In Ngai Lik Electronics Company Limited v. the Commissioner of Inland Revenue, FACV No. 29 of 2008 (2009), the Hong Kong Court of Final Appeal (the CFA) affirmed the applicability of the arm’s length principle in a cross-border transfer pricing case.

Facts

The taxpayer, a Hong Kong company, belongs to a group whose business was the design, manufacture, and trading of electronic audio products. The taxpayer subcontracted the production to two unincorporated businesses that belonged to the same group, Din Wai Company and Shing Wai Company.  

In 1987, the group relocated all of its production facilities from Hong Kong to mainland China. Din Wai Company and Shing Wai Company subcontracted the production to parties in China.  

In 1991 and 1992, the group was reorganized. A Bermuda company was incorporated in 1992 to act as the holding company of the group, including the taxpayer, three BVI companies (DWE which took over the business of Din Wai Company from 1991, NWP and SWL), and a Hong Kong company that took over the business of Shing Wai Company (SW(HK)). SWL later took over the assets and liabilities of SW(HK).  

After the reorganization, customers placed orders for audio products with the taxpayer in Hong Kong. The taxpayer would in turn order such products from DWE on the terms that the taxpayer would have the right to refuse to take delivery if the landed cost of DWE’s products should exceed by more than ten percent the cost of goods from the cheapest alternative supplier. DWE would then order the necessary components for the products from companies in China, including its affiliates. The taxpayer performed sourcing, agency and other ancillary activities for SWL, NWP, and DWE under a cost plus five percent arrangement.

In practice, however, sales and purchases of goods between the taxpayer and DWE were recorded in terms of quantities only. The price of such goods was not set at the time the orders were placed, but was decided later by the taxpayer’s accounts department on an annual basis.  

The Board of Review found that the practical or commercial end result was that:  

  • the mode of operation of the group had not changed after the reorganization;
  • while the taxpayer’s turnover represented the group’s turnover, the taxpayer’s profits dropped and its contribution to the profits of the group dropped from 31.19 percent in 1991/92 to 7.19 percent in 1995/96 and
  • the taxpayer’s drop in profitability was offset by the profitability of the three BVI companies and SW(HK), which operated offshore.

The Commissioner took the view that the arrangement involving SW(HK) (replaced by SWL from 1993/94 onwards), DWE and NWP and the inter-company pricing operation were schemes entered into for the sole or dominant purpose of obtaining a tax benefit and raised additional assessments on the taxpayer pursuant to section 61A of the IRO. That was done by treating the whole of the profits shown in the accounts of SW(HK) (and as from 1993/94 SWL), NWP and DWE as the taxpayer’s assessable profits. The assessor subsequently reduced each of the additional assessments by half. The Board of Review upheld the additional profits tax assessments against the taxpayer. The taxpayer lost its appeals to the Court of First Instance and the Court of Appeal. It then appealed to the CFA.

Court of Final Appeal’s Decision

The CFA allowed the taxpayer’s appeal. The Court annulled the additional assessments and ordered the case to be remitted with a direction that fresh additional assessments be raised for three of the five years of assessment at issue.

The CFA held that the price-fixing arrangement between the taxpayer and DWE had the effect of conferring on the taxpayer a tax benefit involving a reduction of its assessable profits by transferring them to DWE. That was done with the dominant purpose of obtaining a tax benefit for the taxpayer. Therefore, the general anti-avoidance provisions in section 61A of the IRO applied to the years of assessment 1993/94, 1994/95 and 1995/96.

The CFA further held that the Commissioner must exercise her power under section 61A(2)(b) of the IRO on the basis of a reasonably postulated hypothetical transaction that produces an assessment designed rationally to counteract the tax benefit. In this case, a reasonable approach would have been to raise an assessment on the profits that would hypothetically have been earned if the taxpayer had purchased the goods at arm’s length prices from its affiliated supplier DWE, instead of the prices the taxpayer actually paid pursuant to the price-fixing arrangement. The assessment cannot be raised in some arbitrary amount or be arrived at upon some basis that is unreasonable or not rationally related to the tax benefit in question.

Observations

The CFA’s decision in the Ngai Lik case provides authority for the applicability of the arm’s length principle in a cross-border transfer pricing case. The CFA also makes it clear that the Commissioner does not have unfettered discretion when invoking section 61A of the IRO. If the Commissioner raises an assessment under section 61A, it must be justifiable as a reasonable and proper exercise of her power.

Interestingly, the CFA mentioned in dicta that sections 16(1) and 17(1)(b) of the IRO do not require the Commissioner to compare the purchase prices deducted against market prices and to disallow deductions considered excessive. However, until the point is authoritatively determined after proper argument, in cases where the Commissioner seeks to challenge excessive expenditure resulting in reduced assessable profits, she should mount the challenge on alternative bases under sections 16, 17, 60 and 61A of the IRO insofar as these provisions may be applicable.