grossed up to reflect the
imposition of a withholding tax on the service charges by the country in which
the group entity receiving the services is resident. In these cases the
Department will allow the Hong Kong company to deduct, from the service fee
charged, the foreign withholding tax paid. The effect is to assess the Hong
Kong company on the net (of withholding tax) service fee received. This
reflects the principle set out in DIPN No. 28 (“Profits Tax - Deductibility of
Foreign Taxes”) concerning the deductibility of foreign taxes that are charged
on earnings, regardless of whether or not a profit is made.

FINANCIAL INSTITUTIONS

53. In 1986 the Department reached agreement with practitioners and

their financial institution clients on the taxation treatment of certain interest and
related fee income. This recognised the practical difficulties associated with
determining the assessable profits of such institutions and provided them with
added certainty in their taxation affairs. The agreement reduced the large
number of disputes which had arisen following the 1978 amendment to section
15(1)(i) of the Inland Revenue Ordinance.

54. Following the decisions in the Hang Seng Bank and Orion
Caribbean, questions arose about certain aspects of this practice. However, in
the interest of maintaining certainty the Department is prepared to continue
with this agreed treatment, details of which are set out below.

24
Types of Income Tax Treatment

1. Interest from loans

(a) Offshore loans initiated, negotiated, 100% Non taxable

approved and documented by an
associated party outside Hong Kong and
funded outside Hong Kong, i.e. funds
raised and loaned direct to the borrower
by a non-resident, e.g. head office,
branch, or subsidiary, etc. albeit through
or in the name of the Hong Kong
institution.

(b) Offshore loans initiated, etc. by the 100% Taxable

Hong Kong institution and funded by it
in/from Hong Kong.

(c) Offshore loans initiated, etc. by an 50% Taxable

associated party outside Hong Kong but
funded by the Hong Kong institution.

(d) Offshore loans initiated, etc. by a Hong 50% Taxable

Kong institution but funded by offshore
associates. It is considered that this
category only applies to start-up
positions where the Hong Kong
institution has yet to establish a market
presence.

Note on ‘Funding’

For claims concerning loans funded by

offshore associates, two essential
requirements will have to be satisfied,
namely -

25
 (i) that the Hong Kong institution does
not have the authority to seek its own
source of funds in respect of the loans;
and

(ii) there must be documentary evidence to

show that funds have been directly
provided by an offshore associate even
though such funds may have been
routed through another vehicle in
Hong Kong. In other words, arbitrary
funding by another group vehicle in
Hong Kong will not satisfy this
requirement.

Note on ‘Initiation’

‘Initiation’ refers to the efforts exerted in

obtaining the particular business including
solicitation, negotiation and structuring of
the loans. The financial institution must be
able to substantiate that the mandate or
invitation to participate was secured as a
direct result of the activities of an associated
party outside Hong Kong for an offshore
claim to succeed.

2. Interest on Certificates of Deposit (CDs)

Acquisition of CDs will be treated in a 100% Taxable

similar fashion to deposit placements. This
treatment is predicated on the fact that the
Hong Kong institution operates within
previously approved parameters as to credit
limits and prime banks with whom it may
operate. In other words, there is an obvious
distinction to be drawn between CDs and
loans.

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3. Interest from securities other than CDs

A similar approach to be adopted as for See (1) above

interest from loans. If there is to be any
attribution of interest to offshore
intervention, the role of the Hong Kong
institution must be that of a mere
intermediary in the purchase and sale of
securities with no discretion in the matter. It
is unlikely that any claim for exemption will
be entertained in instances where the Hong
Kong institution possesses its own security
dealing capability and is active in this
capacity.

4. Participation, Commitment, etc. fees

To follow the tax treatment accorded to See (1) above

related loans.

5. Active fee

To be determined by reference to the Depends on the

‘Activity Test’, i.e. services performed to particular facts
earn the fee. of the case

6. Guarantee/underwriting fees

A principal consideration of source is related Depends on the

to whether or not the risk under the particular facts
guarantee or underwriting commitment is of the case
evaluated and is to be borne by the Hong
Kong institution. In instances where the
Hong Kong institution has no discretion on
the acceptance or rejection of offshore
instructions, and undertakes no risk, such
fees will be accepted as merely ‘booked’ and
not assessable.

27
PROCESSING OF OFFSHORE CLAIMS

55. Not all the operations of a taxpayer are relevant in determining the
source of a profit. The process of identification of the source of profits may
differ depending on the nature of transaction in question and the context in
which 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’s

presence and activities in Hong Kong go only to the existence and
operation of a Hong Kong business. If the Taxpayer disputed the
existence and operation of a Hong Kong business - which it does not
- then its presence and activities in Hong Kong would probably be
conclusive against it on such an issue. Of course the Taxpayer’s
presence and activities in Hong Kong are far from conclusive
against it on the question of source. But that does not render such
presence and activities wholly irrelevant to that question.”

56. Taxpayers should be ready to prove in their returns, with supporting

documentary evidence, that a profit from a transaction was derived outside
Hong Kong. The Assessor has a statutory obligation to raise assessment and to
make enquiry. In this process, the Assessor has been given power under
section 51(4) to seek for full information in regard to any matter which may
affect any liability, responsibility or obligation of any person. A request for
detailed information about the “operations” of a transaction in an enquiry
would constitute a reasonable demand as the public interests so require. It has
to be emphasised that the information seeking power entrusted to the Assessor
under section 51(4) has not been restricted or reduced in any way after ING
Baring. In most cases, the reasons why the Assessor asks for a piece of
information should be apparent.

57. The Department holds the view that the final step of the profit
generating process should not necessarily be considered as determinative of the
locality 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 a
person might be the result of a whole series of operations conducted in
different countries. In COT v. Kirk [1900] AC 588, when delivering the
judgment of the Privy Council, Lord Davey said that the fallacy of the lower

28
courts was to leave out of sight the initial stages and fastening their attention
exclusively on the final stage in the production of the income.

AGENCY

58. In ING Baring, when discussing the business of stockbrokers, Lord

Millet NPJ said that it was not necessary to establish that the transaction which
produced the profit was carried out by the taxpayer or his agent in the full legal
sense. It was sufficient if it was carried out on his behalf and for his account by
a person acting on his instructions.

59. The Department is of the view that the act of any person carried out
overseas should not be readily attributed to a taxpayer in Hong Kong. In ING
Baring, Lord Millet NPJ referred to the provision of service and the earning of
a 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 a
group of companies could be ascribed to the activities of another.

BOOKED PROFITS

60. As previously indicated, the existence of a business carried on in

Hong 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 of
business in Hong Kong can earn profits which are not chargeable to profits tax
under s. 14” (see HK-TVBI). The performance in Hong Kong of activities
which do not of themselves give rise to the profits, such as the rental of office
premises, recruitment of general staff, etc., also do not, in themselves,
determine the locality of profits. Where, however, commissions, fees, profits
on 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. The
Department takes a serious view of schemes and devices which seek to “book”
Hong Kong profits offshore. It will not hesitate to apply the general anti-
avoidance provisions in such instances and, where appropriate, impose
penalties in blatant cases involving the non-disclosure of relevant facts. The
opportunity is taken to remind taxpayers and their authorised representatives of

29
the need to accurately complete the return concerning transactions for or with
non-residents.

ADVANCE RULINGS

61. To provide certainty in this area, the Department has been providing
advance rulings on the locality of profits to businesses. This service is subject
to the payment of a fee. Further details are contained in DIPN No. 31
(“Advance Rulings”).

CONCLUSION

62. It is considered that an update of the DIPN, particularly as regards

trading profits, might be helpful. It is hoped that this revised DIPN will further
reduce the possibility of and the areas of dispute between taxpayers and the
Department. It should be reiterated that the examples outlined in this DIPN
represent simple, and straightforward situations and should be viewed
accordingly. As stated at the outset, each case needs to be considered in the
light of its own particular circumstances and facts. There is no simple legal test
that can be employed in all cases.

30