Commissioner of Inland Revenue v. Kwong Mile Services Ltd.
Read the full judgment text of HCIA 1/2002 on BabelCite. This HCIA judgment was delivered on 29 July 2002.
1. The Commissioner of Inland Revenue stated a case for the opinion of the Court against the Board of Review which by a majority of two to one allowed the appeal of the respondent taxpayer against the assessment of profits tax in the sum of HK$6,860,124 for four years of assessment from 1992/93 to 1995/96.
Cites 1 case
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HCIA000001/2002 HCIA1/2002 IN THE HIGH COURT OF THE HONG KONG SPECIAL ADMINISTRATIVE REGION COURT OF FIRST INSTANCE INLAND REVENUE APPEAL 1 OF 2002 --------------
-------------- Coram: Deputy High Court Judge Fung in Court Dates of Hearing: 24 - 25 June, 12 and 15 July 2002 Date of Judgment: 29 July 2002 ------------------------- J U D G M E N T ------------------------- 1.The Commissioner of Inland Revenue stated a case for the opinion of the Court against the Board of Review which by a majority of two to one allowed the appeal of the respondent taxpayer against the assessment of profits tax in the sum of HK$6,860,124 for four years of assessment from 1992/93 to 1995/96. 2.The questions of law stated are : Whether, having regard to all the facts as found by the Board of Review, and on the true construction of the Inland Revenue Ordinance (Cap.112) in particular section 14 thereof, the majority of the Board of Review :
The facts The facts as found by the Board of Review are :
3.The Board noted that both parties accepted that CDL was the agent of the taxpayer in Hong Kong and that CDL's acts were the acts of the taxpayer. The Issues before the Board of Review 4.There were two issues before the Board of Review. The 1st issue was the nature of the transaction, i.e. Whether the taxpayer was :
5.Irrespective of the nature of the transaction, the 2nd issue was : Whether that part of the sale proceeds from the sale of the individual units in Hong Kong that accrued to the taxpayer in its capacity (either as re-seller of the individual units or as underwriter of the sale of the individual units) was taxable in Hong Kong. The Board's decision on the 1st issue 6.The taxpayer argued that it was a trader of foreign property in essence and an underwriter in form. The taxpayer produced two sets of documents, the 1st set to prove the underwriting agreement and the 2nd set purportedly to prove trading in property. Ms Li Nai-ling also gave evidence that the intention was to use the taxpayer to purchase the Property and re-sell the individual units to buyers in Hong Kong, Canada and the USA but the sale in Hong Kong was so well that promotion elsewhere was no longer required. 7.The Board of Review viewed the testimony of Ms Li with circumspection. The Board also did not accept the 2nd set of documents purporting to prove sale and purchase of the Property as it was produced late in the date and also contrary to representations of the taxpayer's tax representatives to the Commissioner. The Board also considered the land law and regulatory regime in the Mainland for the purpose of determining the 1st issue. The Board concluded that the substance of the transaction was underwriting. 8.On the 1st issue, the Board of Review unanimously found that the taxpayer was formed with the purpose of profiting from the Property and its redevelopment. The intention was to acquire an interest at an agreed price from the developer prior to completion of the construction of the Property and to profit in the sale of the uncompleted individual units. There might have been a consideration of a straight forward purchase and resale, but at the end of the day, the manner in which the taxpayer chose to realize its intention was the underwriting arrangement. 9.There is no appeal from the Board's determination on the 1st issue by either party. The majority decision on the 2nd issue 10.The majority has considered the following statutory provisions and legal principles. 11.Section 14(1) of the Inland Revenue Ordinance (Cap.112) provides :
Section 2 of Cap.112 provides :
12.According to CIR v. Hang Seng Bank Ltd [1991] 1 AC 306 per Lord Bridge of Harwich at p.318E :
And further per Lord Bridge at p.322H-323B :
13.In CIR v. HK-TVB International Ltd [1992] 2 AC 397, after citing the above dictum of Lord Bridge, Lord Jauncey of Tullichettle said at p.407B-D :
14.In CIR v. Orion Caribbean Ltd [1997] HKLRD 924, Lord Nolan stated at p.931 that "the ascertaining of actual source of income is a practical hard matter of fact" and that "no simple, single, legal test can be employed". 15.No submissions were made before the Board that the first two conditions in section 14 were not satisfied, and the appeal was only concerned with the third condition: whether the profits arose in or derived from Hong Kong. 16.On the 2nd issue, the majority of the Board of Review posed to themselves a series of questions :
17.The majority found that the underwriting was not service, it was assumption of risk. The reward or profits of the underwriter arose from the assumption of the risk. The profits had already arisen before the subsequent events of the marketing and sale of the units in Hong Kong. 18.The majority stated that the risk was assumed in China where the underwriting agreement was signed and where the subject matter of the underwriting agreement was situated. Although they did take into account the location of the Property (as a subject matter of the underwriting agreement, rather than Property as trading stock), the more important factor was where the risk was assumed. 19.The majority found the sale of the individual units in Hong Kong were in essence sales made by the Developer as vendor. There was no contractual obligation for the taxpayer to market and sell, but only the financial incentive for the taxpayer to do all it can to maximize the profits. And although not contractually required under the underwriting agreement, the taxpayer did all it could to market and sell the individual units. It could not be denied that the taxpayer did, the more it would earn from its underwriting agreement. But all the actions of the taxpayer, whether directly or through CDL, in Hong Kong, were not directly relevant as to how or where the profits arose or derived in underwriting. The majority posed to themselves the following scenario :
20.The majority also stated that :
21.Further, the majority considered an alternative approach by shifting the focus to where the profits materialized. They said they could not ignore the fact that the assumption of risk in Guangzhou materialized into profits only because of the marketing activities conducted in Hong Kong and the receipts of funds in Hong Kong. On this analysis, the profits did not arise when the underwriting arrangement was entered into, but only when the third party users agreed to purchase the units. Until then there was a liability which had been undertaken in order to acquire "contractual rights" which were "marketable". It was only when those rights were marketed that the profit was created. If they were to treat materialization as the more potent factor, then due to the marketing and sale activities of the taxpayer in Hong Kong, they would have concluded that the source of the profits was Hong Kong and not China. In short, the more potent acts to produce the profits occurred in Hong Kong. But at the end of the day, the majority did not take the alternative approach. 22.Yet further, the majority considered the position in the event they were wrong that the transaction between the taxpayer and the Developer was that of purchase, and the taxpayer's profits therefore arose from its property trading activities. They did not agree that the operations test was the appropriate test for properties. There were scant authority to support the proposition that profits from sales in Hong Kong of offshore property were not taxable in Hong Kong (Liquidator, Rhodesia Metals Ltd (In Liquidation) v. Commissioner of Taxes [1940] AC 774). That proposition was consistent with the Departmental Interpretation and Practice Note ("DI&PN") No.21, paragraph 20(b) issued by the Commissioner. The minority view on the 2nd issue 23.The minority's view was the alternative approach rejected by the majority as stated above. 24.The minority agreed that Guangzhou could be said to be the source of the profits because the assumption of the risk giving rise to the subsequent profits occurred in Guangzhou. However, one could not ignore the fact that the assumption of the risk in Guangzhou materialized into profits only because of the marketing activities conducted in Hong Kong and the receipts of funds in Hong Kong. 25.The minority considered that there was a direct tug of war between the place where the risk was assumed and the place where the risk was turned into profit, but the latter factor was the more potent in the production of profits and it occurred in Hong Kong. The profits did not arise when the underwriting agreement was entered into, but only when the third party users agreed to purchase the units. Until then, there was a liability which had been undertaken in order to acquire "contractual rights" which were "marketable". It was only when those rights were marketed that the profit was created. As the marketing took place in Hong Kong, therefore, the profit arose in Hong Kong. 26.The minority also stated that in a case like this, reasonable men could come to different conclusions. Case stated procedure 27.The scope of the case stated procedure is set out in section 69 of Cap.112 :
28.As to the role of the court in a case stated, according to Edwards (Inspector of Taxes) v. Bairstow [1956] AC 14 per Lord Redcliffe at pp.35-36 :
The Commissioner's case 29.Mr Ho for the Commissioner submitted that the majority erred in law in :
30.Mr Ho referred to the dicta of Lord Jauncey in the HK-TVBI case at p.407F :
And further at p.409E :
31.Mr Ho also referred to rule 2A of the Inland Revenue Rules (Cap.112A) :
32.Mr Ho agreed that the present case is not concerned with the apportionment of outgoings and expenses, but rule 2A does underline the significance of "production of profits". 33.Mr Ho submitted that what the taxpayer had done to earn its profits was first to enter into the underwriting agreement, and secondly to market the individual units in Hong Kong through its agent CDL. The making of the underwriting agreement was merely a preliminary step which the taxpayer a possibility of making a profit. The assumption of the risk did not by itself produce any profit. Had there been no subsequent sale of the individual units, no profit would arise. There would only be a liability of $84 million. Hence, the risk had to be turned into profits before profits could materialize. Profits were produced because of the subsequent activities in the promotion, marketing and the actual sales of the individual units. 34.Mr Ho He referred to Willoughby & Halkyard's Encyclopaedia of Hong Kong Taxation (Vol.3, 2001) paragraph II [5986] for the proposition that steps which are merely preliminary or antecedent, or which, although important, produce no income, must be disregarded. 35.Mr Ho submitted that the majority did realize that there was a causal connection between the marketing and sales activities of CDL in Hong Kong, and the generation of profits for the taxpayer, but they were wrong to conclude that the activities were not directly relevant. The majority laid undue emphasis on the lack of contractual obligation in the underwriting agreement for the taxpayer to market the Property. Looking at all the facts, the underwriting arrangement was solicited from the developer and presented to the taxpayer by CDL, and CDL had agreed with the developer that it would solely handle the marketing of the Property. The irresistible inference was that there was a connection between the underwriting agreement and the marketing and sales activities of CDL as an agent of the taxpayer. The respondent's case 36.Mr Chua for the taxpayer submitted that :
37.Further, Mr Chua sought to support the decision of the majority by submitting what the taxpayer did was exploiting foreign immovable property via the underwriting agreement, and the test for the source of profits was the situs of the property and not operations of the taxpayer. 38.It was submitted that the statutory intent of section 69 is clear : finality and expedition. The Board of Review is the final arbiter of facts. If a decision could have gone either way, or where matters of degree are concerned, those are not questions of law but of fact, and no appeal on law shall lie. 39.Mr Chua referred to the dicta of Litton VP (as he then was) in CIR v. Magna Industrial Co. Ltd [1997] HKLRD 173, at p.176I-J :
And also at 181D :
40.The Commissioner must show that the majority's conclusion was "so unreasonable that it can be dismissed as one which could not reasonable be entertained by them" (Griffith v. Harrison [1963] AC 1 per Lord Denning at p.19), or that it consists in a finding of fact which is perverse (Coker v. Lord Chancellor [2002] IRLR 80 per Lord Phillips MR at p.82). 41.According to CIR v. Inland Revenue Board of Review & anor [1989] 2 HKLR 40, per Barnett J at p.58D :
42.And according to Liquidator, Rhodesia Metals Ltd (In Liquidation) v. Commissioner of Taxes [1940] AC 774, per Lord Atkin at p.789 :
43.Mr Chua submitted that the majority did consider all the relevant facts :
44.Mr Chua submitted that the majority adopted the correct legal test and weighed up the facts, and concluded that (b) was the more important factor, (c) was the less important factor, and (d) was not directly relevant. 45.It was submitted that without risking its capital and exercising its business judgment, the taxpayer would not have made the profits. The actual sales were always subject to the inherent risk of political and economic uncertainty in the Mainland and the state of the property market in Guangzhou. Hence, the marketing activities in Hong Kong were incidental or subsidiary to the assumption of the risk by the taxpayer in Guangzhou. 46.Even according to the minority, it was a tug of war between the different factors and a case where reasonable men could come to different conclusions. It was reasonable for the majority to have reached its conclusion that the profits did not arise in, or derive from, Hong Kong. Hence, there was no occasion for the Court to interfere and substitute its own finding for the majority's decision. 47.Mr Chua submitted that none of the tests of "production of profits" or "materialization of profits" used by Mr Ho appears in the words of section 14. Further, rule 2A is concerned with the apportionment of expenses and outgoings and has no relevance to the arising or deriving of profits. 48.It was submitted that the place where the underwriting agreement was made was of importance, and where payment of the purchase price of the units were made was of no relevance. In CIR v. The Hong Kong & Whampoa Dock Co., Ltd [1960] 1 HKTC 85 (C.A.) Reece J stated at p.120-121 :
49.Mr Chua also submitted that one must only look at the essence of the business carried on by the taxpayer, but not services rendered by someone else. The taxpayer was a special purpose company set up for the underwriting. Its business was underwriting as described in its annual reports. The Board found that the transaction was underwriting and not provision of service, and the sales to the individual purchasers were made by the Developer. Hence, what CDL did was not relevant to the taxpayer. 50.In relation to the preliminary or antecedent step point, Mr Chua submitted that one must not look merely at the last profit making activity to determine whether the profits had arisen in or derived from Hong Kong. One should look to the originating cause rather than the last act in determining the source of profits. In the HK-TVBI case, the transactions were two-fold, namely the acquisition of the exclusive rights of granting sub-licences together with the relevant films in Hong Kong, and the soliciting and negotiations with customers overseas for the grant of sub-licences, and the Privy Council held that the profits from granting sub-licences had arisen in or derived from Hong Kong. In the Orion Caribbean case, the taxpayer's business was borrowing and on-lending money with a view to profit. The Privy Council did not find that the source on the interest income was located in the place where the money was on-lent. 51.Further, it was submitted that even if there were substantial Hong Kong activities without which profits could not have earned, it did not connote a Hong Kong source (see CIR v. Magna Indistrial Ltd (supra) per Litton VP at p.176F-G & 178G-H. 52.And on the situs of property point, Mr Chua submitted that the Board had unanimously found that the taxpayer was formed with the purpose of profiting from the redevelopment of the Property. The intention was to acquire an interest at an agreed price from the Developer prior to the completion of the construction of the Property and to profit in the sale of the uncompleted individual units. The manner in which the taxpayer chose to realize its intention was the underwriting arrangement. And the underwriting was not a service. 53.Mr Chua relied on the examples given by Lord Bridge in the Hang Seng Bank case : if the taxpayer has rendered a service or engaged in an activity such as the manufacture of goods, the profit will have arisen or derived from the place where the service was rendered or the profit making activity carried on; but if the profit was earned by the exploitation of property assets as by letting property, the profit will have arisen in or derived from the place where the property was let. He referred to the passage by Lord Bridge at p.320G-H :
54.Mr Chua also referred to Willoughby & Halkyard (op. cit.) at paragraph II [5941] which stated that the "so-called operations test" is applicable to the rendering of services : profits arise where the services are rendered; while the "situs test" is applicable to the letting and sale of immovable property: profits arise where the property is let. 55.It was submitted that exploitation of property was not confined to letting or sale, but could take many forms of profiting from the property, which included underwriting. The majority decision described the taxpayer as having a "vested interest" in the Property, and "contractual rights" which were "marketable". The taxpayer had a substantial financial interest in the Property. Further, in the event of sluggish sales, the Developer would assign the unsold units to the taxpayer upon the payment of the underwritten sum. Hence, the underwriting amounted to an exploitation of the Property. 56.As the majority found the underwriting was not provision of service, and on the basis that it was exploitation of immovable property, the source of the profit should be determined by reference to the situs of the property. 57.In DI&PN No.21, the Commissioner regards the locality of rental income and profits from sale of real property to be the location of the property. The legal test 58.The guiding principle in determining the source of profits is that one looks to see what the taxpayer has done to earn the profit in question and where he has done it. There is no simple, single, legal test of essence of business or place of contract or situs of property. 59.The examples given by Lord Bridge were not intended to lay down an exhaustive list of tests to be applied in all cases in determining whether or not profits arose in or derived from Hong Kong. The "so-called operations test" or "situs test" referred to in Willoughby & Halkyard, according to the authors, are no more than short hand ways of encapsulating the essence of what the taxpayer has done to earn to earn the profits in each case. I hold that they are no more than rules of thumb in a simple and obvious case, and are subject to the guiding principle which they serve to illustrate. It is not right to simply categorize what the taxpayer did as either provision of service or exploitation of property. 60.In the Orion Caribbean case, the taxpayer relied on the example given by Lord Bridge and invited their Lordships to hold on the simple basis that where the gross income in question is interest the source of the income is located, as a mater of law, in the place where the money is advanced. Their Lordships held that :
61.The Board had found against the purchase and sale of the Property by the taxpayer. The taxpayer never had any proprietary interest in the Property. The event that the Developer would assign the unsold units to the taxpayer upon the payment of the underwritten sum was a mere contingency. The majority noted that under Chinese Law, there is a difference between the contract of buying and selling land use rights (which is a contractual right) and the actual assignment of the land use rights (which is a right in property) and stated that it could be that underwriting the sale of properties was not dealing in Chinese real estate and hence regulatory requirements relating to foreigners dealing in Chinese property did not apply. 62.I do not find it appropriate to extend an example given by Lord Bridge by analogy to a situation outside the factual basis of the example. The relevant example given by Lord Bridge was a simple letting of property. It is not intended to cover the very type of underwriting in this case. 63.DI&PN No.21 is stated to be for the information and guidance of taxpayers and their authorized representatives and has no binding force and does not affect a person's right of objection or appeal to the Commissioner, the Board of Review or the Courts. At any rate, the taxpayer is neither letting nor selling real property in the present case. The Rhodesia Metals case was also concerned with purchase of sale of immovable property. 64.It is true that the words "production of profits" do not appear in section 14, and rule 2A is only relevant to the apportionment of outgoings and expenses incurred in the production of profits. Nevertheless, according to the dictum of Lord Jauncey in the HK-TVBI case, in applying the Lord Bridge's guiding principle, the proper approach is to ascertain what were the transactions which produced the profit to the taxpayer. 65.The essence of business test was argued before their Lordships in the Hang Seng Bank case but was not adopted by Lord Bridge. It is a relevant factor to understand the nature of the taxpayer's business, but it is not the legal test of the source of profits as such. 66.The place of payment does not determine the source of profits. In the Whampoa Dock case, the headnote reads :
It is clear that almost the entire services, which gave rise to the profits, were performed outside Hong Kong. The decision is consistent with Lord Bridge's guiding principle. 67.It is true that substantial Hong Kong activities without which profits could not have earned did not necessarily connote a Hong Kong source. The observation of Litton VP in the Magna Industrial case is not inconsistent with Lord Bridge's guiding principle. Error of law? 68.What the taxpayer did was to enter into the underwriting agreement with the Developer, and to market and promote the sale of the individual units through its agent CDL. The Board found that the acts of CDL were the acts of the taxpayer. What the taxpayer did was to ensure that the sale proceeds of the individual units exceed the underwritten sum, such that the underwriting would result in a profit instead of loss. The taxpayer was not providing service to the Developer or any other party, but to ensure the underwriting would be profitable. 69.At the time of entering into the underwriting agreement and assuming the risk, no profit was produced. The profit only arose when the units were sold to the purchasers and the sale proceeds exceeded the underwritten sum. The majority noted that it was only when the "contractual rights" were marketed that the profit was created. It is a fact that the taxpayer did undertake (through CDL) marketing activities in Hong Kong. It does not detract from that fact that CDL was also the agent of the Developer in the sale and purchase agreements. It is non sequitur that if no marketing were done in Hong Kong, the taxpayer would not be liable to profits tax. 70.The issue before the Board was whether the profit of underwriting arose in or derived from the assumption of the risk, or from the marketing activities in Hong Kong. The question is one of correctly identifying the income producing activities. The majority clearly recognized that the assumption of the risk in Guangzhou materialized into profits only because of the marketing activities in Hong Kong. Having so recognized the causal connection, the only reasonable conclusion is that the profit of underwriting arose in or derived from those activities in Hong Kong. It is not a matter of weighing different factors and coming to an either way decision. 71.It is true that the question of the actual source of profits is a practical hard matter of fact. However, in Edwards v. Bairstow, Lord Redcliffe stated at p.38 :
72.With respect, the majority erred in law in wrongly identifying that the profits arose or derived from the assumption of risk in Guangzhou, and not from the marketing activities in Hong Kong. Conclusion 73.In the premises, I shall answer the questions stated for the opinion of the Court as follows :
Representation: Mr Ambrose Ho, SC, leading Mr Stewart Wong, instructed by the Department of Justice, for the Appellant Mr Chua Guan Hock, instructed by Messrs Fred Kan & Co., for the Respondent Remarks: Appeal by the Respondent to the Court of Appeal. Appeal dismissed. Please refer to the appeal judgment of CACV000371/2002. | ||||||||||||||||||||||||||||||||||||
Cases cited in this judgment