Court rules the profits of an interposed Hong Kong SAR trading company cannot be taxed

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Court rules the profits of an interposed Hong Kong SAR trading company cannot be taxed

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Lewis Lu and John Timpany of KPMG China discuss the latest court judgment on the chargeability of a taxpayer’s trading profits.

On April 20 2022, the Court of First Instance (CFI) ruled that the profits of an interposed Hong Kong SAR trading company are not taxable in Hong Kong SAR.

In the case Newfair Holdings Limited v Commissioner of Inland Revenue, the court ruled that the taxpayer did not carry on a business in Hong Kong SAR, and that its profits did not arise from commercial operations in Hong Kong SAR. Therefore, these profits are offshore-sourced and not chargeable under the Hong Kong SAR profits tax.

Background to the case

The taxpayer, Newfair Holdings Limited (Newfair), is a Hong Kong SAR incorporated company within a group whose principal business was the distribution of electronic products in the European markets sourced from manufacturers in the Far East. Newfair was interposed between a Dutch group company (VBABV) and third-party suppliers for Dutch tax mitigation purposes.

Newfair’s master sales and purchase agreements were signed outside of Hong Kong SAR, and all of the office work was done by staff from group companies outside Hong Kong SAR. While Newfair did not employ any staff or physically operate in the Hong Kong SAR office, it maintained a Hong Kong SAR bank account to pay suppliers and to receive revenue.

Two key substantive issues were raised.

Issue 1: Did Newfair carry on a business in Hong Kong SAR?

The CFI held that Newfair did not carry on a business in Hong Kong SAR, based on the following analysis:

  • ‘Carrying on of business’ usually calls for some activities on the part of the taxpayer in the pursuit of commercial gains;

  • The operations that gave rise to Newfair’s profits were the sales of goods, and all merchandise contracts were concluded outside Hong Kong SAR;

  • The receipt of revenue and paying to suppliers are only incidental administrative acts and not the revenue generating activities;

  • The location where the suppliers managed the shipments or carried on their businesses is irrelevant; and

  • Designating a principal place of business (for contracting purposes) was not the same as identifying the place where the profits actually arose.

The Commissioner of Inland Revenue (the Commissioner) argued that the interposition of Newfair between VBABV and the suppliers did amount to a profit-generating activity. The Commissioner stated that its presence, together with the associated arrangements, in Hong Kong SAR was the effective cause of producing the profits. However, the CFI held that these relate to Newfair’s role within the group and not its acts/operations that gave rise to profits.

Issue 2: Did Newfair’s profits, derived from the Hong Kong SAR business, arise in Hong Kong SAR?

The CFI applied various principles established in the case law and held that Newfair’s profits were not sourced in Hong Kong SAR. In particular, the CFI pointed out that:

  • Profits arising from merchandise trade should be taken as arising in, or derived from, the place where the contracts of purchase and sale were effected;

  • In Newfair’s case, the profit-generating transactions were the purchase of goods from the suppliers and the resale of the same goods at a fixed mark-up to VBABV, and the negotiations and conclusion of the purchase and contracts were effected outside Hong Kong SAR;

  • The operation of the Hong Kong SAR bank account could not amount to profit-producing operations;

  • The Board’s finding on Newfair’s legal title to the goods was not supported by any evidence, so there was an error in law; and

  • The CIR could not impose profits tax liability on what Newfair was; only on what it did.

Accordingly, the CFI ruled that the Board’s decisions in Case No. D14/20 on both issues were contrary to the only true and reasonable conclusion. The court allowed the taxpayer’s appeal on both issues.

KPMG’s observations

We welcome the CFI’s judgment on the source of profits in this case. In our view, the judgment has upheld the principles of Hong Kong SAR’s territorial tax regime and reaffirmed the proper test established by case law. 

In this judgment, the place where the sale and purchase contracts are effected remain the determining factor of the source of trading profits. Other considerations – such as setting up a Hong Kong SAR company to facilitate or effect the transactions, or not paying tax for those profits elsewhere – should not be relevant. The judgment also implies a meaningful distinction between carrying on a business in Hong Kong SAR, and carrying on a business with someone in Hong Kong SAR.

This case could have a widespread impact on the Inland Revenue Department’s (IRD) practice of assessing offshore claims. While a further appeal has yet to be lodged by the Commissioner, taxpayers with any outstanding offshore claims to be agreed by the IRD should revisit their cases and consider whether there are any fresh arguments to support their claims.

 

Lewis Lu

Partner, KPMG China

E: lewis.lu@kpmg.com

 

John Timpany

Partner, KPMG China

E: john.timpany@kpmg.com

 

 

 



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