In Board of Review Case D28/14, the taxpayer was a Hong Kong incorporated company with “trading garments and investment holding” as its principal business activities. It claimed that it bought garments manufactured by its wholly owned subsidiary in the PRC (the “PRC subsidiary”) and on-sold them to its overseas customers.

In support of the claim that its trading profits were derived outside Hong Kong and should not be chargeable to profits tax, the taxpayer asserted that the negotiation and conclusion of all sale and purchase transactions were conducted by its subsidiary in the PRC. It also claimed that, as part of the trading activities, it engaged the legal representatives of the PRC subsidiary who travelled overseas to maintain the network of customers and suppliers on its behalf and the staff of the PRC subsidiary were responsible for sourcing suppliers, processing purchase sale orders and contracts, preparing shipping documents, inspecting and testing the quality of goods and issuing sales invoices. 

The questions were, whether (i) the taxpayer was “carrying on a trade, profession or business in Hong Kong” and (ii) the trading profits were ‘profits arising in or derived from Hong Kong’ for the purpose of Section 14(1) of the Inland Revenue Ordinance. 

It was held by the Board that the taxpayer did carry on business activities in Hong Kong and that the trading profits derived by the taxpayer were sourced in Hong Kong and hence, taxable, on the following bases: 

(a) The Board rejected the taxpayer’s claim that it did not employ any person in its office in Hong Kong because items of expense such as “staff salaries”, “staff messing”, “recruitment fees” and “staff training” were included in its audited financial statements and the taxpayer failed to provide a meaningful explanation for the booking of these employee-related expenses in its accounts; 

(b) The profit and loss accounts of the taxpayer showed that a sum of around HK$1M was written off as bad debt and booked as an expense, which illustrated the bearing of commercial risk by the taxpayer in its sales. Such accounting treatment was done in Hong Kong as part of the taxpayer’s trading activities;

(c) The profit and loss accounts of the taxpayer also disclosed substantial transportation and communication expenses on a year by year basis. This showed that the communication between the taxpayer and the PRC subsidiary as well as the transportation of goods, which formed part of the taxpayer’s trading activities, were performed in Hong Kong; 

(d) The taxpayer’s operations in Hong Kong, albeit covering not all the steps of a trading operation, were not only in the nature of the carrying on of its business in Hong Kong but also instrumental and essential to the success of its commercial objective of trading in garments manufactured in the PRC to customers overseas and the earning of profits from the accomplishing of that commercial objective; and

(e) The effective cause giving rise to the taxpayer’s profits from its trading business was the bringing together of the complementary needs of the manufacturer in PRC and the overseas customers. The PRC subsidiary by selling goods to the taxpayer instead of the overseas customers directly stood to be buffered by any risk of non-payment by the ultimate buyer. Such risk would be borne and was indeed borne on one occasion by the taxpayer. The overseas customers wanted their goods to be shipped from Hong Kong due to time efficiencies. Also, effecting payments in Hong Kong was obviously more convenient and efficient. The bringing together was done in Hong Kong. 

This case demonstrates that the Board may not take the traditional approach of focusing on the location(s) where the sale and purchase contracts were effected in determining the source of trading profits. The Board seems to take a more stringent approach by taking into account all the relevant facts and surrounding circumstances, in particular the roles (including the purposes of setting up the company in Hong Kong) and trade-related activities of the taxpayers in Hong Kong.