For this edition of our round-up of notable tax decisions, we have the rare pleasure of summarising not one but two prominent successes of the taxpayer against the Inland Revenue Department (Revenue). Both cases emerged from the assessing practices of the Commissioner of Inland Revenue (Commissioner), which in recent years has become notable for its aggressiveness and inflexibility; both cases were determined by the Court in favour of the taxpayer, and both decisions are now under appeal. If these decisions are any indication of things to come, we expect an increase in tax disputes between taxpayers and the Revenue, together with an increased willingness of the Commissioner to progress appeals to the higher Courts should a decision not go his way.
Koo Ming Kown & Murakami Tadao v CIR  HKCFI 2593
In Koo Ming Kown & Murakami Tadao v CIR  HKCFI 2593, the appellants were directors of a company that had been involved in a tax dispute with the Commissioner. The company lost its appeal before the Board of Review (Board) and, in 2012, it was wound up pursuant to a petition brought by the Commissioner for unpaid tax debts. Unable to recover any further sums directly from the company, the Commissioner issued the appellants with penalty notices under section 82A of the Inland Revenue Ordinance (IRO), seeking to recover penalty tax from both appellants on the basis that they had authorised financial statements and tax returns that the Commissioner considered to be incorrect, and had therefore made an incorrect return within the meaning of section 82A(1).
The appellants appealed to the Board, and the Board dismissed their appeal. The appellants then sought and obtained leave to appeal to the Court of First Instance. The principal question before the Court was whether a penalty levied under section 82A against a taxpayer could be recovered directly from the officers of the taxpayer who had authorised the making of the incorrect return. Lam J first considered the scope and import of the penalty provisions in section 82A. Penalties levied under that section are sanctions on the taxpayer for making incorrect returns, or otherwise for providing incorrect information. Section 51 provides that anything done for and on behalf of the taxpayer in terms of tax administration is regarded as having been done by the taxpayer himself. The directors, in filing the return, did no more than file the return on the company’s behalf. It was the company that was responsible for filing the return, and was therefore primarily liable for any default in the manner in which the return was furnished, or in its contents.
It was the company, as the taxpayer, which was the only person statutorily obliged to make a tax return. Officers of a company were, under section 57, required to take such administrative or other steps as were required to enable the company to comply with its obligation, but they could not, thereby be held liable for filing an incorrect return. That default was, within the schema of the IRO, the company’s default, and not that of its officers. It followed that the taxpayer’s officers could not be liable for a pecuniary penalty levied with respect to a default that was not, technically, their own. To argue otherwise would be inconsistent with the presumption against doubtful penalisation, since penalties under section 82A, it was common ground, were criminal in nature for human rights purposes.
The Court further held that the finality provisions in section 70, by which an assessment to which no objection had been duly and timeously lodged became final and conclusive, could not be invoked by the Commissioner to prevent a person he alleged should be sanctioned under section 82A from arguing in his own defence that the return furnished was not incorrect. Section 82B provided for a discrete dispute resolution mechanism specifically for penalties levied under section 82A, which paralleled the taxpayer’s right to object to and appeal an assessment in section 64. It would have been perverse to enable the Commissioner to argue that a penalty should be levied under section 82B on the one hand and, on the other, to bar the taxpayer from defending himself against such an assertion by contending that the assessment was, in fact and law, correct.
We agree with the Court’s reasoning. The Commissioner’s attempts to recover penalties that should have been levied on the company for the company’s own defaults directly from its officers was plainly inconsistent with norms of procedural fairness and the schema of the IRO. If the draughtsman had wanted to penalise officers of the taxpayer for the taxpayer’s defaults, he would have expressly included provisions to that effect, as exist in the tax codes of certain other common law jurisdictions. That there is no such provision in Hong Kong indicates that the Legislature never contemplated shifting liability from the taxpayer to its officers. It was, in our view, alarming for the Commissioner to suggest that this could be, by default, the case.
Company officers should continue to exercise the greatest prudence in approving financial statements and tax returns; however, they should likewise resist any suggestion that they may be made directly accountable for penalties that should properly be imposed on the company itself.
Dairyfarm Establishment & The Dairy Farm Company, Limited v CIR  HKCFI 2245
Compare the Court of First Instance decision in Dairyfarm Establishment & The Dairy Farm Company, Limited v CIR  HKCFI 2245, which represents another important victory for the taxpayer in procedural matters. Dairy Farm is, of course, a well-known brand name in Hong Kong, and is one of the few domestic dairy products suppliers. In a structure evidently devised to mitigate tax, the various Dairy Farm trademarks were owned by Dairyfarm Establishment (DFE), a company incorporated in Liechtenstein, which licensed the marks to The Dairy Farm Company, Limited (DFCL) in Hong Kong in consideration for very large annual royalties. The Commissioner raised two alternate and mutually exclusive assessments. He assessed DFE to tax under section 14 – the general charge to profits tax, on the grounds that it allegedly carried on a trade or business in Hong Kong – and, in the alternative, under section 15(1)(b), which charges to profits tax royalties for the use or the right to use intellectual property in Hong Kong, and section 21A, which imposes a withholding tax requirement on payors of such royalties. The Commissioner also disallowed the deductions claimed by DFCL with respect to the royalty expenditure, and denied DFE the benefit of the reduced rate of withholding tax on royalties under the Hong Kong – Liechtenstein Double Taxation Agreement.
The sections 14 and 21A assessments, it was common ground, were alternative assessments: DFE could only be chargeable to tax under one of them, not both. DFCL was joined to the dispute because section 21A would have imposed a withholding obligation on it as the payor of the royalty, and because it disputed the Commissioner’s view that the royalty was not deductible expenditure.
Pursuant to Hong Kong’s longstanding ‘pay first, argue later’ approach to tax dispute resolution, the Commissioner demanded the payment of amounts claimed as profits tax due under both the section 14 and section 21A assessments, and DFE complied. In view of the fact that it would not ultimately be liable for both assessments even if it lost its substantive appeal, it subsequently requested that the Commissioner refund the excess amount paid on account of tax. The Commissioner refused, and proceeded to raise additional protective assessments, with respect to which he demanded further payments on account of tax, again on both section 14 and section 21A grounds. Having failed to come to an agreement with the Commissioner, the taxpayer brought judicial review proceedings.
The dispute in summary turned on whether the Commissioner had erred in law in refusing to withdraw one of the alternative assessments by concluding that he was not statutorily entitled to do so. The Commissioner argued that, once an assessment was validly issued, he had no general discretion to withdraw or amend it, such that he was obliged to require the payment of at least a portion of the tax claimed. Chow J disagreed. On a proper construction of section 64(2) of the IRO, the Commissioner was clearly empowered to annul one of the alternative assessments and, should it subsequently emerge that the subsisting assessment was unfounded in fact and law, he could thereafter re-issue a fresh assessment in lieu of the annulled assessment without engaging the finality provisions in section 70. Reliance was further placed by the Court on section 46 of the Interpretation and General Clauses Ordinance, which provides that where a person is empowered to issue a notice, it is also empowered to amend or to withdraw it.
Reading between the lines, it is plain that the Revenue’s hostility to the taxpayers was in part motivated by what it considered to have been an aggressive tax avoidance structure. That displeasure evidently translated into what a fair-minded observer could only describe as a predatory assessment policy. It is therefore encouraging that the Court was swift to restrain the Commissioner: the suggestion that one could be required to pay tax claimed with respect to twoassessments where, even in the worst case scenario from the taxpayer’s perspective, only one would have become payable, is Kafkaesque. Dairyfarmis a stark reminder that the tax administration system in Hong Kong structurally favours the Revenue. If the Commissioner so wishes, he may assess very large amounts of additional tax and demand their upfront payment as a condition precedent to progressing the substantive appeal. Even for very large undertakings like the Dairy Farm group, this might impose an intolerable stress on the taxpayer’s cashflow position. With an increasingly aggressive Revenue to contend with, it is in the right circumstances in the taxpayer’s interest to refer the dispute to the Courts with a view to obtaining relief.