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backCHINAtalk July, 2008

Hong Kong: Court Clarifies Application of DIPN 21 on Locality of Profits Issue

The Hong Kong Court of First Instance has ruled in favor of the taxpayer in the case of Commissioner of Inland Revenue v. Datatronic Limited. The decision, handed down on 13 June 2008, allows profits derived by a Hong Kong taxpayer from the sale of goods manufactured by its Mainland subsidiary under an import processing arrangement to be apportioned on a 50/50 (onshore/offshore) basis.

The 50/50 apportionment is a concession granted by the Hong Kong Inland Revenue Department (IRD) in Departmental Interpretation and Practice Note No. 21 (DIPN 21) issued in March 1998, which sets out the IRD’s position on the source of various types of income.

The court’s decision conflicts with current practice of the IRD, which only grants the 50/50 apportionment to contract processing arrangements. According to the IRD, import processing arrangements do not qualify for apportionment; instead, profits derived from such arrangements should be taxed as trading profits and taxed in full.

Background of the Case
The taxpayer, Datatronic Limited, a Hong Kong company, is a manufacturer of electronic commercial products. In the early 1980s, the taxpayer was engaged in the manufacturing and sale of electronic products under a contract processing arrangement with a factory in Mainland China. In 1993, the taxpayer established a wholly owned subsidiary, Datatronic (Shunde) Corporation (DSC), in China and arranged for its products to be manufactured by DSC under an import processing arrangement, rather than a contract processing arrangement.

At issue was whether the profits derived by Datatronic Limited from the sale of goods manufactured or processed by DSC under an import processing arrangement should be apportioned on a 50/50 onshore/offshore basis for Hong Kong tax purposes. The taxpayer lodged an appeal to the Board of Review (Board) against the IRD tax assessments, under which the profits were fully charged to tax in Hong Kong. The Board ruled in favor of the taxpayer, allowing the profits to be apportioned and taxed on a 50/50 basis. The IRD appealed the Board’s decision to the Court of First Instance.

Contract Processing v. Import Processing
“Contract processing” refers to a situation where a non-Mainland entity enters into a processing agreement with a Mainland factory under which the non-Mainland entity supplies raw materials to the Mainland factory for processing. The processed goods must be delivered back to the non-Mainland entity for onward export sales. The Mainland factory does not own the raw materials and finished goods – in other words, the title of raw materials does not change during the entire manufacturing process. The finished goods have to be exported and sold outside the Mainland. In addition to the provision of raw materials, the non-Mainland entity also provides machinery, designs and technical support, and manages and supervises the factory workers. The Mainland factory provides the land, building and labor. The non-Mainland entity typically is a Hong Kong entity.

In recent years, an increasing number of contract processing arrangements have been converted to import processing arrangements. Under an import processing arrangement, the Mainland factory purchases raw materials from the non-Mainland (Hong Kong) entity and sells the finished goods it manufactures to the non-Mainland (Hong Kong) entity on its own account.

Hong Kong’s taxation system is territorial-based, so that only profits arising in or derived from Hong Kong are subject to profits tax in Hong Kong. Offshore income is generally not subject to Hong Kong tax. As noted above, DIPN 21 sets out the IRD’s position on the source of various types of income. For manufacturing profits, the source is where the manufacturing operations take place.

Where a Hong Kong manufacturing business enters into a processing arrangement with a Mainland entity and the Hong Kong entity provides the raw materials, technical know-how, management, production skills, design, skilled labor, training and supervision for locally recruited labor, the IRD generally will allow the profits derived by the Hong Kong entity on the sale of the relevant manufactured goods to be apportioned and taxed on a 50/50 basis on the grounds that the sales activities are carried out in Hong Kong but the manufacturing activities are carried out outside of Hong Kong.

In practice, however, the IRD restricts apportionment to situations where the underlying arrangement is a contract processing arrangement. Profits derived from import processing arrangements are treated as trading profits (rather than manufactured profits) and are fully chargeable to tax. Under DIPN 21, apportionment is not allowed for trading profits.

To download complete 5-page review, please click here.

Source: Deloitte Tax - GAI

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