Chapter Seven

Hong Kong Advance Ruling Cases: Taxability of Profits

The Government of the Hong Kong Special Administrative Region (Hong Kong) has been issuing substantive advance ruling case results since 2000. Hong Kong’s Inland Revenue Department issues these advance ruling case results infrequently, issuing just 38 such results during this nearly ten-year interval. This analysis reviews the Inland Revenue Department’s taxability of business profits, together with its treatment of expense allocation and transfer pricing, as Hong Kong’s advance ruling case process reflects these results.

ADVANCE RULING PROCESS

Hong Kong’s Inland Revenue Department designed the Hong Kong advance ruling case results to provide the taxpayer with a defined area of certainty concerning the taxability of business operations. The Inland Revenue Department publishes the advance ruling case results only for general reference, similar to the Internal Revenue Service ruling process in the United States. The department cautions taxpayers not to rely heavily on these advance ruling case results. When the issue becomes the treatment of current tax results, the department will rely on the previously issued ruling only if the factual pattern is the same as in the prior ruling.

Hong Kong’s Inland Revenue Department cautions that the Hong Kong government might have changed the relevant tax provisions in the interim after the issuance of the ruling. The department acknowledges that it might have modified its relevant case law interpretation and practice. Further, the department might take a different position than it did in the past if the department believes that the taxpayer is using its tax approach as an avoidance device. More recent rulings reflect the Hong Kong government’s strong anti–tax haven response.

Hong Kong’s Inland Revenue Department issues these advance ruling case results in a manner that protects taxpayer confidentiality. The department edits the rulings prior to publication and removes identifying information and provides these case results only by ruling number.

The Inland Revenue Department’s primary impetus for issuing advance ruling cases is the taxability of profits provision, section 14 of the Inland Revenue Ordinance. The department issued 17 advance ruling cases in this taxability category compared with issuing 38 advance ruling cases in total. The 17 advance ruling cases address various products and trading fact patterns and the treatment of services activities. These taxability of profits provisions frequently address threshold nexus issues and permanent establishment activities.

ADVANCE RULING CASE NO. 4

The taxpayer incorporated its business in Hong Kong on March 31, 1999, for the purpose of trading accessories. This taxpayer maintained a registered office in Hong Kong, effectuating this registered office through a local accounting firm. An Australian enterprise, Company B, was the headquarters of business operations. Mr. A, the sales manager of Company B, was the beneficial owner of the Hong Kong enterprise.

Mr. A. is responsible for negotiating and concluding Company B’s purchase contracts. Mr. A’s purchasing responsibility applies both to Hong Kong sales and to overseas sales. Mr. A. ordinarily lives in Australia and visits Hong Kong at intervals of about three months.

Company B relies on its local accounting firm to provide documentation of the transactions and to provide other administrative activities. The administrative activities include these activities under Mr. A’s direction:

• Preparing purchase orders and sales orders
• Preparing invoices
• Operating bank accounts
• Maintaining accounting records

Company B obtains much of its products from its overseas suppliers. The local accounting firm places its purchase orders with the suppliers and accepts sales orders from Hong Kong. The accounting firm makes the purchase and sales determination under Mr. A’s instructions. The suppliers then send its invoices, packing lists, and other documents to Company B’s Hong Kong office.

The suppliers deliver the goods to Company B for its sales to local customers and for other offshore customers. Company B keeps the goods in warehouses in Hong Kong. Company B pays the suppliers by letter of credit and receives settlement from its customers by letter of credit.

Company B appointed a People’s Republic of China (PRC) agent to act as its agent for selling accessories to a PRC customer. Mr. A negotiates with the PRC customer and with its PRC agent directly for the purpose of securing price, quantity, quality, and shipment. At the same time, Mr. A negotiates with a supplier in Italy for the price, the production schedule, and the delivery of the goods.

The parties operate their trading transactions in this manner:

• Mr. A receives a sales confirmation.
• Mr. A then asks the PRC customer to issue purchase orders to the Hong Kong office directly.
• Mr. A informs the local accounting firm as to the details of the transaction at the same time customer issues the purchase order.
• The local accounting firm then places purchase orders to the Italian supplier, placing that order in accordance with Mr. A’s instructions.
• Company B then ships the goods to the PRC customer directly.
• The customer and the supplier settle the transactions on a back-to-back letter of credit basis.
• The local accounting firm sets up the company’s back-to back basics.

Hong Kong’s Inland Revenue Department, in issuing Advance Ruling Case No. 4, held that Company B’s profits that arise from sales to the PRC are onshore profits. These onshore profits are subject to the Hong Kong profits tax pursuant to section 14 of the Inland Revenue Ordinance.

The ruling itself did not provide a rationale for its decision to impose taxation based on the company’s onshore activities. We suspect that the department might have viewed the accounting firm’s relationship in Hong Kong as creating an agency relationship with the taxpayer. It appears the above-mentioned agency relationship, coupled with the physical presence of the goods in Hong Kong by having a warehouse in Hong Kong, and the presence of the taxpayer’s Hong Kong sale activities, created taxable nexus and made the company subject to tax on onshore profits.

ADVANCE RULING CASE NO. 8

The taxpayer incorporated its business in Hong Kong on March 25, 2002, for the purpose of trade in processed fruits and food-related products outside Hong Kong. The company purchases processed fruits and food-related products from Asia, excluding Hong Kong. The company resells processed fruits and food-related products to customers principally in Europe and other countries, excluding Hong Kong.

The company maintains offices in Taiwan and in Indonesia. Two directors of the company manage its daily operations. The two directors reside in Taiwan and in Indonesia, respectively.

The company has two marketing and procurement officers. The company presently locates these procurement officers in its Indonesia office and aims to recruit additional marketing and procurement officers. The company plans to expand its operations into Thailand. The company plans to locate these additional marketing and procurement officers in its soon-to-be-created Thailand office.

All of the negotiation processes for sales and purchase transactions take place in different countries. The company requires a centralized administrative function to administer and coordinate work performed by employees and directors in these various locations. The company selected Hong Kong as its “centralized administrative office” for the purpose of contributing to the smooth running of the administrative function.

The company plans to set up this office in Hong Kong. The staff of the Hong Kong office is to undertake these activities:

• Issue or accept invoices, but not orders, from a non–Hong Kong customer or supplier.
• The company would make that sale and purchase arrangement on the basis of contracts of sale or purchase that the non–Hong Kong associate already effectuated.
• Arrange for a letter of credit.
• Operate a bank account, and make and receive payments.
• Maintain accounting records.

The company undertook these activities:

• The company intends to enter into purchase contracts with an Indonesian supplier, S Ltd.
• The company intends to enter into sales contracts with a U.S. customer, C Ltd.
• The Taiwanese director located S Ltd. during a business trip to Indonesia.
• The Indonesia director located C Ltd. at a German food exhibition.
• The company followed up the communication between suppliers and the customer outside Hong Kong by e-mail.

The company will arrange for direct shipment from S Ltd. to C Ltd. upon the conclusion of both purchase and sale arrangements. The goods will not pass through Hong Kong. The company will not maintain a stock of merchandise in Hong Kong.

The Hong Kong office will perform these functions:

• Issue or accept invoices
• Arrange for letters of credit
• Operate a bank account
• Make and receive payments
• Maintain accounting records

Hong Kong’s Inland Revenue Department determined in Advance Ruling Case No. 8 that it will not tax under section 14 the profits the company derives as to its trading transactions with supplier S Ltd. and with customer C Ltd. In contrast with Advance Ruling Case No. 4, the taxpayer in Advance Ruling Case No. 8 had no nexus to Hong Kong. The goods did not pass through Hong Kong and the activities took place elsewhere.

ADVANCE RULING CASE NO. 9

LC is a life insurance company that offers various life insurance products in the Hong Kong market. LC developed a new life insurance product, X, which is a unit-linked insurance product. X provides the policyholder primarily with life insurance coverage and provides the policyholder with the ability to invest in 12 mutual funds. X is a linked long-term life insurance business under Hong Kong rules.

LC invests policyholder premiums as to X in various investment funds that the policyholder nominates. LC, upon receiving the policyholder’s premium, deducts 5% of the premium as its buy-sell charge. LC invests the balance of the premium it receives by buying units in various mutual funds in accordance with the policyholder’s instructions.

LC deducts from the policyholder’s notational holdings in the investment funds sufficient units to cover the life insurance charge at the beginning of each month. LC determines the life insurance charge by using the same parameters as apply to the company’s traditional life products. LC at all times solely owns the investment funds and solely owns all assets in the investment funds, legally and beneficially.

LC permits the policyholder to switch investment funds, making that switch up to a maximum of six times per year without cost. LC imposes a switching charge of 1% for additional changes.

LC might apply an early surrender charge to the policyholder if the policyholder surrenders a policy before its life coverage began. The surrender charge is the life insurance premium that is applicable when the policyholder purchases the coverage. LC expresses the surrender charge as a percentage of the initial surrender charge. The surrender charge diminishes down to zero by the eighth coverage anniversary.

LC receives a premium from policyholders as to the issuance of the product. LC invests the total premium, less the buy-sell charge, in the mutual funds the policyholder nominates. LC derives income from product X by way of the monthly insurance charge and from other charges that LC imposes on the policyholder. LC retains the income from these sources to cover its operating costs and to invest for future liabilities.

The Inland Revenue Department, in Advance Ruling Case No. 9, sought not to impose tax on the insurance income. Instead, the department sought to preclude the deductibility for activities connected with the insurance activities:

• The Inland Revenue Department does not impose tax on LC under section 14 for the income that LC derives by buying, selling, and switching charges as to product X.
• The Inland Revenue Department does not impose tax on LC under section 14 for income derived by way of X’s management charge.
• The Inland Revenue Department does not impose tax on LC under section 14 for its income derived from the surrender charge imposed in year 1 through year 8.
• The Inland Revenue Department does not permit a deduction under section 16 for LC’s expenses for buying, selling, switching, management, and surrender charges.

ADVANCE RULING CASE NO. 10

The company was in the business of trading bedding products and in trading its related raw bedding materials. The company set up its operations in Hong Kong in 1989. The company maintains offices in Hong Kong and maintains showrooms in Hong Kong. The company’s affiliate (Affiliate) in the mainland manufacturers the bedding products.

The company’s affiliate is a wholly foreign enterprise, incorporated in the mainland in 1993. China licensed the affiliate to import raw materials and to manufacture bedding products for export and local sale. Affiliate operates an import processing trade owning its factory premises, plant, and machineries. The profits of Affiliate are subject to tax in the mainland.

Here is how the bedding manufacturing process works:

• The company purchases raw materials in Hong Kong.
• The company sells these materials at cost to Affiliate.
• Affiliate processes the raw materials to produce products the company specifies.
• The company sends some supervisors to monitor the manufacturing process in the mainland to ensure production quality.
• Affiliate sells the finished goods at a profit to the company.
• The company sells the finished goods to customers in Hong Kong.
• The company and Affiliate issue invoices to effect the transactions.
• The company and Affiliate make declarations in the import/export forms they present to their customs bureaus.
• The company’s trading profits are fully subject to Hong Kong profits.

The company plans to retain its operations in Hong Kong as to its sourcing, purchase of raw material, and the sale of finished products. The company intends to manufacture its products in the mainland. The company intends to execute a processing and assembly agreement with Affiliate, which agreement would be a cost-plus arrangement. The agreement contains three major terms:

Affiliate will not furnish the agreement for registration in the mainland. The company and Affiliate will cease to treat both the delivery of raw materials to Affiliate and the furnishing of finished goods to the company as being trading transactions. Instead of reflecting these activities as being separate trading transactions, the company and Affiliate will record these activities as one activity, reflecting the combined results as an internal basis.

After applying the combined results, the parties will no longer prepare invoices to each other. The company and Affiliate will continue to make customs declarations, making those declarations in import/export forms. Both the mainland and Hong Kong customs bureaus will recognize the existence of the import of raw materials and the export of finished goods.

Affiliate continues to operate its bedding products trade in the form of an import processing activity. Affiliate will continue to undertake its processing work for other mainland customers.

Hong Kong’s Inland Revenue Department held in Advance Ruling Case No. 10 that the company-affiliate agreement does not cause to license the company to manufacture or to carry out business in the mainland. The Inland Revenue Department held that Affiliate is the manufacturer and that the company is not the manufacturer.

Hong Kong’s Inland Revenue Department held that the company derives its profits from trading in Hong Kong. The company is fully subject to section 14 of the Hong Kong profits tax. The Inland Revenue Department rejected the application of the allocation process and held that the trading profits are not subject to allocation.

In Advance Ruling Case No. 10, the company had offices in Hong Kong, had operations in Hong Kong, and had showrooms in Hong Kong. Nexus was not an issue as the company had passed that threshold.

ADVANCE RULING CASE NO. 11

Advance Ruling Case No. 11 appears to describe a reinvoicing structure, a three-party arrangement utilizing a quasi–tax haven (Hong Kong) and two high-taxed countries, South Africa and the United States. X Ltd. was in the business of trading ink products and incorporated the business in Hong Kong on August 24, 2001. S Ltd., a fellow subsidiary, manufactured the goods in South Africa. X Ltd. makes 80% of its sales to related companies, one of which is A Ltd., a fellow subsidiary in the United States.

X Ltd. entered into a master purchase agreement with S Ltd. and enters into master sales agreements with related customers, such as with A. Ltd. The parties make these agreements outside Hong Kong. The enterprise has a holding company that is located in Israel, H Ltd. H Ltd. coordinates the trading transactions and product production. X Ltd. makes all transfer pricing determinations among its subsidiaries, such as X Ltd., and with A Ltd. and S Ltd. X Ltd. prepares X’s production plan.

H Ltd. prepares a delivery notice to an individual trading the transaction in Israel for issuance to S Ltd. The individual copies the delivery notice to X Ltd. and to A Ltd. X receives the delivery notice in Hong Kong and prepares a delivery notice to S Ltd. S Ltd. prepares the invoices in South Africa, sends the invoices to Hong Kong, and X receives the invoices to Hong Kong. X Ltd. then prepares the invoices in Hong Kong and sends the invoices to A Ltd. in the United States as to S Ltd.

The parties settle their accounts by remittance to and from X’s bank account, which X Ltd. maintains in Hong Kong, taking into account the remittance instructions from Israel. The Inland Revenue Department concluded that the X Ltd. profits arising in or derived from Hong Kong are taxable as to section 14 of the Hong Kong Inland Revenue Ordinance. It appears that the company’s activities in Hong Kong necessitated taxability.

ADVANCE RULING CASE NO. 12

A private limited company traded computer commodities, motherboards, chips, and the like. The company incorporated the business in Hong Kong in 2000. The company does have a registered address in Hong Kong, which is the address of the company secretary. The company secretary is an independent service provider that is responsible for annual return filing to the Hong Kong Company Registry. All of the directors of the Hong Kong company are Taiwanese residents. The parent company is T Ltd., a company the Taiwan Stock Exchange lists for trading.

The Hong Kong company does not maintain any office in Hong Kong, nor does it employ any staff in Hong Kong. The Hong Kong company filed a zero tax return for its initial taxable year. The company claimed that it had no trading during the period that began from incorporation and carried forward until December 31, 2000.

The group set up a manufacturing plant in Shenzhen under the name M Ltd. The group sent up this operation in Shenzhen to expand its manufacturing operations and to benefit from the low production overhead on the mainland. The directors of T Ltd. and the directors of M Ltd. are Taiwanese residents. The group does not require the directors to carry out any duties in Hong Kong or to make any decisions for the Hong Kong company in Hong Kong.

The Hong Kong company commenced its business with T Ltd. and with M. Ltd. during the 2001 taxable year. The Hong Kong company has suppliers and customers that are part of the overseas group only. The Hong Kong company holds bank accounts in both Hong Kong banks and Taiwan banks. The T Ltd. staff is responsible for handling the bank transactions on behalf of the Hong Kong company. The staff is authorized to take this banking responsibility. The Hong Kong company does not have its own staff in Hong Kong. T Ltd.’s staff in Taiwan handles the purchases and sales transactions with T Ltd. and M. Ltd.

The owners of the business set up the Hong Kong company as an intermediary to facilitate trading between Taiwan and the mainland. The intermediary arrangement operated in this manner: T Ltd. would source raw materials from suppliers in Taiwan and overseas. M Ltd. would process the raw materials on the mainland.

M Ltd. must import the material it needs in the name of the Hong Kong company. The processing and importation process operates in this manner: M issues purchase orders to the Hong Kong Company. The ultimate purchaser is T Ltd. regarding the purchasing and importation of raw materials.

The Hong Kong company charges a specified markup for the sale of raw materials. The T Ltd. staff in Taiwan, acting on behalf of the Hong Kong company, would confirm and sign the purchase orders the staff received. The T Ltd. staff would prepare the sales invoice and prepare the packing list to M Ltd.

M Ltd. processes and assembles the raw material into finished goods. M Ltd. exports and sells the finished goods that M Ltd. manufactures to the Hong Kong company instead of to T Ltd. directly. T Ltd. then issues purchase orders to the Hong Kong company simultaneously regarding the purchase of the same products. The parties would charge no markup for the sale of finished goods from the Hong Kong company to T Ltd. T Ltd. sells the goods to ultimate customers, including both independent customers in Taiwan and elsewhere.

The Hong Kong company keeps no stock of raw materials or finished materials in Hong Kong. The Hong Kong company delivers the raw material from T Ltd., or from other suppliers, and imports the raw material to Shenzhen directly. The Hong Kong company might ship the finished goods directly from the manufacturing plant in Shenzhen. Alternatively the Hong Kong company might pass through the finished items through Hong Kong for shipment to T Ltd. or to the Hong Kong company’s ultimate customers.

The Hong Kong company, besides making sales to T Ltd., makes minor sales to other overseas group companies in Mexico and Japan. The Hong Kong company imposes no markup as to the purchase of raw materials or from the sale of finished goods to the Mexican company. The Hong Kong company charges a prescribed markup for the sale of parts to the Japanese company.

The Hong Kong company books profits it derived from trading transactions that the group companies entered into. The Inland Revenue Department concluded that the purpose of the Hong Kong company is to facilitate trading between Taiwan and the mainland. Profits that the Hong Kong company books are not subject to section 14 of the Hong Kong profits tax. The Inland Revenue Department reached its ruling on the assumption that the operations of the Hong Kong company would remain the same and that the role of the Hong Kong company would follow the contemplated operational transactions.

The Inland Revenue Department failed to conclude that the company had nexus in Hong Kong. It appears that the department was swayed by the company’s compliance with the legal and financial formalities that the company had met.

ADVANCE RULING CASE NO. 13

A group of companies having a head office in the United States conducts its operations globally. The group manufactures its products throughout the world and sells its products in over 150 countries. The group comprises four types of entities in various jurisdictions throughout the world: manufacturing entities, distribution entities, marketing entities, and logistical support entities.

None of the manufacturing entities has operations in Hong Kong. The distribution companies are established outside Hong Kong. These distribution companies have no employees in Hong Kong. The manufacturing companies receive orders from the distribution companies and sell the products to the distribution companies. The distribution companies in turn sell its products to the marketing companies.

One marketing company was incorporated in Hong Kong. The Hong Kong marketing company is responsible for the marketing and sale of the group’s products in Hong Kong and in the PRC. The group’s head office determines the products the company manufactures. The group sets the intergroup selling prices.

The group established Company L in Hong Kong. Company L provides support services to the distribution companies. The logistic companies, including Company L, provide logistical and administrative support to the distribution companies for the purposes of handling procurement and providing supply services.

The group maintains a Web-based international supply system (ISS):

• The group’s head office manages the ISS.
• The marketing companies place orders with the distribution companies through this ISS.
• Company L downloads the purchase orders from the ISS as to the Asian marketing purchase orders.
• Company L verifies the details of the purchase orders.
• Company L then consolidates the order into a summary of purchases.
• The distribution companies issue the orders to the manufacturing companies.

Company L then forwards the summary of purchases by e-mail to the respective distribution companies for approval. If applicable, the distribution companies confirm the purchases approval to Company L by e-mail. The group’s head office worldwide pricing guidelines determine the acceptance or rejection of the purchase order.

Company L structures the purchase order process:

• Once the head office approves the purchase order, Company L prepares an order form under the name of the distribution company as to purchasing for the manufacturing companies.
• The manufacturing companies confirm the purchase order with Company L via e-mail as to the quantity of goods available for export to the Asian marketing companies.
• Company L then forwards the confirmation of the products available for export to the Asian marketing companies by e-mail to the manufacturing companies.
• Company L then requests the Asian marketing companies to confirm its purchase agreement.

Company L applies this accounts receivable structure:

• Company L prepares pro forma invoices to the Asian marketing companies based on the purchase orders the distribution companies approved and the manufacturing companies confirmed.
• Company L prepares these pro forma invoices under the letterhead of the relevant distribution companies.
• The Asian marketing companies issue purchase orders to the distribution companies upon receipt of the pro forma invoices.
• Company L issues the purchase orders contained in the pro formas.

Company L consolidates the detail transactions of the Asian marketing companies’ orders, then forwards these details to the distribution companies via e-mail for approval.

The manufacturing companies ship most of the finished products from them directly to the Asian marketing companies in the region without warehousing the finished products in Hong Kong. The manufacturing companies forward the shipping documents or fax the shipping documents to Company L once they ship the products. Company L issues invoices to the Asian marketing companies under the letterheads of the distribution companies.

On some occasions, the group ships the products to Hong Kong for warehousing. In such circumstances, Company L notifies the Asian marketing companies of the products to be warehoused in Hong Kong. Company L arranges for the shipment of these products. Company L also provides services, including transportation, coordination of customs arrangement and clearance, and visual checking to verify the quantity and package of the products the group imports into Hong Kong. Company L liaises with the suppliers to arrange for the delivery of products to the Hong Kong marketing company for sales to Hong Kong and to the PRC.

Company L maintains all accounting records in connection with the distribution companies’ trading activities in the Asia region. This record keeping includes maintaining details of all sales Company L made to the Asian marketing companies and maintaining details of all purchase and sale of raw materials to the manufacturing companies. Company L summarizes and reports the distribution company’s accounting transactions to the group treasury center, which is outside Hong Kong.

The distribution companies maintain bank accounts located outside Hong Kong. The group treasury center monitors these bank accounts and fund flows, undertaking these financial activities with Company L. Company L provides the details of the trade receivables and payables to the group treasury center on a monthly basis.

In addition to performing the following activities, Company L undertakes the following activities:

• Company L provides information technology services, including a technology platform and software to enable order processing, stock management, and location processing.
• Company L provides miscellaneous reporting and general communication to customers and management of the distribution companies.

Company L charges a service fee to the distribution companies. The charge is cost plus 5% markup. The Inland Revenue Department, in issuing Advance Ruling Case No. 13, held that the distribution companies carried on its business in Hong Kong through Company L and that the profits that the distribution companies derive from their trading operations with group companies in the Asia region arose in or derived from Hong Kong. The Inland Revenue Department viewed these profits as taxable under section 14 of the Hong Kong profits tax.

The Inland Revenue Department failed to delineate its decision to impose taxation on Country L in contrast with other fact patterns. It is our view that the department reached its taxability decision largely in response to the presence of a Hong Kong marketing company, the presence of a warehouse entity in Hong Kong, and the fact that Company L notifies the Asian marketing companies of the products to be warehoused in Hong Kong.

ADVANCE RULING CASE NO. 16

B is an overseas incorporated bank. B incorporated Company A, its wholly owned subsidiary, in Country X, structured as a limited liability company. Company A has a central management and control in Country X, and does not have any business establishment in Hong Kong. Company A has a branch in London (A-London) that carries on business in London.

The bank provides these services:

• Company A has three business lines: equity derivatives, cash equity sales and trading, and corporate advisory.
• Company B maintains a branch office in Hong Kong (B-HK). Company B principally engages in corporate banking, corporate finance, and mergers and acquisitions.

Company A’s equity derivative business consists of these activities: structuring, risk management, and the trading of equity-linked and fund-linked products. Equity-linked and fund-linked products include both listed and over-the-counter financial arrangements. Company A acts as the issuer of these financial products, selling the products to retail banking customers, private banks with European and Asian institutional client bases, financial institutions, and pension funds.

A-London engages B-HK to provide liaison and support services to clients in Asia as to Company A’s equity derivative business. Under this liaison and support arrangement, B-HK designates one liaison staff to perform the services. The liaison and support services include five activities:

The liaison staff also is involved in providing feedback from clients to Company A. Company A designs the feedback so as to modify the products. Additionally, Company A contacts the private banks and financial institutions to market the products.

The role of the liaison staff is to act as a link between clients and Company A in London. The liaison staff can pass on the client’s specific requirements to London for incorporation of these requirements into the structure of the product. The liaison staff in Hong Kong locates and then contacts the clients and communicates negotiations between A-London and the clients.

B-HK is not an agent of A-London and will not hold itself out as agent of A-London. The engagement between B-HK and A-London applies only to the referral of potential investors to A-London. B-HK will not have any power or any authority to conduct transactions on behalf of A-London. B-HK will receive from Company A a fee calculated at a 5% markup on the actual direct and indirect cost B-HK incurs in return for the services B-HK performs.

The Inland Revenue Department concluded in Advance Ruling Case No. 16 that Company A carries on business in Hong Kong through B-HK and that profits arising in Hong Kong or the profits deriving from Hong Kong are subject to tax under section 14. This ruling request addressed only the question of whether Company A carries out business in Hong Kong. The applicant for the ruling did not request or present sufficient information as to whether the Inland Revenue Department has profits arising or deriving from Hong Kong. The department determined that an agency relationship exists notwithstanding the express disclaimer and that an agency relationship can be implied based on the facts at hand.

ADVANCE RULING CASE NO. 19

A company entered into a contract processing agreement with a Chinese party to operate a factory in China, thus creating establishing a China factory. Pursuant to the contract processing agreement, the China party provides labor, factory premises, and water and electric facilities to process the goods for operating the China factory. The Chinese party provides these proceeding inputs in return for receiving processing fees. The company provides raw materials, plant, machines, and the training of workers. The China factory is not initially operational.

After the China factory comes into operation, the company activities in Hong Kong will:

• Complete the sales function
• Purchase raw materials the company would deliver to the factory
• Employ product design

The China factory will be responsible for the processing of the goods. A number of the company’s employees will visit the China factory to train the labor and to supervise the production. Some employees work five or six days in the China factory every week.

The Inland Revenue Department determined in Advance Ruling Case No. 19 that the company can apportion its profits arising from the sale of goods processed by the China factory under the contract processing agreement. The profits can be apportioned on a 50/50 basis for Hong Kong profits basis under section 14.

ADVANCE RULING CASE NO. 21

The company is a member of an international group. The group incorporated the company in Country X and registered a branch in Hong Kong (the Branch). In country X, the company imports goods from affiliated companies in Hong Kong and from Country Z. The group set up the Branch to fulfill the requirements that the company’s customers impose in Country X. The goal is for the company’s customers to manage by themselves the import-related logistics in a more efficient manner.

The company does not maintain any office in Hong Kong other than having a registered address. The company does not have any employees or agents in Hong Kong. The company’s staff in Country X carries out the sales transactions. The company’s staff in Country X carries out the purchasing transactions with affiliated companies. The computer ordering system bolsters the company’s staff in Country X.

The company, by using the Branch, benefits from shorter payment terms from customers under the company–Branch arrangement. But for that arrangement, the parties would rely on local payment terms, which usually would be two to three times longer.

The group purchases goods internally. The product division sets up prices using the resale price method (the market minus method) under the Organisation of Economic Cooperation and Development guidelines.

The company introduces the product in Country X through presenting a product sample and demonstrating the product to potential customers. The company’s key account managers and salespeople in Country X will negotiate with customers the price and quantity per product type after they introduce the product. The company confirms the price by fax or e-mail. The company’s key account managers in Country X prepare and sign sales contracts on behalf of the Branch.

The company’s field application staff will assist customers in the product evaluation until customers agree to the final version and send their purchase orders to the company in Country X. The company applies this field application process only for large volume customers. The company’s salespeople then pass on the order information to the company’s customer service staff for inputting into the computer ordering system. The computer ordering system automatically generates the purchase order and sends the purchase order to the supplier.

The suppliers then accept the orders. The suppliers then confirm the delivery schedule and input that information to the ordering system. The company’s customer service staff then sends the confirmed delivery schedule list to Country X customers by e-mail. The suppliers in Country Z and in Hong Kong will change the order status sign in the computer ordering system to confirm delivery when they complete their orders. The company normally delivers the products by air to the customers in Country X or to their designated factories outside Hong Kong. The Branch usually will not keep a stock of inventory except for storing of certain goods in Country X for some important customers.

The company’s financial control team in Country X decides on the credit terms for each customer. The company makes some sales under letter of credit terms. The company’s Shared Service Centre (SCT) in Country Z on behalf of the Branch will negotiate the letter of credit with the banks in Hong Kong. The SCT charges a service fee to the Branch for that financial service.

The financial controller of the company in Country X and SCT’s accounting manager can operate the Branch’s bank account in Hong Kong for receiving customers’ money and for making payments. In addition, the financial controller of the company in Country X and SCT’s accounting manager have financial control duties and report and handle transaction posting and intercompany and bank reconciliation. The Hong Kong branch books the profits it derives from the sales and purchase transactions it invoiced in its name. SCT enters and keeps the financial accounts and records of the Branch on its behalf.

The Inland Revenue Department under Advance Ruling Case No. 21 held that the profits booked in the accounts of the company’s Hong Kong branch are not “arising in nor derived from Hong Kong.” As a result, these profits are not subject to tax under section 14(1) of the Hong Kong profits tax.

ADVANCE RULING CASE NO. 23

An international group contains Company B and Company A. The group incorporated Company A in Hong Kong. B is a foreign-based multinational. Company A is a wholly owned subsidiary of Company B. Company B is engaged in the retailing of fashion wares, cosmetics, and accessories principally in European countries and in the United States through its own outlets. Company B appointed Company A as its buying agent to procure overseas suppliers and to source garments in the mainland and in other Asian countries. The garments that Company A procures include knitwear, underwear, woven products, and accessories.

Company A establishes numerous representative offices in various overseas countries to perform its procurement services for Company B. Company A needs to establish these numerous representative offices because of the geographical locations of the overseas suppliers. Company A’s representative offices do not have the authority to negotiate, conclude, or execute Company B’s sales and purchases. Company B negotiates and concludes the terms of the sales and purchases with its suppliers directly outside Hong Kong. Company B will, once it concludes the contracts, instruct the representative offices to follow up the orders with the suppliers.

Company A receives commission income from Company B for procurement services it rendered outside Hong Kong. Company’s commission income is 3% of the freight-on-board value of Company B’s purchases. Company A does not employ any staff in Hong Kong. Company A engaged Company C, an affiliated subsidiary in Hong Kong, as its service agent to perform its necessary administrative functions. Company A pays Company C a service fee for the services rendered on the basis of cost plus 5%.

Company A currently maintains a number of representative offices outside Hong Kong. Company A has three representative offices in Shanghai, Beijing, and Guangzhou to perform procurement activities in the mainland. Company A is considering setting up Company D on the mainland to take over the functions that the three representative offices perform.

Company A would completely shut down the Shanghai, Beijing, and Guangzhou representative offices subsequent to the commencement of Company D’s operations. Company A would transfer the staff of the three representative offices now stationed on the mainland. The staff would work for Company D going forward.

Company A will enter into a services agreement with Company D outside Hong Kong to engage Company D to perform the procurement services in the mainland for Company B. Under the services agreement, Company A will pay a service fee to Company D for these services that Company D rendered. The fee under the services agreement is based on cost plus 10%.

Company A will continue to receive commission income from Company B on the same basis as before the Company D services agreement. Company A will continue to appoint Company C as its service agent to perform the necessary administrative functions, and will pay its service fee on the same basis as before.

The Inland Revenue Department in Advance Ruling Case No. 23 held that Company A will not be subject to the profits tax on the commission income that Company A derives from the procurement services that Company D renders outside Hong Kong in respect of its participation in the arrangement.

ADVANCE RULING CASE NO. 26

The company is a member of the X Group, whose principal business is the production and trading of chemical products. The Group has production sites in various countries. The company performs its worldwide sales functions in Country B.

The Group incorporated the Company in Hong Kong during 2005–2006. The directors of the company are non–Hong Kong residents. The company is a wholly owned subsidiary of H Ltd., which carries on business in Country A.

The Group has started sourcing chemical S from Country C. The Company’s director has a well-established network in sourcing chemical S in Country C. The Group designated the company as X Group’s sourcing and sales representative of chemical S.

The company and H Ltd. have entered an agreement under which H Ltd. will handle the purchase and sale of chemical S to its territories, excluding Hong Kong. H Ltd. pays a commission to the company for enabling H Ltd. to derive trading profits in utilizing the director’s well-established network in Country C. The company does not maintain any office in Hong Kong, employ any staff in Hong Kong, apply any agent in Hong Kong, or operate any bank account in Hong Kong.

The Inland Revenue Department, in Advance Ruling Case No. 26, held that the company does not carry on business in Hong Kong. The department held that the commissions that the company received pursuant to the commission agreement are not chargeable to the Hong Kong profits tax under section 14. The Commissioner has assumed that the parties would implement the subject arrangement in the way stated in the ruling application and ruling. Section 14 provides that every person who carries on a trade, business, or profession in Hong Kong is subject to the profits tax on profits arising in or derived from Hong Kong. Unofficially, the Inland Revenue Department held that in the present case, the company has no business carried out in Hong Kong to earn the commission in question, making section 14 inapplicable.

ADVANCE RULING CASE NO. 30

The company is an affiliate of Y Group, whose principal business is the production and sale of motors. The company provides administrative services to Y Group in Hong Kong. During 2005–2006, Mr. X became the company’s majority shareholder and a director of the company. He has been residing in the PRC. Mr. X has extensive working experience and knowledge concerning a specific type of ship. He has developed a shipping industry business network in the Far East, excluding Hong Kong.

The company and a U.K. firm, R Company, will enter into a services agreement. The services agreement provides that the company will provide marketing research services to R Company. In addition, the services agreement provides that the company will introduce Far East suppliers and customers as to a specific type of ship to R Company in return for receiving service fees.

The company has set up an office in the PRC. Mr. X and the company’s staff in Hong Kong will perform all of the services set out in the agreement outside Hong Kong. The staff of the company’s Hong Kong office and the Hong Kong director will render none of the services arising from or in connection with the agreement. The staff of the company’s Hong Kong office and the Hong Kong director will continue to provide administrative services to Y Group in return for management fees. The management fees are subject to the Hong Kong profits tax.

The Inland Revenue Department, in Advance Ruling Case No. 30, held that the profits that the company derives in the performance of services set out in the agreement will not be chargeable under section 14 under the Hong Kong profits tax. The ruling presupposes that the Far East, and the Far East Region, does not include Hong Kong. In addition, the ruling presupposes that the company will not subcontract services the company provides under the agreement to Y Group, to the company’s affiliates, or to any other third parties.

As a commentary, the Inland Revenue Department provides that under section 14, every person who carries on a trade, business, or profession in Hong Kong is chargeable to profits tax on the profits arising in Hong Kong or derived in Hong Kong. The source of profits in the case of service fee income is the place where the provider performs the services. Unofficially, the Inland Revenue Department provided that, in the present case, the company’s profits emanating from the agreement are not chargeable to profits tax because the company performs all relevant services outside Hong Kong.

ADVANCE RULING CASE NO. 34

The company is principally engaged in the distribution of products (“the Products”) for a group of companies (“the Group”) in Hong Kong and the rest of Asia. The Group incorporated the company in Hong Kong. Factories outside Hong Kong manufacture the Products. The company is contemplating setting up a branch in Country X in Southeast Asia (“the Branch”) as part of the Group’s business plan to further expand into markets in Asia and in particular Southeast Asia.

The Branch will initially employ 26 personnel: 22 persons in the sales department, 3 persons in the marketing department, and 1 person in the accounting department. The Branch will purchase the Products directly from Group factories at arm’s length prices. The Branch will sell the Products to distributors/customers in countries in Southeast Asia based on mutually agreed prices. The Branch’s personnel will negotiate purchase and sales contracts, conclude these contracts, and execute these contracts. The Branch’s personnel will conduct these activities outside Hong Kong. The Branch in Country X will receive and approve all purchase and sale orders.

The company in Hong Kong will not be involved in the negotiation or the conclusion of the purchase or sale of the Products. In addition, the company in Hong Kong will not be involved in receiving or approving the purchase orders from distributors and customers.

The management of the Group is setting up a bonded warehouse in Country X to provide storage facilities for the Products. Management might first consolidate the Products in the warehouse or ship the Products directly to other countries in Southeast Asia depending on logistics and transportation needs of the distributors and customers in Southeast Asia from time to time.

The Branch will have bank accounts in Country X. The Branch’s personnel will handle all payments to factories and receipts from customers through the Country X bank accounts. The Branch’s personnel will handle all trade finance arrangements, such as letters of credit, guarantees, and so forth, through the Country X bank accounts.

The company in Hong Kong, to achieve economic efficiency, will provide information technology, finance, accounting, research, and other administrative support to the Branch. The company in Hong Kong will allocate the above-mentioned costs and expenses in providing these services to the Branch for statutory reporting in Country X.

The Inland Revenue Department, in Advance Ruling Case No. 34, held that the profits to be derived from the Branch are offshore sourced. Pursuant to section 14, the Hong Kong Inland Revenue Department will not tax those offshore profits. Under section 14 of the Inland Revenue Ordinance, every person who carries on a trade, business, or profession in Hong Kong is chargeable to profits tax on profits arising in Hong Kong or derived from Hong Kong.

The Inland Revenue Department considers, on an unofficial basis, the Branch in Hong Kong in this case to be a permanent establishment in Country X, where the personnel of the Branch will initiate, negotiate, conclude, and execute the purchase and sales contracts. The Inland Revenue Department views the functions that the company in Hong Kong performs as being ancillary in nature. Accordingly, section 14 does not apply to the Branch’s profits.

ADVANCE RULING CASE NO. 35

The company is engaged in the manufacture and sale of printing machinery and manufacture and sale of spare parts for such machinery. The company was incorporated in Country A, and the company manufactures spare parts in Country A. The company, apart from its own manufacture, purchases spare parts from ex–Hong Kong suppliers. The company sells its spare parts to global subsidiaries, which act as distributors in their local markets.

The company employs an independent warehouse manager (“Warehouse Manager”) to facilitate the distribution of these products to subsidiaries in the Asia Pacific Region. The company will locate its spare parts in Hong Kong on the premises of the Warehouse Manager.

The Warehouse Manager will undertake to perform these limited functions:

• The Warehouse Manager will neither display information nor provide information regarding the inventory.
• The Warehouse Manager will not communicate with the company’s customers.
• The Warehouse Manager will not be involved in any negotiation or conclusion of purchase or sale orders on behalf of the company.
• The Warehouse Manager will merely store the products safely and pack the products for shipment upon instructions from Country A company.

The Company will undertake these functions:

• The company will, in Country A, negotiate directly with third-party carriers for the delivery of spare parts from the Hong Kong stockpile to the customers.
• The company will not maintain any office in Hong Kong in regard to the purchase and sale of spare parts.
• The company will not employ any staff in Hong Kong in regard to the purchase and sale of spare parts.
• The company will not appoint any agent in Hong Kong in regard to the purchase and sale of spare parts.

The company in Country A will negotiate and conclude all spare parts purchases and sales contracts. The company in Country A will handle all paperwork and banking activities relating to purchases and sales.

The Inland Revenue Department, in making its determination for Advance Ruling Case No. 35, held that the company, pursuant to section 14 of the Inland Revenue Ordinance, will not be subject to the profits tax. Under section 14, every person who carries on a trade, business, or profession in Hong Kong is subject to tax on the profits arising in Hong Kong or derived from Hong Kong. The department reached its no-tax conclusion as to the company’s profits from the trading of such spare parts located in Hong Kong.

The Inland Revenue Department ruled unofficially that, in this case, the company did not effect any purchases or sales of spare parts in Hong Kong. Section 14 does not apply. The creation of a Hong Kong stockpile at the premises of a third-party Warehouse Manager will not alter the offshore nature of the profits the company derives from the trading of spare parts.

ADVANCE RULING CASE NO. 36

X Group is in the principal business of fish trading. X Group has business operations in various countries, and it bases its management team in Europe. Y Ltd. is a member of X Group. Y Ltd. has been carrying on business in Europe by managing the product requirements of companies within X Group. X Group began sourcing fish in Asian countries and formed the company in order to manage and expand X Group’s supplier base in Asia.

An agreement exists between the company and Y Ltd. (“the Agreement”). Pursuant to the Agreement, the company will receive remuneration from Y Ltd. for providing to Y Ltd. sourcing, procurement services, and other services as the agreement spells out. The company will employ local staff in Asian countries where the suppliers are located. The company will use that local staff to perform its services under the agreement. The company will not maintain any office, employ any staff, appoint any agent, or operate any bank account in Hong Kong as long as it has no supplier in Hong Kong.

The Inland Revenue Department, in response to Advance Ruling Case No. 36, held that the Hong Kong government will not tax profits to be derived by the company in providing services under the Agreement under section 14 of the Inland Revenue Ordinance. The ruling presupposes that the company will render no services in Hong Kong and that there is no supplier in Hong Kong.

As to services income, the Inland Revenue Department unofficially held that the source of profits is the place where the company performs the service that gives rise to service fee income. In this case, the government will not impose taxes on profits to be derived by the company from the agreement because the company’s relevant services take place outside Hong Kong.

ADVANCE RULING CASE NO. 37

The company is a member of an international group. The group incorporated the company in Country X. The company registered a branch in Hong Kong (“the Branch”). The company imported goods from affiliated companies and sold these goods to customers in Country X. The company set up the Branch to fulfill the customers’ requirements in Country X so that the company’s customers can manage the import-related logistics by themselves in a more efficient manner.

The company does not maintain any office in Hong Kong other than having a registered address. The company does not employ any employees in Hong Kong nor does it have agents in Hong Kong. Company staff in Country X carry out the sales and purchase transactions. The computer ordering system assists the company’s staff. The company benefits by having the Branch to make use of shorter customer payment terms under the arrangement compared with local payment terms, which are usually two to three times longer.

The procurement process works in this manner: The Country X prospective customers issue notice of procurement schedules for which the vendors are to bid. The company prepares for the bidding. The company’s key account managers will discuss the price and the product configuration with its Country X customers.

After the bidding process occurs, the company prepares and signs the sales and purchase contracts in the name of the Branch. The company’s general manager signs the purchase and sales contracts on behalf of the Branch and the Country X customers.

The sales and purchase contracts provide that the staff of the order desk of the company in Country X will input its customer orders into the ordering system. After that inputting process takes place, the ordering system will automatically generate the purchase orders in the name of the Branch. The ordering system will send these purchase orders to affiliated suppliers. The company sets purchase prices by using the resale price method (or market minus method). The company will not make any purchases from suppliers in Hong Kong.

The suppliers deliver the goods directly to the customers in Country X. The suppliers make the customers’ deliveries without transshipping the goods through Hong Kong. The company in Country X monitors the detailed delivery status. The company sends all shipping documents and suppliers’ invoices to the company in Country X to input these documents into the ordering system. The company issues customer invoices in the name of the Branch in Country X.

After the company delivers the goods to the customers, the company installs the equipment. The company provides after-sales service for its Country X customers. The company in Country X decides on credit limits extended to customers. The company makes some of these sales on letter-of-credit terms. The company’s finance staff in Country X negotiate the letters of credit with the Branch’s bank. The company in Country X monitors and follows up outstanding customer debts.

The company’s financial controller located in Country X undertakes the approval payment process. The company’s financial controller located in Country X and a shared service center in Country Y make payments to suppliers. The company’s financial controller operates the Branch’s bank account opened for the trading of goods.

The Branch books the profits it derives from the sales and purchase transactions the Branch invoiced in its name. The service center handles bookkeeping and accounting for the Branch transactions. The company’s financial controller in Country X approves these determinations.

The Inland Revenue Department, in examining Advance Ruling Case No. 37, held that the trading profits booked in the accounts of the company’s Hong Kong branch do not arise from Hong Kong; nor are these trading profits derived from Hong Kong. As such, these trading profits are not taxable pursuant to section 14(1) of the Inland Revenue Ordinance.

The Inland Revenue Department made material assumptions in making its determination:

• The suppliers and suppliers of the Branch are and will be located outside Hong Kong.
• Associates and companies in Hong Kong within the group will not carry on any business or trading activities on behalf of the Branch or on account of the Branch. This activity includes the preparation of trade documents.
• The existence of the Branch under the arrangement does not form a transaction or scheme or a part thereof contrived to avoid or evade any fiscal liabilities. These anti-avoidance provisions apply to Hong Kong and to other jurisdictions.
• The Branch that books its profits will report the result to the tax administration in Country X. These profits will be subject to tax in Country X under the company’s name.

Section 14 of the Inland Revenue Ordinance provides that every person who carries on a trade, business, or profession in Hong Kong is subject to the profits tax on profits arising in Hong Kong or derived from Hong Kong. The department commented unofficially that in this case, the company would not effect any contracts for purchase or sale of the goods in Hong Kong. The Inland Revenue Department held that the company’s trading profits are offshore sourced and are not taxed, making section 14 inapplicable.