NAM TAI TRADING CO LTD v. COMMISSIONER OF INLAND REVENUE

cacv 8/2006

in the high court of the

hong kong special administrative region

court of appeal

civil appeal no. 8 of 2006

(on appeal from HCAL NO. 80 of 2004)

______________________

_________________________

REASONS FOR JUDGMENT

_________________________

Hon Rogers VP:

1.  This was an appeal from a judgment of Chu J given on 2 December 2005.  The matter before the judge was an application for judicial review of two decisions of the respondent.  The first was a decision of 11 May 2004 to hold over part of the tax payable under a Notice of Additional Profits Tax Assessment for the year 1997/1998 on condition that the applicant purchase Tax Reserve Certificates (“TRC”) in the amount of $4,420,000 on or before 25 May 2004 pending the outcome of the applicant's objection to the assessment.  The second decision was to issue a surcharge notice demanding that the applicant pay a surcharge of 5% on the sum of $4,420,000.  That decision was issued on 28 May 2004.  The judge refused the application for judicial review and the applications for the various relief which were sought.  This appeal was dismissed at the conclusion of the hearing, with reasons to be handed down in writing.

Background

2.  The order that the profits tax assessment should be held over subject to the condition that the TRC should be purchased was made under the provisions of section 71(2) of the Inland Revenue Ordinance, Cap. 112 which reads:

“(2) Tax shall be paid notwithstanding any notice of objection or appeal, unless the Commissioner orders that payment of tax or any part thereof be held over pending the result of such objection or appeal:

Provided that where the Commissioner so orders he may do so conditionally upon the person who or on whose behalf the objection or appeal is made providing security for the payment of the amount of tax or any part thereof the payment of which is held over either-

(a) by purchasing a certificate issued under the Tax Reserve Certificates Ordinance (Cap 289); or

(b) by furnishing a banker's undertaking,

as the Commissioner may require.”

3.  That sub-section gives clear authority to the respondent to make an order such as that of 11 May 2004 and, indeed, there was no challenge to the power of the respondent to have made either of the orders which are the subject of this application.

4.  Neither was there any direct challenge to the appropriateness of the criteria upon which the respondent confirmed that it was acting namely the Inland Revenue Department's Departmental Interpretation and Practice Note No. 6.  Paragraph 8(2) of that Note sets out the policy with regard to the issue of stand-over orders.  Subparagraph (a) states that if the Assistant Commissioner considers that there is a valid objection coupled with a request for a holdover and he is of the view that the objection should be allowed an unconditional stand-over will be ordered.  Subparagraph (b), on the other hand, states that if the Assistant Commissioner considers that the objection has little chance of success no stand-over will be ordered and the tax will be payable on the due dates.  For present purposes subparagraph (c) is pertinent that reads:

“where, upon receipt of a valid objection and request for holdover, it is the opinion of an Assistant Commissioner or other officer authorized by the Commissioner that the objection has some merit but that the balance of probability, based on the facts known to exist at the date of the objection, does not weigh definitely in favour of the taxpayer a stand-over will be ordered conditional upon the purchase of tax reserve certificates in the amount of the tax stood-over.  It is emphasized that, in the generality of cases falling into this category, the purchase of certificates will be required....”

5.  I need only add that the Practice Note appears to me to set out sensible criteria upon which the respondent and those in the Inland Revenue Department (“the department”) can act.  It is said, however, that in this case there were errors of law and fact, the first order made was inconsistent with the decision which had been made in respect of the previous year's accounts, there had been a failure to provide adequate reasons, there was an abuse of power, there was a legitimate expectation that given the approach in respect of the previous year's accounts and the objections raised in respect of that assessment the respondent would treat the 1997/1998 year's accounts and objections raised in respect of the assessment in the same way and that fairness required reasons to be given as to why it did not and, lastly, that there was a lack of proportionality in that it was unnecessary in the circumstances to refuse a complete unconditional hold over.

6.  The applicant is a subsidiary of Nam Tai Electronics Inc. (“NTEI”) a BVI company.  NTEI is the holding company of a group of companies which are involved in the manufacture and sale of electronic products.  The group had from about 1986 moved its manufacturing activities to the Mainland.  By 1992, most of its operations had moved from Hong Kong to Shenzhen.  Within the group are three PRC companies which are also subsidiaries of the applicant.  Those three companies are Nam Tai Electronic (Shenzhen) Co Ltd (“NTSZ”), Zastron Plastic & Metal Products (Shenzhen) Ltd (“Zastron”) and Shenzhen Namtek Co Ltd (“Namtek”).  NTSZ appears to be the primary manufacturing company within the group, whereas NTEE is responsible for selling the products.  Management and administrative services for NTSZ, Zastron and Namtek, were provided by NTEI although in fact they were rendered by a Canadian company within the group.

7.  By a letter of 12 December 2002 the department informed the applicant that it was conducting a tax audit of the returns and accounts for the years 1996/1997 to 2001/2002.  Consequent upon that, one of the matters which the respondent queried were the costs of the management and administrative services which were paid by the applicant to NTEI.  For example in the year 1996/1997 management fees of $32,313,540 were paid by the applicant to NTEI.  Given the fact that it is the applicant's case put in correspondence by its tax advisers, Grant Thornton, that the applicant performs little function within the group, the respondent's query in this regard is not surprising.  However the respondent eventually agreed to hold over the additional assessment in respect of the year 1996/1997 which had been raised on 28 February 2003 because the applicant demonstrated that its accounts showed that management fees had been received from the three PRC subsidiaries totalling $17,654,943.  Of that sum $15,365,527 had been paid by NTSZ.  This amount had been shown in the accounts audited by the applicant's auditors, Price Waterhouse.  Indeed in the notes to the accounts, under the heading Significant Related Party Transactions, the total amount of management fees received from the subsidiaries was listed.  Likewise the management fee paid to the ultimate holding company, NTEI, was also listed.

8.  However the position in relation to the 1997/1998 accounts was rather different.  In those accounts although a management fee of a similar amount was paid to the ultimate holding company, NTEI, namely the sum of $34,790,641, the management fee received from the subsidiaries was markedly lower namely $5,039,809.  No payment had been made by NTSZ.

9.  The applicant's explanation, proffered by its tax advisers, was that the management and administrative services were covered by a service agreement between the applicant and NTSZ.  That service agreement provided that NTSZ would pay the applicant a fee equivalent to an aggregate of 7.4% of the total turnover of goods supplied subject to a minimum payment of US$10,403,000.  Under clause (7) of that agreement the fee payable by NTSZ would be reduced by any taxes which it had to pay on the fee and would be realised by the purchase price of the finished goods purchased by the applicant from NTSZ being reduced by the amount of the fees due under the agreement.

10.  That explanation did not satisfy the respondent.  It is not surprising that it did not satisfy the respondent.  In the first place the accounts which had been audited by the auditors at the relevant time did not show any related party transactions.  If the management and administrative services fee had indeed been paid by NTSZ, whether by a direct payment or by an indirect allowance given by means of a reduction of the price paid by the applicant for the goods supplied by NTSZ, those transactions and payments would still constitute related party transactions and should, therefore, have been included in the notes to the account.  The fact that the auditors at the time approved the accounts showing that there was no related party transaction as regards NTSZ was thus very significant.

11.  In addition the further point arises that it appears that there was an arrangement amongst the companies in the group that the applicant would show gross profit on turnover of something in the order of the 7% of turnover.  Indeed the gross profit on turnover in the years under question are shown in a table produced by the respondent, the accuracy of which was not disputed.  For the year 1996/1997 the gross profit the ratio was 7.29% and for the year 1997/1998 the gross profit ratio was 7.28%.  Those turnover amounts would seemingly have been constituted by products from NTSZ, since more than 99% of the products sold by the applicant were supplied by NTSZ.  Those figures showed a consistency.  As a separate matter from the turnover, there was a direct payment from the three PRC companies of management fees in the amount of $17,654,943 in the first year, whereas, in the year in question, there was no payment by NTSZ in respect of management fees, the amount of $5,039,809 being paid by the other PRC subsidiaries.  These payments of management fees were quite separate from the turnover on which the gross profit was calculated.

12.  Quite understandably therefore the respondent took the view that the protestations by the tax adviser were not borne out by what happened in practice as recorded in the contemporaneous accounts audited by the company's then auditors.  In a letter dated 10 May 2004 the respondent drew attention to that fact that a significant proportion of the fee paid by the applicant to NTEI could be traced to the provision of services that benefited other group companies but not the applicant.  Importantly that letter said at paragraph 3(c):

“No evidence was adduced to support the assertion that NTEE (the applicant) had recouped from the PRC group companies management fee paid on their behalf by including a margin on the purchase costs from the PRC group companies concerned.  Analysis of the trend of the gross profit margins by NTEE over a number of years lent little support that the margin attributed to NTEE on its purchase transactions conducted with the PRC group companies had reflected any element of recovery of management fee from the PRC group companies concerned.”

13.  In my view the respondent was more than amply justified in taking this view.  The provisions of clause (7) of the agreement relating to the 1997/1998 service fees were also contained in the previous year's service agreement and yet in the earlier year a substantial fee had been paid quite separately from the percentage allowance on the cost of the products which went to make up the 7.29% gross profit, which was in line with the group's arrangement.

14.  In so far as the respondent came to the conclusion that the objection made on behalf of the applicant had some merit, no objection at all to the respondent's approach could be taken.  In so far as the respondent came to the conclusion that the balance of probability, based on the facts known to exist at the date of the objection, did not weigh definitely in favour of the taxpayer, my view of the matter is that the respondent was being particularly generous to the applicant.  The respondent was not saying that there was no evidence of a framework which might result in applicant being reimbursed by NTSZ.  What was said was that there was no evidence produced to support the assertion that the applicant had in fact recouped the fees from NTSZ.  Two conclusions flow from that.  In the first place there could be no criticism of the decision making process.  In the second place the decision was clearly right.  It may be that, at the end of the day it will be accepted or proved that the applicant had recouped the expenditure, but using the words of the Interpretation and Practice Note, I cannot see how it could be said that the arguments adduced to date “weigh definitely in favour of the taxpayer”.

15.  From what has been said above, there was thus no inconsistency in the approach to the objections in respect of the two years in question.  In part, it might be said that the very difference between the two years in question and their treatment in the applicant's accounts has mandated that the respondent should impose a condition of the purchase of the TRC.  In my view this appeal was without any merit whatever.

Hon Cheung JA:

16.  I agree.

Hon Sakhrani J:

17.  I also agree.