As more and more Hong Kong companies operate globally with their offshore entities, it has become highly contentious to determine whether the profits generated from these activities abroad is chargeable to Hong Kong tax.

This has been highlighted by Hong Kong’s trading conglomerate Li & Fung’s recent victory to counter the Hong Kong Inland Revenue Department’s claim to levy Hong Kong profits tax for its commission income earned from sourcing goods for its foreign suppliers and customers with its offshore affiliates. The tax amount in question totaled about HK$110 million for the years between 1992 to 2002.

After a torrid three-year debate, Hong Kong’s Court of Appeal finally ruled in March that Li & Fung Group’s affiliate Li & Fung (Trading) Limited’s commission income was fully sourced offshore and not subject to Hong Kong profits tax. The test case clarified that in determining the source of profits, it should centre on the profit-making transactions instead of any supervisory or management activities.

The facts

Here are the key facts surrounding the dispute: Li & Fung Trading (LFT) was the buying agents of its overseas customers abroad and was paid 6% of the free on board (FOB) value of the merchandise supplied for arranging the orders and quality control of the products under a standard agency agreement it entered with its clients.

LFT then contracted with the group’s overseas affiliates with standard affiliates contracts, under which LFT’s entities provided services to LFT in return for 4% of the FOB value of the total export sales of the goods. In practice, many services LFT provided to its customers were executed by its affiliates offshore, which are often tasked to research and locate suppliers, advise on sourcing, provide information on product availability and pricing, and obtain export licenses for suppliers.

Crux of the problem

While LFT insisted that its commission was offshore income, the Hong Kong tax bureau argued that LFT was running a supply chain management business and claimed its overseas affiliates were “subcontractors, not agents”, and the 2% difference earned by LFT showed that LFT’s Hong Kong headquarter was managing its offshore affiliates. Therefore, the commission income was sourced in Hong Kong and subject to local taxes.

Nonetheless, Board of Review ruled that LFT was a commission agent which hired its affiliates abroad as agents to execute the agency services for its customers. Hence, the argument went that LFT’s profits were gained at the location where the LFT’s affiliates carried out LFT’s instructions abroad and the commission income was not originated in Hong Kong and should be exempt from Hong Kong tax.

Such a decision followed the principles laid out in the case of ING Baring which stressed that the focus in establishing the geographical location of LFT’s “profits-producing transaction” is different from “antecedent or incidental activities to those transactions,” which include supervisory or decision-making functions. The tax focus should be what activities generated the gross profits in question.

To counter the Board’s claim, the Commission of Inland Revenue (CIR) argued that LFT’s management and supervision of its offshore affiliates in Hong Kong was key to the commission income.

CIR touted the idea that LFT’s commission income of 6% should be apportioned in a manner that the 4% was attributable to LFT’s offshore affiliates and 2% to LFT’s activities in Hong Kong, while taking into the account that both LFT’s Hong Kong activities and tasks its affiliates performed offshore were needed to generate the 6% profit.

The judge disagreed, noting that although LFT provided management and supervisory support services for its offshore affiliates in Hong Kong, those were “antecedent activities” even though they were “commercially essential to the operation and profitability of [LFT’s] business… [but they] do not provide the legal test for ascertaining the geographic source of profits.” The Court of First Instance then ruled that the 6% commission income received were offshore income that were not subject to Hong Kong profits tax.

Take home lessons

“The LFT case confirms that back-up or support services in Hong Kong (regarded as ‘antecedent or incidental activities’ in the LFT case) that may be commercially essential to the operations and profitability of a taxpayer’s business do not provide the legal test for ascertaining the geographical source of profits,” said accounting firm Deloitte in a tax analysis it published in April.

That said, Deloitte advised taxpayers carrying on offshore agency businesses they should undertake a detailed review of their existing mode of operations to ascertain the applicability of the LFT case to any offshore claims.

Hong Kong barrister and accountant Ho Chi-ming said the Court of Appeal took the view that the 2% earned by LFT was not from handling the day-to-day orders, but from maintaining a long term relationship with customers and monitoring the performance of the contracts.

He also noted that the case showed the court rejected the totality approach of the Inland Revenue Department (IRD), and there’s no effect on whether the overseas affiliates were considered agents or subcontractors. “The Li & Fung case was an important departure from the previous understanding that a party acting on a principal to principal basis with the taxpayer may carry out acts outside Hong Kong which is regarded as the acts of the taxpayer,” Ho said.

Following such logic, he floated the question that Li & Fung’s profit maybe exempt globally unless overseas tax authorities challenge the transfer pricing of overseas affiliates.

However, Ho cautioned others that Li & Fung’s ruling may not be applicable to other sectors, such as a manufacturing business with a processing factory in mainland China that acts differently from an overseas sub-agent.