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back to index backASIAtalk September,  2005

Hong Kong: Commissioner Issues Ruling on Apportionment of Profits of Cross-Border Manufacturing

The Hong Kong Commissioner of Inland Revenue recently issued an advance ruling (Case No. 19) addressing the tax treatment of Hong Kong-China contract processing agreements,” concluding that profits arising from the sale of goods under such agreements could be apportioned for profits tax purposes.

This ruling reiterates previous views of the Inland Revenue Department (IRD) articulated in Departmental Interpretation and Practice Notes No. 21 (DIPN 21). Only profits arising in, or derived from, Hong Kong are subject to profits tax in Hong Kong. In the case of Hong Kong-China cross-border manufacturing operations, as explained in DIPN 21, the IRD takes the view that the apportionment of profits applies specifically where a Hong Kong company has a contract processing agreement with a processing factory in the Mainland and that agreement has been properly approved by the PRC local government. This position is based on the rationale that the PRC processing factory is considered to be a manufacturing agent for the Hong Kong company.

The contract processing agreement at issue in the ruling is a typical agreement, whereby the PRC factory is responsible for the production process in return for processing fees paid by the Hong Kong company, while the Hong Kong company provides the raw materials, plant and machinery, and training for the workers. The ruling allows the profits arising from the sale of the goods processed by the China factory under the contract processing agreement, presumably an agreement approved by the local government, to be apportioned on a 50-50 basis for purposes of Hong Kong profits tax purposes.

The ruling can be distinguished from two decisions issued in 2004 by the Board of Review stating that apportionment is applicable only where the taxpayer has an approved contract processing agreement with a factory unit in the Mainland. In Case D111/03, the taxpayer purchased raw materials and sold them to a PRC associate that manufactured the products. The finished products were then sold to the taxpayer with a mark-up. The Board found that, as there was no processing arrangement between the taxpayer and its PRC associate, the manufacturing activities of the PRC associate could not be treated as the activities of the taxpayer. The Board concluded that the profits of taxpayer were not derived from the manufacturing activities in the Mainland.

In a more recent case, D56/04, the taxpayer entered into a joint venture agreement with an enterprise in Mainland China to form a JV limited company. The JV company manufactured knitwear apparel products for the taxpayer. Similar to D111/03, the Board decided that the JV company was not the manufacturing agent of the taxpayer and did not allow the profits of the taxpayer to be apportioned.

While the advance ruling in Case No. 19 provides an example of an arrangement where the taxpayer could receive concessionary treatment, the two Board of Review decisions provide legal authority to the IRD to disallow apportionment in situations other than those described in DIPN 21.

Source: Deloitte Hong Kong - GAI

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