The Li & Fung (Trading) Limited case was regarded as an agency case, whereby the Hong Kong agent (principal) provided services to its non-related customers in connection with the manufacture, sale and purchase of goods. Such services included finding suppliers to manufacture the goods, which would then be sold by these non-related manufacturers to the Hong Kong agent’s customers.

Many of the Hong Kong agent`s services were carried out by its offshore affiliates, and the Hong Kong agent’s activities were ‘restricted’ to managing the sourcing and manufacturing process to ensure that satisfactory goods were supplied to its customers.

The Hong Kong agent usually received a commission of 6% from its customers, of which 4% was passed on to the Hong Kong agent’s affiliates.

A discussion negatively re-confirmed in CIR v Li & Fung (Trading) Limited

The Commissioner for Inland Revenue argued in front of the Board of Review that all of the 6% commission was taxable in Hong Kong, as it suggested that the Hong Kong agent operated a ‘supply-management businesses.

The Court reformulated the Commissioner’s case so that it no longer pressed the submission that there was a ‘supply-management business’ but that the commission should be apportioned, with 4% attributable to the offshore activities of the Hong Kong agent’s affiliates and the remaining 2% attributable to the Hong Kong agent’s activities in Hong Kong. In short, the High Court, in agreeance with the Board of Review’s decision, came to the following conclusions:

1. “In ING Baring, the Court of Final Appeal criticised an approach to profits tax which fixed the geographical location of a taxpayer’s profits by reference to ‘activities antecedent or incidental’ to those transactions: Ribeiro PJ commented (at para.38): “Such antecedent activities will often be commercially essential to the operations and profitability of the taxpayer’s business, but they do not provide the legal test for ascertaining the geographical source of profits for the purpose of section 14””;
2. “In ING Baring it was stressed by the Court of Final Appeal that to determine the source of a profit, one must first identify the transaction which directly gives rise to the profit”;
3. “Ribeiro PJ said in ING Baring that “use of a ‘brain’ analogy or the place of administration of the business as criteria for ascertaining the geographical source of profits is plainly inconsistent with the decisions [… ] in Hang Seng Bank. In a case like the present, source is determined by the nature and situs of the profit-producing transaction and not by where the taxpayer’s business is administered or its commercial decisions is taken”” (NB: NO management and control test);
4. “The Hong Kong agent’s affiliates assisted the Hong Kong agent’s customers in placing orders with offshore sellers, supervised the manufacturer by those sellers of goods to the specifications of the Hong Kong agent’s customers, and arranged for the shipment of the finished goods from the sellers to the Hong Kong agent’s customers. It was those activities which directly led to the payment of the 6% commission which took place outside of Hong Kong”; and
5. “It is true that the Hong Kong agent maintained back-up or support services for its affiliates at its Hong Kong headquarters. But it was allowed to disregard these as merely antecedent activities which although commercially essential to the operations and profitability of the Hong Kong agent’s business they do not provide the legal test for ascertaining the geographical source of profits”.

CIR v. Li & Fung (Trading) Limited Court of Appeal Arguments

On the 14th and 15th of February 2012, the Hong Kong Court of Appeal (CACV86/2011) dealt with the appeal hearing by the Commissioner of Inland Revenue (“Appellant”) from the Hong Kong Court of First Instance decision (HCIA 1/2010 and HCIA 3/2010) regarding commission income received by Li & Fung (Trading) Limited, a company in Hong Kong (“Respondent”). Although no judgment has been made yet, some interesting tax issues were brought forward by both the Appellant and Respondent.

It should be noted here, however, that the judgment of the Hong Kong Court of First Instance took place on the 18th of April 2011. The Board of Review Decision (B/R 39/04, from which both the Appellant and Responded appealed) was actually handed down on the 12th of June 2009, and this was the result of a Board of Review hearing that initially took place over three years prior, on the 19th of January 2006! In the words of the Judge of the Hong Kong Court of First Instance, “It seems to me that, by any standard, a delay of 3.5 years in handing down a Decision must be unacceptable.”

During the appeal hearing it was therefore also argued by the Respondent that this delay in combination with the 2007 Court of Final Appeal judgment in ING Baring Securities (Hong Kong) Ltd v. CIR (2007) 10 HKCFAR 417 (“ING Baring”) might have led to some wrong facts finding by the Board of Review (see further below). One of the Judges during the appeal hearing commented on this, saying that he was not sure if ING Baring has changed the current law at all and wondered whether the Appellant should not have reported this ‘complaint’ earlier in front of the Court of First Instance.

The facts of the Li & Fung Trading case are briefly as follows: the Respondent provided agency services to its non-related customers in connection with the manufacture, sale and purchase of goods. Such services included finding suppliers to manufacture the goods, which would then be sold by these non-related manufacturers to the Respondent’s customers. Many of the Respondent’s services were carried out by its offshore affiliates, and the Respondent’s activities were ‘restricted’ to managing the sourcing and manufacturing process to ensure that satisfactory goods were supplied to its customers.

The Respondent usually received a commission of 6% from its customers, of which 4% was passed on to the Respondent’s affiliates. The Appellant argued in front of the Board of Review that 2% (6% less 4%) of the commission was taxable in Hong Kong, as it suggested that the Respondent operated a ‘supply-management business.’ The Appellant reformulated their case during proceedings so that it no longer pressed the submission that there was a ‘supply-management business’ but that the commission should be apportioned, with 4% attributable to the offshore activities of the Respondent’s affiliates and the remaining 2% attributable to the Respondent’s activities in Hong Kong. The Hong Kong Court of First Instance agreed with the Board of Review’s Decision and denied apportionment.

During the appeal hearing in front of the Hong Kong Court of Appeal the following tax issues were brought forward:

First of all, the Appellant made a distinction between the concluding and primary facts. According to the Appellant, in B/R 39/04 at paragraph (para.) 84, the Board of Review came to a concluding fact which had to be considered as an error of law. Para. 84 reads as follows: “We find as a fact that all the profit-producing/making activities/transactions took place outside of Hong Kong.” The Appellant was of the opinion that the Board of Review did not properly discuss in para. 84 how it came to this ‘concluding’ fact.

As a result, there was an omission, i.e. the primary facts were missing and it was the Board of Review’s duty to find out these primary facts. The appellant said that the Board of Review should have focused more on questions such as ‘what has the Respondent done to earn the 2% commission’ and that the answers to such questions would have led to the correct primary facts, therefore the inference made by the Board of Review was incorrect. It follows that there must have been an error of law.

The Respondent replied to the above by saying that (i) there was no error of law at all and (ii) the Courts should abstain from facts finding, as that is a duty of the Board of Review.

Subsequently, the Appellant discussed why he thought that the concluding fact in para. 84 of B/R 39/04 was incorrect. The Appellant referred to ING Baring and agreed with the fact that the ING Baring case makes clear what should have been a profit-producing transaction and what things can be considered as antecedent or incidental activities. However, the Appellant argued that the commission income earned by the Respondent cannot have been the result of antecedent activities (as was decided by the Board of Review and Court of First Instance), as this income was a result of substantial activities by the Respondent in Hong Kong.

The Appellant argued that if the Board of Review had focused on the agency agreement (from which the commission income was derived) as a whole, which it failed to do, it would have realised that the Respondent also provided knowledge and the settlement of transactions, not only back office or support services. This as, according to the Appellant, the commission income could not have been earned without doing all the steps/actions described in the agency agreement, which only partly required involvement from the Respondent’s overseas affiliates, but also necessitated the involvement of the Respondent himself. The Appellant therefore argued that the agency agreement was the profit-producing transaction and that the Board of Review had misidentified this, as one should not only look at the commercial reality, but also at the terms of the contract (form over substance?). In the words of the Appellant, “What is the purpose of agreeing to something which is not relevant?”

The Respondent then replied to the above, claiming that the Appellant repeated his arguments of “supply-chain management business” and “brain analogy”, which had already been previously rejected by the Board of Review and Court of First Instance. Also, the Respondent argued that one needs to look foremost at commercial reality (substance over form?). One of the Judges commented on the Appellant’s arguments by saying that if all the steps/actions described in the agency agreement had to be considered, this would have required a detailed analysis/audit of the activities of the Respondent internally and externally, thereby creating an overburden for the Board of Review.

The Appellant finally argued that as a result of the agency agreement being the profit- producing transaction, 2% out of the 6% commission income should be apportioned to the Respondent and be subject to Hong Kong profits tax. This as the Respondent himself followed an apportionment of 2%, which was based on a contractual arrangement.

The Appellant was unlikely to succeed because the Judges seemed to think that a great deal of delay has already occurred in this case and they are unsure of whether the Board of Review overlooked something that was not argued before them in the first place. Or, in the harsh words of one of the Judges, “Maybe you (Respondent) just have to live with the consequences.”

 Court of Appeal Decision 

On 19th of March 2012, the Hong Kong Court of Appeal (CACV86/2011) gave its judgment in Commissioner of Inland Revenue (“Appellant”) and Li & Fung (Trading) Limited, a company in Hong Kong (“Respondent”).

The facts are briefly as follows: the Respondent provided agency services to its non-related customers in connection with the manufacture, sale and purchase of goods. Such services included finding suppliers to manufacture the goods, which would then be sold by these non-related manufacturers to the Respondent’s customers. Many of the Respondent’s services were carried out by its offshore affiliates, and the Respondent’s activities were ‘restricted’ to managing the sourcing and manufacturing process to ensure that satisfactory goods were supplied to its customers.

The Respondent usually received a commission of 6% from its customers, of which 4% was passed on to the Respondent’s affiliates. The Appellant argued in front of the Board of Review that 2% (6% less 4%) of the commission was taxable in Hong Kong, as it suggested that the Respondent operated a ‘supply-management business.’ The Appellant reformulated its argument during proceedings in front of the Court of First Instance so that it no longer pressed the submission that there was a ‘supply-management business’ but that the commission should be apportioned, with 4% attributable to the offshore activities of the Respondent’s affiliates and the remaining 2% attributable to the Respondent’s activities in Hong Kong. The Hong Kong Court of First Instance however agreed with the Board of Review’s Decision and denied apportionment as it did not recognise any profit-producing activities in Hong Kong.

During the appeal hearing the following tax issues were brought forward:

First of all, the Appellant said that the Board of Review statement “we find as a fact that all the profit-producing/making activities/transactions took place outside of Hong Kong” was not properly motivated. From the judgment it however follows that the Judges were of the opinion that there was no ‘substance’ in this complaint as all the evidence was summarized by the Board of Review with great care, the majority of the evidence was ‘uncontentious’ and when potentially controversial, the Board of Review dealt with it critically.

The Appellant further argued that if the Board of Review had focused on the agency agreement (from which the commission income was derived) as a whole, which it failed to do, it would have realised that the Respondent also provided knowledge and the settlement of transactions, not only back office or support services. This as, according to the Appellant, the commission income could not have been earned without doing all the steps/actions described in the agency agreement, which only partly required involvement from the Respondent’s overseas affiliates, but also necessitated the involvement of the Respondent himself. As a result, 2% out of the 6% commission income should be apportioned to the Respondent and be subject to Hong Kong profits tax.

The Respondent then replied to the above, claiming that the Appellant repeated his arguments of “supply-chain management business” and “brain analogy”, which had already been previously rejected by the Board of Review and Court of First Instance.

The Judges dealt in the judgment with the Appellant’s latter argument shortly as follows: it qualified the submissions of the Appellant as being of a ‘protean’ nature, was of the opinion that the Appellant’s ‘reformulated’ argument was brought in too late during the proceedings, that the judges would ‘recoil’ from the idea of remitting this case to the lower courts again as too much delay had already been incurred and the principles of taxation were rightly applied in this case.

Li & Fung Case Main Takeaway

The above shows that the approach of the Courts is now more a `totality of facts` approach and is not limited to contractual matters. Also, section 14 of the Hong Kong Inland Revenue Ordinance is only applicable when the profit producing transaction is in Hong Kong.

Nevertheless, determining the source as Hong Kong is not a straightforward and easy exercise and is often confused with antecedent or incidental activities.