Chapter Ten

Winning Hong Kong’s Landmark Transfer Pricing Case

Hong Kong had its first transfer pricing case, Ngai Lik Electronics Company Limited v. the Hong Kong Commissioner of Inland Revenue,1 in 2008. This case sheds light on Hong Kong’s judicial process in the transfer pricing context. Most importantly, the case examines sourcing and agency issues before the court addresses transfer pricing issues. We can expect the taxpayer and the Hong Kong Commissioner of Inland Revenue to continue to square off in the years to come.

NGAI LIK LITIGATION

The case at bar has had many gyrations, both in the Hong Kong administrative tax system and in the courts. The Hong Kong Commissioner of Inland Revenue brought an assessment against taxpayer, Ngai Lik Electronics Co. Limited, for five taxable years, 1991–1992 through 1995–1996. The taxpayer contested the Inland Revenue assessment before the Board of Review. The Board dismissed the taxpayer’s appeal but stated a case on a question of law for the Court of First Instance in this way: “Whether, on the facts bound by the Board, the Board erred in law by concluding that the Taxpayer and the other participants in the Scheme entered into or carried out the Scheme for the dominant purpose of enabling the Taxpayer to obtain a tax benefit?”

The Court of First Instance dismissed the taxpayer’s appeal, and the case went before the Court of Appeal. The Court of Appeal then rejected the taxpayer’s appeal,2 and the taxpayer brought an appeal before the Court of Final Appeal. The Court of Final Appeal allowed the taxpayer’s appeal, thus annulling the Commissioner’s additional assessments.3

HONG KONG’S ADVANCE RULING DETERMINATIONS

The Government of the Hong Kong Special Administrative Region began issuing substantive advance ruling case results in 2000. Hong Kong’s Inland Revenue Department issues these advance ruling case results infrequently—approximately four ruling cases per year. Many of these cases address the Inland Revenue Department’s taxability of business profits, often together with the department’s treatment of expense allocation and transfer pricing. The Inland Revenue Department does disclose the company subject to its review and changes the facts before issuing the rulings to the public. Nevertheless, certain advance ruling determinations may be applicable to the case at bar.

HONG KONG ISSUES TRANSFER PRICING GUIDELINES

The Inland Revenue of Hong Kong issued its “Transfer Pricing Guidelines— Methodologies and Related Issues” in December 2009. Inland Revenue formulated this approach as Departmental Interpretation and Practice Note No. 46. The Hong Kong Special Administrative Region (SAR) issued the transfer pricing guidelines for the information of taxpayers and their tax representatives, thus suggesting that Inland Revenue had preserved other nonpublic advice for the tax collector itself. Nevertheless, the guidelines were exceedingly clear regarding abusive tax schemes and the remedies to these schemes the Hong Kong Inland Revenue would pursue. These guidelines contain the Inland Revenue Department’s interpretations and practices in relation to Hong Kong’s transfer pricing law as this law stood at date of publication in December 2009.

The Hong Kong December 2009 transfer pricing guidelines follow closely the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, as revised earlier in 2009. Inland Revenue has not provided guidance as to whether it will follow the extensive revisions to the OECD Transfer Pricing Guidelines promulgated July 22, 2010,4 including the elevation of the transactional profit split method.5 The audit practice followed by the Inland Revenue Department, in general, does not differ from the transfer pricing methodologies recommended in the OECD guidelines. Nevertheless, there are significant issues of departure from the OECD guidelines and the Hong Kong guidelines, even with the 2009 OECD guidelines.

Five differences apply between the OECD Transfer Pricing Guidelines and the Hong Kong transfer pricing guidelines.6 The Hong Kong transfer pricing guidelines:

STATUTORY PROVISIONS

The Commissioner of Inland Revenue assessed the taxpayer based on section 61A of the Hong Kong Inland Revenue Ordinance, which provides a remedy to the Commissioner to counter tax avoidance. The ordinance divides section 61A into three parts:

Section 61A(1) enumerates these seven listed transactions to which the Commissioner is to undertake scrutiny:

DETERMINATION BY THE COURT OF FINAL APPEAL

The Court of Final Appeal reached a unanimous determination, reversing the Court of Appeal’s decision against the Commissioner.

Justice Ribeiro, in his determination of the case before the Court of Final Appeal as to the interpretation of section 61A to the facts of this case, concluded that three conditions need apply before the Commissioner can exercise her power under section 61A(2) to provide an additional assessment against the taxpayer. These three interlocking conditions are the transaction, the tax benefit, and the dominant purpose:

Justice Ribeiro would have the Commissioner identify “with some precision” the taxpayer’s tax benefit. The Commissioner can then examine the transaction in light of the seven enumerated matters to determine whether its sole or dominant purpose is to enable the taxpayer to obtain a tax benefit.

Barrie Barlow represented the taxpayer. Mr. Barlow argued that section 61A was inapplicable to the case at bar because the scheme created no “tax benefit.” Ambrose Ho and Joyce Leung, representing the Commissioner, sought to uphold the additional assessments.

THE COMMISSIONER’S DETERMINATION

The Commissioner formulated the scheme as consisting of eight steps:

DETERMINATION BY THE BOARD OF REVIEW

The Board of Review accepted the Commissioner’s formulation of the scheme and described the tax benefit in this manner: “The effect of the Scheme was to reduce the amount of the profits (manufacturing and trading) of the taxpayer.” The scheme reduced the amount of the profits allocated to Din Wai Electronics Limited through Din Wai Electronics Limited to Shing Wai, to Ngai Wai Plastic Manufacturing Limited, and to Shing Wai Limited. The whole of the profits thus allocated would not be taxable to the taxpayer. The scheme had the result of conferring a tax benefit on the taxpayer by reason of the reduction in the amount of the tax as a result of the allocation. The Board of Review concluded that dominant purpose of the taxpayer “and of other participants in the Scheme, was to enable the taxpayer to obtain a tax benefit.”

DETERMINATION BY THE COURT OF FIRST INSTANCE

Judge Reyes, speaking for the Court of First Instance, acknowledged that, insofar as the manufacturing profits of Din Wai Electronics Limited, Shing Wai Limited, and Ngai Wai Plastic Manufacturing Limited arose offshore, these profits were not taxable in Hong Kong. Nevertheless, Judge Reyes upheld the decision by the Board of Review on the basis of findings that:

• The taxpayer had engaged in manufacturing-related activities.
• The pricing mechanism operated by the taxpayer and Din Wai Electronics did not result in arm’s length prices being paid by the taxpayer.
• This operated to allocate some of Ngai Lik’s assessable profits to Din Wai Electronics, and these profits “could be spread around” through the price setting and discount arrangement between Din Wai Electronics on one hand and on Shing Wai, Shing Wai Limited, and Ngai Wai Plastic Manufacturing Limited on the other hand.

Judge Reyes also took into account the Board’s finding in relation to the agency agreements that the 5% that the taxpayer was entitled to charge thereunder “was not enough to cover even the costs of Ngai Lik’s disbursements on behalf of the other companies.” Judge Reyes stated that “but for the scheme involving after the fact price-setting by accountants, arbitrary additional discounts and low management fees, Ngai Lik’s assessable profits (and thus its liability to profits tax) would have been greater.” But for the scheme, Ngai Lik presumably would have been charged a lower price (reflecting market profit) for goods supplied by Din Wai Electronics. It would also have earned higher fees for the manufacturing-related services that it provided to the BVI companies. Judge Reyes concluded that the Board of Review was entitled to reach a conclusion that the dominant purpose of the scheme was to enable the taxpayer to obtain a tax benefit.

DETERMINATION BY THE COURT OF APPEAL

The Court of Appeal reviewed the opinion reached by the Court of First Instance. The appellate court had a three-judge panel consisting of Judges Le Pichon, Stone, and Chu. Le Pichon issued an opinion to the case at bar, to which Stone and Chu agreed. The court noted that the Ngai Lik group carried out all of its manufacturing work in mainland China by the three BVI companies. Nevertheless, the taxpayer Ngai Lik Electronics Company Limited had on its payroll a small staff that would order materials as an agent for Shing Wai and Ngai Wai Plastic. The taxpayer had on its payroll a team for sourcing materials on behalf of Din Wai Electronics.

The Court of Appeal noted that the taxpayer prepared and processed purchase orders in Hong Kong. The taxpayer had a storage area for goods and purchased raw materials. If the taxpayer had the goods and raw materials delivered in Hong Kong, the taxpayer would transport the goods and raw materials by trucks owned by the group. The taxpayer made periodic remittances to manufacturing subsidiaries associated to local government corporations.

Based on these mentioned facts, the Court of Appeal upheld the Board of Review’s finding that the taxpayer continued its substantial involvement in manufacturing even after the taxpayer relocated the group’s production facilities to the mainland in 1987. That substantial involvement gave rise to a “manufacturing element in the taxpayer’s profits.” Judge Le Pichon thought the taxpayer had reflected this manufacturing element in its financial statements prepared prior to the reorganization.

The Court of Appeal focused on adoption and application of the taxpayer’s transfer pricing policy and on the derisory level of management fees, not to mention their nonpayment as between the taxpayer and Din Wai Company. Judge Le Pichon considered the above-mentioned matters to be features of the scheme that did not arise from dealings at arm’s length and cannot be explained as a means of minimizing the taxpayer’s taxable income. Judge Le Pichon held that it was unnecessary for section 61A purposes to quantify the tax benefit; nevertheless, Judge Le Pichon considered that these facts demonstrated the section 61A benefit: The taxpayer’s contribution to the profits of the group dropped from 31.19% in 1991–1992 to 7.19% in 1995–1996. At the same time, the profitability of Shing Wai Hong Kong and the three BVI companies rose accordingly.

Judge Le Pichon then addressed the dominant purpose of the transaction, stating that the scheme was replete with features designed to enable the taxpayer to manipulate and shift its income offshore to its fellow subsidiaries. At the very heart of the scheme was the free hand to rewrite the acquisition cost after the event on an annual basis. The dealings between the taxpayer on one hand and Shing Wai Hong Kong and the three BVI companies on the other hand plainly were not at arm’s length. There was a total absence of any commercial reason or other legitimate reason for the transaction. Accordingly, it is hardly surprising that the Board of Review, having considered the various matters set out in section 61A(1), came to the conclusion that “the dominant purpose” of the taxpayer was to confer a tax benefit on the taxpayer.

THE CASE BEFORE THE COURT OF FINAL APPEAL

According to the Court of Final Appeal, the central feature of the tax benefit, as characterized by the Board of Review, was that it had the effect of reducing the amount of the tax payable by the taxpayer by reducing the amount of the profits, both manufacturing and trading, to the taxpayer by the amounts allocated to Din Wai Electronics Limited and through Din Wai Electronics Limited to Shing Wai Co. Limited, to Ngai Wai Plastic Manufacturing Limited, and to Shing Wai Limited.

The Court of Final Appeal sought to identify the scheme, as formulated, with the tax benefit, as so identified. The Court of Final Appeal examined the eight points of the scheme, as formulated by the Commissioner. The Court narrowed significantly the scope of the scheme: “It is obvious that Items (1) to (7) of the Scheme merely give an account of certain steps taken in the reorganization of the taxpayer’s business. They do not, in themselves, produce any tax benefit. The Commissioner’s case depends on Item (8) of the Scheme” (i.e., the adoption of the transfer pricing policy). The Court of Final Appeal, then, vitiates the heart of the scheme, the use of BVI corporations for mainland operations.

The Board of Review interpreted these facets of the scheme, as conferred by three facets of the taxpayer’s transfer pricing policy after the company transferred the business to the BVI companies, per Item 8:

DEFICIENCIES IN THE SCHEME AS TO ADDITIONAL ANNUAL BULK DISCOUNTS RECEIVED BY DIN WAI ELECTRONICS LIMITED

The Court of Final Appeal examined the ramifications concerning additional annual bulk discounts as to the tax benefit. Writing for the Court, Justice Ribeiro held that the providing of additional annual bulk discounts “clearly lacks any connection with the Tax Benefit.” As formulated by the Commissioner, Ngai Lik’s tax benefit was the reduction of the taxpayer’s profits by the amount allocated to Din Wai Electronics Limited. The objectionable amount is the price-fixing mechanism that Din Wai Electronics Limited and the taxpayer adopted. The thrust of the Commissioner’s complaint is that this price-shifting mechanism enabled the taxpayer to pay to Din Wai Electronics an inflated price for the finished goods, resulting in a corresponding reduction of the taxpayer’s taxable income. The taxpayer allocated the profits to Din Wai Electronics Limited, which was outside the purview of the Hong Kong tax authorities. The taxpayer allocated profits away from Ngai Lik, which was taxable in Hong Kong.

The Court of Final Appeal then concluded that the additional annual discount amounts given to Shing Wai (Hong Kong), Shing Wai Limited, and Ngai Wai Plastic Manufacturing Limited to Din Wai Electronics Limited, as referred to Item 8(c) of the scheme, involved different transactions between different parties. The additional annual discounts, according to the Court of Final Appeal, had no impact at all on the taxpayer’s profits or its liability to tax. The Court views that the effect of the additional annual discount amounts was to diminish the profits of Shing Wai (Hong Kong), Shing Wai Limited, and Ngai Wai Plastic Manufacturing Limited and to swell the profits of Din Wai Electronics Limited. The Commissioner has viewed the shifting as being artificial. In contrast, the Court of Final Appeal viewed the additional annual discount amounts as having no connection with the tax benefit conferred on the taxpayer by the pricing mechanism and that the Commissioner should not have included the additional annual discount amounts in the scheme.

The Court of Final Appeal then returned to the Board of Review’s formulation to consider whether such additional annual discount amounts were the means by which the taxpayer “allocated” profits to Din Wai Electronics Limited, and through Din Wai Electronics Limited to Shing Wai (Hong Kong), Ngai Wai Plastic Manufacturing Limited, and Shing Wai Limited.

Judge Reyes, writing for the Court of First Instance, had commented that “the profits allocated to Din Wai Electronics as a result of the price-setting mechanism could be spread around among Shing Wai and Ngai Wai Plastic.” Judge Le Pichon, writing for the Court of Appeal, commented that the scheme “was replete with features designed to enable the taxpayer’s assessable profits to be manipulated and shifted offshore to its fellow subsidiaries.”

The Court of Final Appeal commented that the last suggestion is inconsistent with the self-evident effect of the additional discounts, as found by the Board of Review. The other fellow subsidiaries gave these additional discounts to Ngai Wai Plastic Manufacturing Limited. The Court of Final Appeal concluded these additional discounts did not involve Din Wai Electronics passing on to these fellow subsidiaries any amounts that the taxpayer should have declared as part of its taxable profits. The flow of finance was in the opposite direction. The effect of the additional discounts was to diminish the profits of those other fellow subsidiaries and to augment Din Wai Electronics’ profits.

Ambrose Ho, representing Hong Kong’s Department of Justice, accepted that Item 8(c) of the scheme is irrelevant. Further, aspects of Items (1) through (7), which address the formation of Shing Wai, Shing Wai Limited, and Ngai Wai Plastic and the agreements among those companies, and between those companies, are also irrelevant.

DEFICIENCIES IN THE SCHEME AS TO MANUFACTURING PROFITS

The tax benefit, as contended by the Commissioner, involves the allegation that the effect of the scheme was to reduce the amount of the profits, both the taxpayer’s manufacturing income and the taxpayer’s trading income, by the amounts that the taxpayer allocated to Din Wai Electronics Limited and through Din Wai Electronics Limited to Shing Wai, to Ngai Wai Plastic Manufacturing Limited, and to Shing Wai Limited. Justice Ribeiro, writing for the Court of Final Appeal, expressed his puzzlement regarding a reference to manufacturing profits in the Commissioner’s contention. Justice Ribeiro commented that Item 8(a) and Item 8(b) can be readily understood to be an alleged reduction in the taxpayer’s trading profits resulting from the annual price-fixing mechanism but questioned whether that taxpayer had any manufacturing profits to allocate.

Justice Ribeiro continued his attack on the concept that the taxpayer allocated manufacturing profits, stating that if the taxpayer did indeed have manufacturing profits from the source, the scheme does not identify any transaction conferring a tax benefit as to such profits. In contrast, the Commissioner alleged a scheme with a tax benefit that involves manipulation of the prices at which Din Wai Electronics Limited sold the goods to the taxpayer (i.e., transactions that affect the taxpayer’s trading profits standing alone).

Justice Ribeiro commented that the Commissioner’s reference to manufacturing profits is not a mere slip of the pen. The Board of Review had laid heavy emphasis on the taxpayer earning such manufacturing profits in Hong Kong. The Board took the view that the Commissioner was justified in making the additional adjustments unless the taxpayer could show that it could allocate more than 50% of these profits to its fellow subsidiaries operating on the mainland.

The Board of Review, in addressing the issue of manufacturing profits, noted that, before the scheme, the taxpayer included manufacturing as part of the taxpayer’s business. The Board cited the taxpayer’s financial statements for the 1988–1990 through 1990–1991 tax years. In contrast, the company treated the entire income (manufacturing income and trading income) as subject to Hong Kong taxation for 1988–1989 and 1989–1990. The taxpayer claimed that slightly more than half of its profits, 50.6%, for 1990–1991 were offshore and not taxable. The taxpayer did much to earn the manufacturing profits in Hong Kong prior to effectuation of the scheme. Since the taxpayer effectuated the scheme, the taxpayer still did much to earn the manufacturing profits allocated to Shing Wai and to the three BVI companies, doing so in Hong Kong.

Hong Kong Inland Revenue’s Interpretation and Practice Notes No. 21 generally provided for a 50–50 split as to manufacturing income and trading income but permitted a taxpayer to exclude more than 50% in limited circumstances. The Board of Review, commenting on the case at bar, stated that unless the taxpayer could make good claim for apportionment, which it could make as to 50% of the manufacturing profits as being offshore profits, the best it could hope for was a 50–50 apportionment under the Revenue’s Departmental Interpretation and Practice Notes No. 21.

Justice Ribeiro concluded that the Board of Review’s approach regarding the 50–50 split as to manufacturing income and trading income directly relates to the manner in which the Commissioner determined the additional tax assessment (i.e., by purporting to treat half of the manufacturing profits of the taxpayer’s fellow subsidiaries on the mainland as the taxpayer’s profits arising in Hong Kong). Justice Ribeiro then concluded that it is necessary to examine the suggestion that the taxpayer earned such manufacturing profits as a matter of substance.

Section 14 of the Inland Revenue Ordinance provides that the profits of a business that arise offshore are not taxed in Hong Kong, a well-established principle not in dispute. This exemption applies when the taxpayer carries on a business in Hong Kong so long as the profits in question derive from its operations abroad. Section 14(1) of the Inland Revenue Ordinance looks to taxable income “arising in or derived from Hong Kong.” Judicial decisions have accepted this allocation approach. Judge Lord Bridge of Harwich noted in CIR v. Hang Seng Bank Ltd.7 that the structure of the section presupposes that the profits of a business may accrue from different sources, some located within Hong Kong, others overseas. Activities in Hong Kong are taxable; the other activities are not taxed in Hong Kong.

Judge Lord Bridge of Harwich noted in CIR v. Hang Seng Bank Ltd. that the taxpayer may ensure that the local and offshore businesses are clearly separated by ensuring that the separate businesses of the overseas branch are carried out by a separate company or subsidiary company. Justice Ribeiro commented that this separate entity structure should be borne in mind when considering the respective activities in Hong Kong and its fellow subsidiaries on the mainland.

The Court of Final Appeal, through Justice Ribeiro, then reviewed the source rule issues impacting the case at bar. After the reorganization in 1987, the taxpayer operated manufacturing businesses in the mainland. Din Wai Electronics Limited then sold the finished products to the taxpayer. The taxpayer then sold the finished products to its customers. Justice Ribeiro concluded that “it cannot be in doubt that the relevant manufacturing processes took place outside of Hong Kong.” Justice Ribeiro further commented that the profits from these operations would not be chargeable to Hong Kong since the taxpayer would source these activities offshore.

Justice Ribeiro viewed source rules as being a country-by-country determination. Moreover, it is clear that those operations and “those profits were not those of the taxpayer but of its fellow subsidiaries.” Those profits were then not within the purview of section 14. The Board of Review’s focus was on sourcing and agency activities:

• The taxpayer’s activities undertaken in connection with the sourcing of raw materials for use by its fellow subsidiaries in the manufacturing process
• The taxpayer’s activities undertaken in connection with other agency services the taxpayer provides

The Board of Review thought that the taxpayer’s involvement in the sourcing activity and the agency activity meant that the taxpayer continued to have a manufacturing business and that the taxpayer should treat half of such manufacturing business as arising offshore. Thus, the Board equated the taxpayer’s sourcing and agency activities with an involvement in manufacturing. Justice Ribeiro rejected outright the concept that the taxpayer continued to be involved in manufacturing, reaching that conclusion despite the fact that the taxpayer had teams for ordering materials and for sourcing materials as agent, preparing and processing purchasing orders, and had representative and services agreements. Instead, Justice Ribeiro viewed the above-mentioned activities as being trading transactions.

Justice Ribeiro acknowledged that the above-mentioned activities could be described as “involving manufacturing” or as Judge Reyes, speaking for the Court of First Instance, described as “manufacturing-related activities,” these activities were at most “ancillary and incidental” to the offshore manufacturing operations. The manufacturing profits arose only on the disposal of the manufactured goods, but the presence of such incidental activities does not provide the basis for locating profits in Hong Kong. Justice Ribeiro viewed the activities as being antecedent activities, activities that do not meet the legal test to determine the source of profits.

Nevertheless, Justice Ribeiro acknowledged that sourcing and agency activities might give rise to taxable income. In this regard, Justice Ribeiro focused on the services incurred pursuant to the representative and service agreements, and according to Judge Le Pichon, was set at a derisory level and was frequently unpaid. Justice Ribeiro then commented that the Commissioner did not identify the underpayment of management or service fees either as part of the scheme or as part of the tax benefit, nor did the Commissioner seek to counteract any tax benefit the taxpayer received for undercharging its sourcing and agency services. Justice Ribeiro viewed the references to the Board of Review and courts below as being “wide of the mark.”

DEFICIENCIES IN THE SCHEME AS TO THE RELEVANT YEARS OF ASSESSMENT

Justice Ribeiro challenged timing issues connected to section 61A. The scheme itself connotes the transfer of activities taking place in April 1993 to BVI companies and the adoption of the transfer pricing after the transfer of the BVI companies, meaning that the starting point as to the objectionable transactions took place after April 1993. The Commissioner cannot prevail as to 1991–1992 and 1992–1993 from a time standpoint.

ARE THE SCHEME AND THE TAX BENEFIT STILL VIABLE BASES FOR SECTION 61A ASSESSMENTS?

Justice Ribeiro concluded that the Board of Review’s formulation of the scheme and benefit suffered from three serious deficiencies:

Justice Ribeiro then raised two questions:

Justice Ribeiro concluded affirmatively to the first inquiry, suggesting that Items 8(a) and 8(b) remain, and the tax benefit remains after deleting all references to manufacturing profits and to allocation of profits. This would leave the contention, which, according to Justice Ribeiro, was “always the heart of the case,” that the price-fixing arrangement with Din Wai Electronics Limited had the effect of conferring on the taxpayer a tax benefit involving a reduction of taxable income.

Justice Ribeiro then addressed the second inquiry, suggesting that such a de facto amendment is possible providing the amendment is consistent with the findings of the Board of Review, meets the statutory definitions, and does not create unfairness to the taxpayer. Justice Ribeiro viewed this truncated approach as permitting the Commissioner to put the case in alternative ways. Section 61A(2)(a) permits the Commissioner to fashion her assessment as a response to “any part of” a transaction caught by any provision.

IS THERE A “TAX BENEFIT” WITHIN THE MEANING OF SECTION 61A?

Counsel for the taxpayer, Barrie Barlow, contended that, even if the Court strips away the “earlier irrelevances,” there was no “tax benefit” within the meaning of section 61A. Mr. Barlow characterized the price-fixing arrangement as being “gratuitous payments” enabling the taxpayer to overstate the cost of acquiring the finished products and therefore to make “unjustified deductions” against the profits arising from their sale to customers. The taxpayer, then, according to Mr. Barlow’s approach, understated its taxable income.

Justice Ribeiro rejected Mr. Barlow’s approach as to the “gratuitous payments” and “unjustified deductions,” suggesting that the payments are not gratuitous payments but reflect payments made in return for goods ordered and delivered. Further, Justice Ribeiro did not accept that such payments were “impermissible deductions.” In addition, Justice Ribeiro concluded that excessive prices do not necessarily lead to the disallowance of deductions.

Section 16 of the Inland Revenue Ordinance permits the taxpayer to deduct expenditures to the extent that the taxpayer incurs these expenditures in the production of the taxpayer’s profits. Section 17 of the Inland Revenue Ordinance excludes as deductions of disbursements or expenses that the taxpayer does not expend for the purpose of producing such profits. Mr. Barlow took the position that the above-mentioned sections did not require the Commissioner to compare the purchase prices deducted against market prices and to disallow deductions the Commissioner views as excessive. Justice Ribeiro accepted Mr. Barlow’s view of these sections, thus precluding the Commissioner from disallowing deductions on the basis that a price paid was not reasonable. Thus, Justice Ribeiro took the position that the taxpayer can deduct all expenses if the taxpayer incurs these expenditures in the production of the taxpayer’s profits.

THE NARROWER SCHEME AND THE NARROWER TAX BENEFIT

The case addresses both the narrower scheme and the narrower tax benefit—two different approaches to section 61A:

Justice Ribeiro held that, according to findings made by the Board of Review, the taxpayer’s payments made pursuant to the narrower scheme were deductible. Following the approach taken by the Court of Final Appeal, the taxpayer did successfully alter its legal liability in the narrower scheme. The taxpayer could claim these deductions that, but for Section 61A, would have the effect of conferring a tax benefit on the taxpayer.

Justice Ribeiro then addressed Lord Hoffmann’s determination of the tax benefit in CIR v. HIT Finance Ltd.8 and CIR v. Tai Hing Cotton Mill (Development) Ltd.9 In CIR v. Tai Hing, Lord Hoffmann stressed the need to compare the effect of the transaction on the taxpayer’s tax liability against its tax liability on some other basis. Lord Hoffmann looked to causation and comparison under section 61A. “If the effect of the transaction is that your liability to tax is less than it would have been on some other appropriate hypothesis, you have had a tax benefit.” In CIR v. HIT Finance, Lord Hoffmann described the tax benefit as a “difference favourable to taxpayer” based on “his tax liability computed on one basis and his liability computed on a different basis.”

The Court of Final Appeal concluded that the Commissioner made an error in not mounting a challenge based on sections 16, 17, 60, and 61A rather than just on section 61A. Justice Ribeiro commented that the Commissioner initially proceeded with all four sections and then later abandoned them but for section 61A.

DOMINANT PURPOSE OF THE NARROWER SCHEME

Justice Ribeiro then sought to assess whether the taxpayer and Din Wai Electronics Limited entered into the price-fixing arrangement with the sole purpose or the dominant purpose of obtaining a tax benefit for the taxpayer. The Court of Final Appeal then examined the seven items listed in section 61A(1)(a) through section 61A(1)(g). Justice Ribeiro noted that sections 61A(1)(a), section 61A(1)(b), and section 61A(c) provide guidance on methodology (i.e., the manner in which the Commissioner is to approach the facts in determining the question of dominant purpose). In contrast, section 61A(1)(d), section 61A(1)(e), section 61A(1)(f), and section 61A(1)(g) point to certain fact classes as possible signposts to the requisite dominant purpose. The Court of Final Appeal went through a point-by-point analysis:

• Section 61A(1)(a) tells us that it is permissible for the Commissioner to look at the genesis of the transaction and at the manner in which the taxpayer implemented the transaction.
• Section 61A(1)(b) tells us that it is permissible for the Commissioner to look beyond the form and substance of the transaction.
• Section 61A(1)(c) requires the Commissioner to assess the fiscal effects of the overall transactions.
• Section 61A(1)(d) and Section 61A(1)(e) require the Commissioner to look at the financial effects of the particular scheme on the taxpayer and on persons connected with the taxpayer. Under section 61A(1)(d), the scheme might bring about no changes to the taxpayer’s financial position while, at the same time, producing a tax benefit. Under section 61A(1)(e), the scheme might involve transactions among group members resulting in an unchanged financial position for the group as a whole but confer a tax benefit on the taxpayer. The hallmark of the tax avoidance is that the taxpayer reduces its tax liability without incurring its economic consequences.
• Section 61A(1)(f) can specify that the scheme might incorporate dealings that are not at arm’s length and may suggest that the taxpayer entered into transactions for the dominant purpose of producing a tax benefit for the taxpayer.
• Section 61A(1)(g) can suggest participation in an offshore corporation in the transaction, and might indicate the requisite “dominant purpose.”

BOARD OF REVIEW’S APPROACH

The Board of Review emphasized the genesis of the transaction and the manner in which the taxpayer implemented the transaction under section 61A(1)(a), that is, the manner in which the taxpayer entered into and carried out the transaction. The Board regarded the advice given by Ernst & Young (E&Y) was meant as a tax benefit for the taxpayer. Justice Ribeiro thought that this objective as viewed by the Board as being “obviously correct,” as the taxpayer achieved this goal by segregating Hong Kong operations and offshore activities to segregate taxable income from nontaxable profits.

In contrast, Justice Ribeiro viewed the statutory purpose of section 61A was not to attack arrangements that the taxpayer has made to secure its tax benefits, especially in situations in which the legislature had intended these benefits to be available to the taxpayer. As Lord Norlan pointed out in IRC v. Willoughby,10 it would be absurd in the context of the relevant anti-avoidance legislation to describe as tax avoidance the acceptance of an offer of freedom from tax that Parliament has deliberately made.

E&Y had provided advice to Ngai Lik, but the advice that E&Y provided did not pertain to the narrower scheme. Justice Ribeiro commented that E&Y never had suggested any annual price-fixing arrangement between Din Wai Electronics Limited and Ngai Lik. In contrast, E&Y suggested that the taxpayer set up a master supply arrangement having a 10% price margin over the cost of purchasing items from the cheapest alternative supplier. The advice that E&Y provided to Ngai Lik, then, was not relevant to paragraph 61A(1)(a).

The Board of Review had considered the manner in which the parties conducted the transaction to be highly significant, not only pursuant to paragraph 61A(1)(a) but also under most of the paragraphs under section 61A for three reasons:

Justice Ribeiro, writing for the Court of Final Appeal, found those conclusions of the Board to be “misdirected.”

RIBEIRO’S DOMINANT PURPOSE OF THE NARROWER SCHEME

Justice Ribeiro, while concluding that the above-mentioned conclusions of the Board to be “misdirected,” did specify that the findings relating to arm’s length transactions are “properly relevant to the Narrower Scheme and to the Narrower Tax Benefit.” The Board noted that the taxpayer did not follow the agreement under which the landed cost of each delivery exceeded by more than 10% the costs of an alternative supplier or unless Din Wai Electronics Limited was unable to supply the quantity or quality required. Relying on Mr. Lam’s statement that the accounting department determined the price sold by Din Wai Electronics Limited to the taxpayer, the Board stated that this activity points to “manipulation of the amount of profits” transferred from the taxpayer to Din Wai Electronics Limited.

The Board of Review, in examining the Ngai Lik–Din Wai Electronics Limited relationship, accepted payments of 10% more than the costs of alternative supplier as being arm’s length. The Board failed to further analyze this cost-plus-10% arrangement as being arm’s length—an issue that Justice Ribeiro failed to address. Instead, the Board’s focus was not on the agreement itself but on deviations made from this agreement by the accounting department.

The Board of Review found that the taxpayer’s profits dropped. The taxpayer’s contribution to the profits dropped from 31.19% in 1991–1992 to 7.19% in 1995–1996. Justice Ribeiro found that conclusion by the Board of Review to be relevant in determining the dominant purpose of the narrower scheme, stating that these conclusions “provide a proper basis” for concluding that the taxpayer entered into the price- fixing arrangement with Din Wai Electronics Limited for the dominant purpose of obtaining a tax benefit for the taxpayer.

Justice Ribeiro held that three portions of section 61A(1) are of particular importance to that conclusion:

Justice Ribeiro based a conclusion on the fact that because Ngai Lik and Din Wai Electronics Limited had entered into “an ostensibly binding master agreement” that required Ngai Lik to scrutinize Din Wai’s Electronics Limited’s prices against competing supplier’s prices, the price-fixing arrangement superseded the binding master agreement. Ngai Lik’s accounting department determined the prices at which Din Wai Electronics Limited sold the finished audio products to Ngai Lik.

Justice Ribeiro commented on Ngai Lik’s change in financial position that resulted from the price-fixing arrangement. The arrangement reduced Ngai Lik’s profits to the extent that the arrangement inflated Din Wai Electronics Limited’s price, producing the tax benefit. Justice Ribeiro criticized the Board of Review for not quantifying the extent of this inflation.

Justice Ribeiro then postulated the changes made by the narrower scheme to the financial position of the group (the group consisted of companies that had a “connection with” the taxpayer within the meaning of section 61A(1)(e)). Justice Ribeiro then concluded that the change in financial position of the group, “significantly, is ‘None.’” The path that Justice Ribeiro took would validate all tax haven restructuring, whether to Bermuda, as in the case of Ngai Lik Industrial Holdings Limited, to BVI, as in the case of the other Ngai Lik companies, or to other tax-haven entities. This stance on the part of Justice Ribeiro would put section 61A(1)(e) clearly in conflict with the tax-haven provisions in the Hong Kong transfer pricing guidelines.

Justice Ribeiro looked at an aggregate approach that equates tax-haven entities with taxable entities, providing this aggregate information:

The Board of Review found that the taxpayer’s contribution of the group profits fell from 31.19% in 1991–1992 to 7.19% in 1995–1996, which, according to Justice Ribeiro, “plainly suggests” that the narrower scheme profits “diverted” profits away from the taxpayer. Justice Ribeiro concluded that “when one asks why the parties entered into the price-fixing arrangement which resulted in group profits being passed from one pocket to another, the irresistible conclusion is that this was done with ‘the dominant purpose’ of obtaining a tax benefit for the taxpayer.” Justice Ribeiro concluded that the Commissioner engaged section 61A, but only as to three tax years from 1993–1994 to 1995–1996. The Commissioner, by virtue of section 61(A)(2), became bound to assess the taxpayer’s tax liability. Mr. Barlow, representing Ngai Lik, then argued that the Commissioner misapplied her powers in making the additional assessment claim.

COMMISSIONER’S ASSESSMENT POWER

Section 61A(2) enables the Commissioner to proceed against the taxpayer under two alternative theories:

As to the second of the two options, the Commissioner must design an assessment based on a “reasonable postulated hypothetical transaction that produces an assessment designed rationally to counteract the tax benefit.” The assessment cannot be raised in some arbitrary amount or arrived at on some basis that is unreasonable or is not rationally related to the tax benefit in question. For example, the Commissioner cannot select an alternative transaction that attracts the highest tax rate. However, the Commissioner can take appropriate steps to counteract the taxpayer’s unwarranted benefit, such as disallowing the interest deduction on a borrowing that is in excess of the net proceeds of a loan.

COMMISSIONER’S EXERCISE OF THE SECTION 61A(2) POWER

Justice Ribeiro held that the Commissioner seriously miscarried the exercise of the section 61A(2) power in Ngai Lik. The Commissioner sought to treat the whole of the profits of Shing Wai Co. Limited and the three BVI companies as the taxpayer’s chargeable profits. The Commissioner then reduced these assessments by half (i.e., assessments that treated half of the profits of the taxpayer’s fellow subsidiaries as the taxpayer’s assessable profits in Hong Kong).

Justice Ribeiro concluded that these additional assessments (i.e., the entirety of the profits or half the profits) are not based on the first of the two alternatives the Commissioner can select. The Commissioner did not raise these additional assessments based on whether the parties carried out their price-fixing arrangements. Instead, the Commissioner was evidently purporting to exercise the second alternative with a view toward counteracting the tax benefit in question. In other words, the Commissioner was purporting to counteract non–arm’s length transactions that had reduced the taxpayer’s taxable income.

The Court of Final Appeal concluded that the Commissioner did not reach its objective by raising the additional assessments. The Commissioner could have created an assessment based on the profits that the taxpayer hypothetically could have earned if the taxpayer had purchased the goods at arm’s length prices instead of at the prices fixed annually. Instead of applying this approach, the Commissioner raised an assessment equal to half of the profits derived by the taxpayer’s fellow subsidiaries from their operations on the mainland. Justice Ribeiro held that is “impossible to see any rational connection between that figure and the excessive prices allegedly paid by the taxpayer to Din Wai Electronics Limited.” In short, the additional assessments raised do not counteract the relevant tax benefits.

Justice Ribeiro appeared to be puzzled by the Commissioner’s approach. “It appears that” the Commissioner adopted the 50% figure simply on the Revenue’s practice concerning the apportionment of profits that are attributable to offshore operations. Nevertheless, Justice Ribeiro contended that the Commissioner failed to properly exercise her section 61A(2) powers in raising the additional assessments. Justice Ribeiro held that the Commissioner miscarried her power.

BOARD’S APPROACH TO THE EXERCISE OF THE SECTION 61A(2) POWER

The Board of Review made its assessment under section 61A(2)(a) rather than under section 61A(2)(b). The Board stated that the taxpayer’s manufacturing activities were clearly not wholly offshore. The taxpayer had not made any claim for apportionment and had not made good any claim for apportionment of more than 50% of the manufacturing profits as offshore profits, the onus being on the taxpayer to prove that the assessments appealed against were incorrect or excessive. Unless the taxpayer could make good any claim for apportionment that it might make of the more than 50% the manufacturing profits as offshore profits, the best it could hope for was a 50–50 apportionment under the Revenue’s Departmental Interpretation and Practice Notes No. 21.

The Board upheld the additional assessments. Nevertheless, Justice Ribeiro held that “no basis exists for treating any share of the manufacturing profits of the fellow subsidiaries as the taxpayer’s assessable profits.” Justice Ribeiro further held that “there is a clear mismatch between the Board’s approach and the content of the scheme and tax benefit which engages section 61A.” The Court of First Instance and the Court of Appeal did not deal with the validity of the Commissioner’s exercise of the section 61A(2) power.

DISPOSAL OF THE APPEAL

The Court of Final Appeal terminated the Commissioner’s additional assessment for 1991–1992 and 1992–1993. In contrast, for 1993–1994, 1994–1995, and 1995–1996, the Court found section 61A(2) to be relevant and mandatory under the “shall access” terminology. “It follows that since section 61A(1) is engaged in relation to those three years of assessment, the Commissioner ought in principle to carry out her duty under section 61A(2) by raising additional assessments on a proper basis, taking into account the opinion of this Court.” Justice Ribeiro provided that such fresh assessments should be aimed at counteracting the tax benefit derived from the price-fixing arrangement for the years in question.

Finally, the Court of Final Appeal acknowledged that there might be difficulties in trying to ascertain what such arm’s length prices might have been. One could not expect the exercise to be conducted in great detail or with a high degree of precision. The Court suggested that parties determine a “reasonable estimate of the taxpayer’s assessable profits.” The Commissioner’s aim ought to be to arrive at a figure that assessable profits deriving from dealings at arm’s length would at least have attained.

NOTES

1. Ngai Lik Electronics Company Limited v. the Hong Kong Commissioner of Inland Revenue, FACV No. 29 of 2008.

2. CACV No. 22 of 2008.

3. Final Appeal No. 29 of 2008 (CIVIL).

4. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Paris: July 22, 2010).

5. R. Feinschreiber and M. Kent, “What You Need to Know About the Transactional Profit Split Method,” Corporate Business Taxation Monthly (February 2011):29.

6. R. Feinschreiber and M. Kent, “Hong Kong Issues Transfer Pricing Guidelines,” Corporate Business Taxation Monthly (March 2010): 17.

7. CIR v. Hang Seng Bank Ltd. [1991], 1AC 306 at 318.

8. CIR v. HIT Finance Ltd. [2007], 10 HKCFAR 717.

9. CIR v. Tai Hing Cotton Mill (Development) Ltd. [2007], 10HKCFAR 704.

10. IRC v. Willoughby [1997], 1 WLR 1071 at 1079.