2011 unit 2 source

7/30/2019 2011 Unit 2 Source

1/56

1

Unit 2

Locality of Profits

( )

7/30/2019 2011 Unit 2 Source

2/56

2

LEARNING OBJECTIVES

After this lecture, you should be able to:

determine whether profits are attributable to a HK

source

Explain and apply the rules of determining the source

of profitsdetermine the locality of profits and bases of

apportionment according to DIPN 21(REVISED)

apply tax case decisions in determining the source ofprofits

analyse the decisions of case law and highlight the

main issues and principles

7/30/2019 2011 Unit 2 Source

3/56

3

Source/Locality of Profits: Arising in

or derived from HKs.14(1): Subject to the provisions of this Ordinance,

profits tax shall be charged for each year ofassessment at the standard rate on every personcarrying on a trade, profession or business in HongKong in respect of his assessable profit ARISING INOR DERIVED FROM Hong Kong( )

For that yearfrom such trade, profession or business(excluding profits arising from the sale ofcapital asset)as ascertained in accordance with this Part.

7/30/2019 2011 Unit 2 Source

4/56

4

Meaning of arising in or derived

from Hong Kongs.2 of IRO: arising in or derived from HongKong includes all profits from business

transacted in Hong Kong, whether directly orthrough an agent (Therefore, a non-residentwho has no permanent establishment in HKmay still carry on business in HK through anagent).

Per Oxford dictionary, transact meansperform, or carry through (business)

7/30/2019 2011 Unit 2 Source

5/56

5

Nathan v. FCT (1918):

source means not a legal concept, but something that

apractical man would regard a real source of

income ...the ascertainment of the actual source of a

given income is apractical, hard matter of factThe fundamental principle: source of profit is a

question of factthere is no hard & fast rule( )

7/30/2019 2011 Unit 2 Source

6/56

6

CIR v. Lever Brothers and

Unilever Ltd. (1946):the source of receipts is the originating cause

of their being received as income and that this

originating cause is the work which the

taxpayer does to earn them

7/30/2019 2011 Unit 2 Source

7/56

7

Source of profits

Court cases have laid down principles in

determining the source of profit

The source depends on the nature of the income

that can be divided into:Commission

Manufacturing

InvestmentTrading

Non trading / service

7/30/2019 2011 Unit 2 Source

8/56

8

Tests are relevant in determining the

source of certain income

1) contract conclusion test / contract effected

test

2) operations test3) provision of credit test

4) situs (or location) test

However, there is nosimple, single, legal test can beemployed when ascertaining the source of a

profit. To formulate a universal test is impossible.

7/30/2019 2011 Unit 2 Source

9/56

9

Contract conclusion test /

Contract effected testContract conclusion test

The most important and indeed the crucialquestion is where the contracts of sales are made[Maclaine & Co. V. Eccott(1926)]

Normally applicable to trading profits, i.e. profitsfrom buying & selling of goods/merchandise

Contract effected test

A wider scope than contract conclusion testMeans legally executed, negotiation, conclusion

and execution of the contracts

7/30/2019 2011 Unit 2 Source

10/56

10

Operation test ( )

where do the operations take place from which theprofits in substance arise? [Smidth & Co. V.Greenwood(1921)]

3 steps(1) there must be some operationswhat are they?

(2) these operation must have been done insomewherewhere are the places?

(3) some operations must have differentweightings against each otherhowimportant are they?

7/30/2019 2011 Unit 2 Source

11/56

11

Operation test

Normally applicable to non-trading

profits e.g. manufacturing, service

income, etc..The most basic and common approach

adopted by IRD

7/30/2019 2011 Unit 2 Source

12/56

12

Provision of Credit test

where is the place where the credit is

made available to the borrower? [CIR v.

Lever Brothers & Unilever Ltd.; CIR (NZ)v. N.V. Philips Gloeilampenfabrieken]

normally applicable to interest income

from passive transaction

7/30/2019 2011 Unit 2 Source

13/56

13

Departmental Interpretation and Practice

Note No. 21 (REVISED)Locality of

profits

Territorial concept fundamental to HKtaxation system

Profits tax: S.143 conditions

DIPN 21 (revised, Dec 2009) - give generalguidelines of tax treatment for different

types of income15 principles for determining locality of

profits (see below)

7/30/2019 2011 Unit 2 Source

14/56

14

Broad Guiding Principle

DIPN 21 re-affirms the broad guidingprinciples (or the operations test)

Broad, general & unspecific; not a set of

rulesBokhary PJ in Kwong Mile case:

- need to grasp the reality of each case,

focusing on effective causes without beingdistracted by antecedent or incidentalmatters

7/30/2019 2011 Unit 2 Source

15/56

15

Antecedent or incidental matters

Focus on establishing the geographicallocationof the taxpayers profit-producingtransactions

Whether an act is an antecedent or incidentalactivity is a question of fact, depending on thenature of the transaction

No further guidelines on how to determinewhether an act is an antecedent or incidentalactivity

7/30/2019 2011 Unit 2 Source

16/56

16

DIPN 21 Locality of profits

IRD: The 15 basic principles for determining the

locality of profits can be summarised as follows

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

practical matter of fact. No universal rule will coverevery case. Whether profits arise in or are derived

from HK depends on

the nature of the profits and

the transactions giving rise to them.

(2) The ascertainment of the source of profits though

a practical, hard matter of fact requires an accurate

legal analysis of the transaction.

7/30/2019 2011 Unit 2 Source

17/56

17

(3) The transactions must be looked at separately andthe profits of each transaction considered on theirown.

(4) The broad guiding principle is that one looks tosee what the taxpayer has done to earn the profitsin question and where he has done it. In otherwords, the proper approach is to ascertain whatwere the operations which produced the relevantprofits and where those operations took place.

(5) The operations in question must be the operationsof the taxpayer.

DIPN 21

7/30/2019 2011 Unit 2 Source

18/56

18

DIPN 21

(6) The relevant operations do not comprise the whole of thetaxpayers activities carried out in the course of his businessbut only those which produce the profit in question. It isnecessary to appreciate the reality of each case, focusing oneffective causes for earning the profits without being

distracted by antecedent or incidental matters.(7) The distinction between HK profits and offshore profits is

made by reference to gross profits arising from individualtransactions.

(8) In certain situations, where gross profits from an individualtransaction arise in different places, they can be apportionedas arising partly in and partly outside Hong Kong.

(9) The place where day to day investment decisions are takendoes not generally determine the locality of profits.

7/30/2019 2011 Unit 2 Source

19/56

19

DIPN 21(10) It is necessary to examine the operations of the taxpayer

irrespective of the fact that the taxpayer may be a companywithin 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 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.

(11) 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..

7/30/2019 2011 Unit 2 Source

20/56

20

DIPN 21

(l2) Identifying an agents acts with those of its principal, whilstimposing 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.

(13) 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 principals behalf creating a contractual

relationship between his principal and a third party). It issufficient that the transaction was carried out on the taxpayers

behalf and for his account by a person acting on his

instructions.

7/30/2019 2011 Unit 2 Source

21/56

21

DIPN 21

(14) Theabsence of an overseas permanentestablishment of a HK business does not, of itself,

mean that all of the profits of that business arise in or

are derived from HK.

(15) The place where the taxpayers profits arise isnot necessarily the place where he carries on business.

However, inHK-TVBILord 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.

7/30/2019 2011 Unit 2 Source

22/56

22

DIPN 21assessing practice on

Trading Profits7 Assessing Practice:

(1) Where both the contract of purchase and contract ofsale are effected in HK--- fully taxable.

(2) Where both the contract of purchase and contract ofsale are effected outside HK--- non-taxable.

(3) Where either the contract of purchase or contract ofsale is effected in HK, the initial presumption:fully

taxable. Matters, such as those mentioned inMagnas case, will be examined to determine theissue.

7/30/2019 2011 Unit 2 Source

23/56

23


Trading Profits

(4) Where the sale is made to a HK customer,

the sale contract will usually be taken as

having been effected in HK.

(5) Where the commodities or goods are

purchased from either a HK supplier or

manufacturer, the purchase contract will

usually be taken as having been effected in HK.

7/30/2019 2011 Unit 2 Source

24/56

24


Trading Profits

(6) Where the effecting of the purchase & sale contracts

does not require travel outside HKbut is carried

out in HK by telephone, fax etc., the contracts will be

considered as having been effected in HK.(7) The purchase & sale contracts are important factors

but all the relevant operations (i.e. solicitation of

orders, negotiation, conclusion, trade financing,

shipment & performance of the contracts) thatproduce the trade profit must be looked at to

determine the locality of the profits.

7/30/2019 2011 Unit 2 Source

25/56

25

No apportionment for trading profit

Trading profits will be either

wholly taxable or

wholly non-taxable.

7/30/2019 2011 Unit 2 Source

26/56

26

Contracts effected outside HK

Cases may arise where it is claimed that contractsof purchase and of sale have been effected outsideHK by:

employees of the HK business travelling

abroad orfully accredited overseas agents.

In this context, an agent is regarded as fullyaccredited if:

it has, and habitually exercises, a generalauthority ( ) to negotiate and concludecontracts on behalf of his principal.

7/30/2019 2011 Unit 2 Source

27/56

27

Contracts effected outside HK continues

Normally the activities of

a fully accredited agent and

an employeeare accorded the same weight if it can be

shown that the employee has full authority to

conclude contracts without reference to the

business in HK.

7/30/2019 2011 Unit 2 Source

28/56

28

Proof of effecting contracts outside HK

In considering claims that contracts have beeneffected outside HK by employees, Assessorswill require details of

travelling, hotel and subsistence expenses inrespect of each individual transaction.

Where it is claimed that contracts are effectedby overseas agents it will be necessary toprovide

agency agreements or other documentary evidenceto support the claim.

7/30/2019 2011 Unit 2 Source

29/56

29

DIPN 21assessing practice on Re-

Invoicing Centre

Profits derived from services rendered in HKare taxable

Trading involves the taking of commercial

risks (e.g. product, inventory, credit, exchange,capital, etc.) indicated by the confirmation ofsales and issue of purchase orders

E.g. Mark-ups earning by a HK re-invoicingcentre which manages the groups foreigncurrency exposures are taxable

7/30/2019 2011 Unit 2 Source

30/56

30


Buying Office ( )

A trading company, carrying on business outside HK,

may set up a branch () in HKto act as a buying

office.

The activities of the branch are confined to thepurchase of goods in HKand it is not involved in

their sale, either in HK or elsewhere.

In such a situation, a liability to HK profits tax

would not arise.

7/30/2019 2011 Unit 2 Source

31/56

31

Buying office continues

The function of a buying office may also be

carried out by

a subsidiary company or

an accredited agent ( ) (either related

or unrelated).

However, as for a branch, the subsidiary

company or accredited agent must not beinvolved in the sale of the goods.

7/30/2019 2011 Unit 2 Source

32/56

32

Buying office continues

On the other hand, any commission or other

remuneration earned by:

the subsidiary company or

The accredited agent

forperforming its services in HKwill be

fully taxable.

7/30/2019 2011 Unit 2 Source

33/56

33


Booked ( ) trading profits

There may be cases where the activities of a HK tradingbusiness are limited to the following -

(a) issuing or accepting an invoice (not order) to orfrom an ex-HK customer or supplier (whetherrelated or not) on the basis of contracts of sale or

purchase already effected by an ex-HK associate;

(b) arranging letters of credit ( );

(c) operating a bank account, making and receivingpayments; &

(d) maintaining accounting records.

7/30/2019 2011 Unit 2 Source

34/56

34

This situation commonly arises when a HK business,

as a member of a group and pursuant to group

directives, carries out the above activities and "books"

the profits in HK.Provided the activities of the HK business do not

include:

the acceptance or issue of sale or purchase orders in or

from HK,

the profits would not be taxable.

Booked ( ) trading profits continues

7/30/2019 2011 Unit 2 Source

35/56

35


Manufacturing Profits

The IRD considers that, where goods are

manufactured in HK, the profits arising from

the sale of such goods will be fully taxable

because the profit making activity isconsidered to be the manufacturing

operation carried out in HK.

7/30/2019 2011 Unit 2 Source

36/56

36


Manufacturing profits

In the situation where a HK company

manufactures goods partly in HKand

partly outside Hong Kong, say in theMainland, then that part of the profits

which relates to the manufacture of the

goods in the Mainland will not be regarded

as arising in HK.

7/30/2019 2011 Unit 2 Source

37/56

37

Arrangement of HK Businesses in PRC

A HK manufacturing business, which does not have alicence to carry on a business in the Mainland, may

enter into a processing ( ) or assembly ( )arrangement with a Mainland entity.

Under these arrangements, the Mainland entity isresponsible for:

processing, manufacturing or assembling the goods that arerequired to be exported to places outside the Mainland.

7/30/2019 2011 Unit 2 Source

38/56

38

Contract Processing ( ) or ( ) V.

Import Processing ( )

IRD will only tax 50% of profits of HK

business undercontract processing

arrangement.

However, IRD will treat the profits ofimport

processing arrangement as trading profits and

is fully taxable.

7/30/2019 2011 Unit 2 Source

39/56

39

Manufacturing profits - Contract

Processing

The Mainland entity provides:

the factory premises, the land and labour.

For this, the Mainland entity:

charges a processing fee and exports the completed goods to the HK manufacturing

business.

The HK manufacturing business normally provides:

the raw materials.

7/30/2019 2011 Unit 2 Source

40/56

40

Manufacturing profits - Contract

Processing

The HK party may also provide:

technical know-how ( ),

management ( ),

production skills ( ), Design ( ),

skilled labour( ),

training and supervision for the locally recruited labour &( )

the manufacturing plant and machinery ( ).

The design & technical know-how development( ) are usually carried out in HK.

A i f

7/30/2019 2011 Unit 2 Source

41/56

41

Apportionment ( ) of

manufacturing profitsIn law, the Mainland processing unit ( ) is asub-contractor( ) separate and distinct from theHK manufacturing business and the question ofapportionment strictly does not arise.

However, recognising that the HK manufacturingbusiness is involved in the manufacturing activities inthe Mainland (in particular in the supply of rawmaterials, training and supervision of the local labour)

the IRD is prepared to concede, in cases of this nature,that the profits on the sale of the goods can beapportioned.

This apportionment will generally be on a 50:50 basis.

M f i fi I

7/30/2019 2011 Unit 2 Source

42/56

42

Manufacturing profits - Import

Processing

In import processing, the manufacturing operations are carried outby a foreign investment enterprise (FIE) related to the HongKong company.

An FIE is often a separate legal entity incorporated in theMainland. The Hong Kong company sells raw materials to the FIEand buys back the finished goods from the FIE. The Hong Kongcompany engages in the trading of raw materials and finishedgoods whilst the FIE manufactures the finished goods.

The legal title to the raw materials and the finished goods passesto/from the FIE.

In import processing, the gross profits arise from tradingtransactions whereby the Hong Kong company purchases finishedgoods from an FIE and sells them for a profit. The manufacturingoperations of the FIE in the Mainland are not performed on behalfof, or for the account of, the Hong Kong company even though theHong Kong company and the Mainland enterprise might be within

the same group of companies.

7/30/2019 2011 Unit 2 Source

43/56

43

Manufacturing contracted to a sub-

contractor (Import Processing )

If the manufacturing in the Mainland has beencontracted to a sub-contractor (whether a related

party or not) & paid for on an arms length basis

( ), with minimal involvement of the HKbusinessno apportionment of trading profits madeby the HK business.

Profits of the HK business = (sales - cost of goods

sold - sub-contracting charges paid)The taxation of such trading profits will bedetermined on the same basis as for a commodities orgoods trading business.

DIPN 21 R ili fi f

7/30/2019 2011 Unit 2 Source

44/56

44

DIPN 21- Retailing profits of

manufacturers

Where a company:

manufactures goods outside HK &

sells them to HK customers,

the manufacturing profits are not liable to profits tax.Where the sale activities in HK are so substantial as toconstitute a retailing business( ), the profitsattributable to the retailing activities are fully taxable.

DIPN21 L li & i f

7/30/2019 2011 Unit 2 Source

45/56

45

DIPN21 - Locality & taxation of

Other ProfitsThe IRD regards the locality of the following types of

profits to be as follows -

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

(b) Profits from the sale of real estate - Location ofthe property

(c) Profits from the purchase and sale of listed ( )

shares - Location of the stock exchange where theshares in question are traded

DIPN21

L li & i f

7/30/2019 2011 Unit 2 Source

46/56

46

(d) Profits from the sale of securities ( )

issued outside HK & not listed on an

exchange - Place where the contracts of

purchase and sale are effected (exceptfinancial institutions in instances where

s.15(1)(l) applies)


Other Profits

DIPN21 L li & i f

7/30/2019 2011 Unit 2 Source

47/56

47

(e) Service fee ( ) income - Place wherethe services are performed which give rise tothe payment of the fees

In the case of an investment adviser that where theadviser's organisation and operations are locatedonly in HK, profits derived in respect of themanagement of the clients' funds are considered to

have a HK source.


Other Profits

7/30/2019 2011 Unit 2 Source

48/56

48

Service feeinvestment advisor

( ) continues

Included in chargeable sums are:

management fees and performance fees ( )

rebates ( ), commissions and discounts received by

the adviser from brokers located

in HK or

elsewhere in respect of securities transactions executed on behalf

of clients.

DIPN21 L li & i f O h

7/30/2019 2011 Unit 2 Source

49/56

49

DIPN21 - Locality & taxation of Other

Profits

(f)Interest earned by persons other than

financial institutions. - Determined on the

basis set out in DIPN No. 13 (Revised).

(g) Royalties( ) other than those

deemed chargeable under s.15 (1) (a) or (b)

Place of acquisition and granting of the licence

or right of use.

DIPN21 L li & i f O h

7/30/2019 2011 Unit 2 Source

50/56

50

DIPN21 - Locality & taxation of Other

Profits

(h) Cross-border land transportation

( ) income -

Normally the place of uplift ( ) of the

passengers or goods.

where the contract of carriage does not

distinguish between outward and inward ( )

transportation, apportionment will not bepermitted.

7/30/2019 2011 Unit 2 Source

51/56

51

DIPN21 - Apportionment of Profits

The IRD accepts that, notwithstanding the absence of aspecific provision for apportionment of profits in the IRO,there are certain situations in which an apportionment ofthe chargeable profits is appropriate, eg

manufacturing profits service fee income where the services are performed partly in

HK & partly outside.

The IRD believes that where apportionment is

appropriate it will, in the vast majority of cases, be on a50:50 basis.

DIPN21 A i f l

7/30/2019 2011 Unit 2 Source

52/56

52

DIPN21 - Apportionment of general

expenses

Further, it will be necessary to scale downclaims forgeneral expenses of the businesswhich contribute indirectly to earning both the

HK & offshore profits.General expenses in this context refer to allindirect expenses.

In most cases, apportion by reference to grossprofits rather than to assets.

DIPN21 P i f ff h

7/30/2019 2011 Unit 2 Source

53/56

53

DIPN21Processing of offshore

claims

Assessors power under s.51(4) to seek for full

information is not restricted or reduced after

ING Baring case.

Final step of the profit generating process is

not determinative of the locality of the source

of profits.

Burden of proof rested with the taxpayer.

Supporting documentary evidence.

7/30/2019 2011 Unit 2 Source

54/56

54

DIPN21 - Agency

Lord Millet NPJ in ING Baring:

Profit-generating transaction needs not be carried out by

the taxpayer or his agent in the full legal sense

Sufficient if it is carried out on the taxpayers behalf and

for the taxpayers account by a person acting on his

instructions

Act of overseas group company is not readily

attributed to a taxpayer in HKRejected the proposition of Commercial Reality

7/30/2019 2011 Unit 2 Source

55/56

55

DIPN21 - E-commerce

Electronic Transactions Ordinance 2000

DIPN 39 Treatment of Electronic Commerce

IRD gives greater weight to the location of the underlyingphysical business operations, rather than the location of the

server, in determining the source of the profits.The following factors in determining the source of profits: Where the goods are stored and delivered

Where the services are provided

Where payments are made and received

Where purchases and sales are made

Where bank accounts are maintained

Where business back-up services are provided

7/30/2019 2011 Unit 2 Source

56/56

Conclusion

S.14(1)

DIPN 21

Case law

2011 unit 2 source

Documents