PATRICK COX ASIA LTD v. THE COMMISSIONER OF INLAND REVENUE

CACV 357/2023, [2024] HKCA 944

On Appeal From [2023] HKCFI 2676

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF APPEAL

CIVIL APPEAL NO 357 OF 2023

(ON APPEAL FROM HCIA NO 4 OF 2023)

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J U D G M E N T

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Hon G Lam JA (giving the Judgment of the Court):

Introduction

1.  Patrick Cox Asia Limited (“PCAL”)  objected to being assessed to profits tax in respect of certain income for the four years of assessment from 2009/10 to 2012/13.  Its appeal was rejected by the Board of Review (“Board”)  in a decision dated 17 March 2023 (“Decision”).[1]  PCAL’s further appeal in point of law to the Court of First Instance was dismissed by Cheng J in her judgment dated 19 October 2023 (“Judgment”).[2]  From the Judgment PCAL now appeals to this court.  The issues raised concern the geographical source of the profits in question and whether certain income is capital or revenue in nature.

Background

2.  PCAL (formerly called Hookedge Ltd)  is a company incorporated in Hong Kong in December 2008, and a wholly-owned subsidiary of a company incorporated in the United Kingdom also called Hookedge Ltd (“Hookedge”). Mr Antares Cheng (“Cheng”)  was at all material times the sole director of PCAL.

3.  Hookedge was the owner of the mark “Patrick Cox” and its related marks, logos and devices (“Trademarks”). 

4.  At a board meeting of Hookedge held in Hong Kong on 26 January 2009, it was noted that PCAL had been incorporated for the purposes of carrying on the business of developing, promoting and managing the distribution and sale of various footwear products, accessories, fashion apparel, bags and other merchandise bearing inter alia the Trademarks, through licensing or other means, in the Asia Pacific Region.  It was resolved that the setting up of PCAL for such purposes be ratified and that the grant of a master licence to PCAL to use the Trademarks in carrying on such business, including the right for PCAL to grant sub-licences to any third party in the Asia Pacific Region, be approved.  It is common ground that the master licence was granted to PCAL there and then, even though a written master licence that had been prepared was never executed.

5.  PCAL was registered as the licensee of the Trademarks at, among others, the Japan Patent Office, with Hookedge being the registered owner.

6.  Having thus obtained a master licence and after some negotiations, on 21 January 2009 PCAL entered into an agreement by deed, called “Deed of Cooperation”, with a Japanese company called “British Luxury Brand Group Ltd” (“BLBG”)  for the exploitation of the Trademarks in Japan.  It is an important document in this appeal and we set out the relevant provisions below. 

7.  The Deed of Cooperation contains these definitions:

(1)  “Business” means the design, manufacture, distribution and sale of the Products in Japan;

(2)  “Products” means various men’s and ladies’ footwear products, accessories, fashion apparel, bags and any other merchandise designed, produced and sold using or under the Trademark or the brand name of “Patrick Cox”;

(3)  “Trademark” means “the trademarks, trade names and service marks and logos which have been applied for registration or registered anywhere in the world, including the mark of ‘Patrick Cox’ and all other trademarks, logos, devices, signs, trade names and service marks that are or may, during the term of this Deed, be applied for registration and/or registered anywhere in the world and designated for use in connection with, inter alia, the Business”;

(4)  “Licensing Program” means the activities and services to be performed by BLBG under the Deed of Cooperation; and

(5)  “Group” means PCAL and its subsidiaries.

8.  Recital E states:

“ BLBG has agreed to coordinate all licensing arrangements for [PCAL] and its sub-licensees in Japan in relation to operation of the Business there and to share the profits generating therefrom with [PCAL] pursuant to the terms and subject to the conditions set out in this Deed.”

9.  In terms of the responsibilities the parties have respectively undertaken, the Deed of Cooperation provides:

(1)  PCAL shall act as the master licensor in Japan. It shall issue a letter of authorisation to BLBG authorising it to act in the capacity of representative of the Patrick Cox Group and brand in Japan for the purposes of the Licensing Program.  For that purpose BLBG may assist in the setting up of a representative office of PCAL in Japan at BLBG’s expense and in such manner and style as PCAL may approve.  (Clause 3.1)

(2)  Subject to the provisions of the Deed of Cooperation, PCAL shall have full power and authority to control, manage and supervise the activities and affairs of the Business, including review, modifications and approval of all the licence agreements to be entered into between PCAL and the respective licensees.  PCAL shall delegate the day-to-day running of the Business to BLBG and shall generally follow the recommendations of BLBG with regard to appointment of licensees and the terms of such appointments, subject to the overall approval of the board of directors of PCAL, such approval to be given in timely fashion and not unreasonably or arbitrarily withheld.  (Clause 4.1)

(3)  PCAL shall grant sub-licences to any third parties introduced or referred by BLBG to use the Trademark in carrying on the Business in Japan on such terms and conditions as PCAL considers appropriate, and shall procure the cooperation and assistance of Hookedge in supporting the Business and the Licensing Program.  (Clause 5.1)

(4)  BLBG has to:

(a)  locate, identify, refer and/or introduce to PCAL any potential distributors or licensees or sub-licensees who are interested in marketing, promoting and distributing the Products in Japan;

(b)  arrange for, coordinate and/or participate in meetings and negotiations for and on behalf of PCAL or any member of the Group as licensor in relation to the licensing of the Trademark and the operation of the Business in Japan;

(c)  bear all expenses for marketing, promoting and implementing the Licensing Program in Japan, including the expenses for promotional trips of Patrick Cox to Japan from time to time;

(d)  employ at its own expense a specified person in Paris/London to liaise with Hookedge on all aspects of implementing the Licensing Program in Japan and assisting with public relations in the fashion industry in Europe and Japan;

(e)  provide a design team to work on the design and development of the Products and, where necessary, work with Patrick Cox;

(f)  use its design team to assist the Group with adaptation and design of the Products for other markets in Asia;

(g)  render services in re-negotiation for renewing an existing contract between Hookedge and Vendome into a contract between PCAL as master licensor and Vendome as sub-licensee with all royalties payable to PCAL;

(h)  endeavour to secure the most favourable terms possible from all licensees and to procure the incorporation of all such terms into the licence agreements; and

(i)  take all necessary actions to ensure that all licensees pay royalties due under their respective licence agreements with PCAL or any member of the Group in a timely manner, and assist PCAL with the collection of the same as necessary.  (Clauses 5.2.2 – 5.2.10)

10.  On payments and financial arrangements, the Deed of Cooperation provides:

(1)  BLBG shall make an “upfront payment” of £500,000 to PCAL upon the signing of the Deed as “initial fee for obtaining the right to participate in the management of the Business and the sharing of profits therefrom”.  (Clause 5.2.1)

(2)  All licence agreements are to be entered into directly between PCAL or a member of the Group and each licensee, so that all royalty income will flow to PCAL.  (Clause 6.1.1)

(3)  Subject to clause 6.1.3, the royalty income received by PCAL under the Licensing Program in Japan, before payment of tax and operation expenses (defined as the “Gross Royalty Income”), shall be shared between PCAL and BLBG on a 40:60 basis during the term of the Deed from 1 August 2009 to 31 January 2013.  (Clause 6.1.2)

(4)  All ongoing operational expenses incurred in implementing the Licensing Program, including staff costs, marketing and promotion costs and so forth, shall be for the account of BLBG.  (Clause 6.1.2)

(5)  PCAL shall be entitled to retain the higher of (i)  40% of the Gross Royalty Income or (ii)  US$750,000 out of the Gross Royalty Income received each year under the licence agreements, and with regard to the 6 months’ period ending on 31 January 2013 PCAL shall be entitled to retain the higher of (i)  40% of the Gross Royalty Income or (ii)  US$375,000 out of the Gross Royalty Income received during such period under the licence agreements.  (Clause 6.1.3)

(6)  In consideration of PCAL’s granting to BLBG on an exclusive basis the right to manage the Business, BLBG guarantees the payment of PCAL’s share of the Gross Royalty Income by providing a separate corporate guarantee of the minimum royalty income for each year and the final 6 months’ period referred to in clause 6.1.3 totalling US$2,625,000. (Clause 7.1 and Corporate Guarantee)

11.  The Deed of Cooperation also provides that nothing in it shall constitute or be deemed to constitute a partnership between the parties, or constitute or be deemed to constitute either party as agent of the other for any purpose whatsoever, and neither party shall have authority or power to bind the other or to contract in the name of the other in any way or for any purpose.  (Clause 14)

12.  Pursuant to the Deed of Cooperation, BLBG managed to procure three sub-licensing agreements that PCAL entered into with three Japanese sub-licensees respectively including Vendome (“Sub-licence Agreements” and “Sub-licensees”)  between April and June 2009.  Each of the Sub-licence Agreements is a contract between PCAL and the Sub-licensee alone.  BLBG is not a party, although it is recited that BLBG has been appointed by PCAL as its agent performing the functions of the representative of the licensor, i.e. PCAL, in Japan.  The main provisions of the Sub-licence Agreements, which are in very similar terms, include:

(1)  Under Art. 2:

“ The Licensor exclusively grants to the Licensee the right to carry out manufacturing and sales within the Licensed Region [i.e. Japan], affixing the Trademark to the Products, as well as the right to use the Know-how in the manufacture and sale of the Products.”

“ The Licensor guarantees and promises that it will make sure that the Trademark continues to remain in effect during the term of validity hereof, that the Trademark does not infringe on the rights of a third party, and that the Licensor shall continue to possess the right to license the use of the Trademark to the Licensee.”

The trademark specified is the “Patrick Cox” mark registered in Japan.

(2)  Under Art. 3:

“ The Licensor shall provide the Know-how for the manufacture and sale of the Products by the Licensee. The specific contents of the Know-how and the timing of its provision shall be determined by the Licensor from time to time during the continuance of this Contract.”

(3)  In manufacturing the products concerned, the Sub-licensee needs the prior consent from PCAL (or through the agent, BLBG)  regarding matters such as design, product planning, raw materials, sample quality, transport materials, and promotion materials.  The prior consent from PCAL (or through the agent, BLBG)  is also required for the retail prices of all the products.

(4)  In return, the Sub-licensee promises to pay PCAL royalties calculated as a percentage of the Sub-licensee’s sales or net turnover.[3] Two of the Sub-licence Agreements contain provisions on the minimum amounts of royalties payable to PCAL for each of the three years in question.  The royalties are to be paid to PCAL’s designated bank account.

13.  Pursuant to clause 5.2.1 of the Deed of Cooperation, BLBG duly paid £500,000, equivalent then to HK$6.25 million, to PCAL (“Upfront Payment”). 

14.  Further, during the operation of the Deed of Cooperation and the Sub-licence Agreements between 2009 and 2013, PCAL received royalties from the Sub-licensees, 40% of which was retained by PCAL as its income, with the other 60% going to BLBG, pursuant to the Deed of Cooperation. We shall refer to the royalties paid by the Sub-licensees collectively as the “Royalties” and the 40% portion received by PCAL as the “Royalties Income”.  The total amount of PCAL’s Royalties Income aggregated over the 4 years in question is approximately HK$16.67 million.  It is common ground that on the facts the Royalties Income came solely from the Sub-licensees and BLBG’s guarantee in the Deed of Cooperation was never called upon.

15.  PCAL in turn paid a licence fee to Hookedge for the use of the Trademarks at the rate of 25% of the Royalties Income.

16.  The tax dispute has centred around whether the Upfront Payment and the Royalties Income are profits assessable to tax.  PCAL contends that they are not, because they are offshore profits and also because the Upfront Payment is a capital receipt.  The Commissioner of Inland Revenue (“Commissioner”)  disputes both contentions.  There was an additional ground previously relied on by PCAL, namely that it did not carry on a trade, profession or business in Hong Kong, but this was rejected by both the Board and the judge and is no longer pursued in this appeal.

17.  There are therefore 3 questions that arise: (1) whether (a) the Upfront Payment, and (b) the Royalties Income, are, in the words of the statute, “profits arising in or derived from Hong Kong”; and (2) whether the Upfront Payment is a capital receipt.

Source of profits

The principles

18.  Section 14(1)  of the Inland Revenue Ordinance (Cap 112)  provides:

“ Subject to the provisions of this Ordinance, profits tax shall be charged for each year of assessment on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business …”

19.  Section 2(1)  provides that “profits arising in or derived from Hong Kong”, unless the context otherwise requires, “shall, without in any way limiting the meaning of the term, include all profits from business transacted in Hong Kong, whether directly or through an agent”.

20.  In the seminal case of Commissioner of Inland Revenue v Hang Seng Bank Ltd [1991] 1 AC 306, profits accrued to the taxpayer bank from the purchase and resale outside Hong Kong of certificates of deposit.  In considering whether such profits were chargeable to tax under section 14, the Privy Council rejected the contention that the business run by the bank in Hong Kong should be treated as one and indivisible and that the profits from the overseas trading in certificates of deposit were mere components of the profits of an entire business in Hong Kong.  It was held that the structure of section 14 presupposes that the profits of a business carried on in Hong Kong may accrue from different sources, some located within Hong Kong, others overseas.  A distinction falls to be made between profits arising in or derived from Hong Kong and those outside Hong Kong according to the nature of the different transactions by which the profits were generated.  The proper approach to that question was explained by Lord Bridge as follows:

“ But the question whether the gross profit resulting from a particular transaction arose in or derived from one place or another is always in the last analysis a question of fact depending on the nature of the transaction. It is impossible to lay down precise rules of law by which the answer to that question is to be determined. The broad guiding principle, attested by many authorities, is that one looks to see what the taxpayer has done to earn the profit in question. If he has rendered a service or engaged in an activity such as the manufacture of goods, the profit will have arisen or derived from the place where the service was rendered or the profit making activity carried on. But if the profit was earned by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities by buying and reselling at a profit, the profit will have arisen in or derived from the place where the property was let, the money was lent or the contracts of purchase and sale were effected. There may, of course, be cases where the gross profits deriving from an individual transaction will have arisen in or derived from different places.”

21.  In that case, it was held that the profits in question were essentially trading profits generated by the buying and selling of certificates of deposit overseas, and were therefore offshore profits.  The fact that the investment decisions relating to the certificates were taken in Hong Kong and the funds used to buy the certificates derived from the banking business in Hong Kong did not lead to any different conclusion.

22.  In Commissioner of Inland Revenue v HK-TVB International Ltd [1992] 2 AC 397, the taxpayer, a Hong Kong company, was granted by its parent company the exclusive right to grant sub-licences for the exhibition outside Hong Kong of various films in Chinese dialects.  It sent representatives abroad to solicit business and to negotiate with potential customers.  The sub-licences were prepared in Hong Kong.  The sub-licensees paid fixed fees, unrelated to their profits, to the taxpayer in Hong Kong.  The films were dispatched to the sub-licensees from Hong Kong.  The taxpayer sometimes also provided facilities for the duplication of films onto video cassettes and for dubbing which was carried out in Hong Kong, and the cost was included in the sub-licence fee.

23.  In its judgment the Privy Council expanded Lord Bridge’s broad guiding principle to say “one looks to see what the taxpayer has done to earn the profit in question and where he has done it.”[4]  The transactions that produced the profit to the taxpayer were identified as, first, the acquisition of the exclusive rights of granting sub-licences together with the relevant films, and secondly, the grant of those sub-licences together with provision of the film by contracts with individual customers.  On the taxpayer’s argument that, like letting a property, it had exploited property assets by sub-licensing rights which were only capable of use abroad, the Privy Council said it is a “false analogy, since it presupposes that intellectual property rights have a situs similar to immovable property”, and did not accept that “intellectual property rights exercisable only in one country are to be equiparated to immovable property in that country”.[5]  Giving the judgment of the Privy Council, Lord Jauncey stated (at p 409E-G):

“ The proper approach is to ascertain what were the operations which produced the relevant profits and where those operations took place. Adopting this approach what emerges is that the taxpayer, a Hong Kong based company, carrying on business in Hong Kong, having acquired films and rights of exhibition thereof, exploited those rights by granting sub-licences to overseas customers. The relevant business of the taxpayer was the exploitation of film rights exercisable overseas and it was a business carried on in Hong Kong. The fact that the rights which they exploited were only exercisable overseas was irrelevant in the absence of any financial interest in the subsequent exercise of the rights by the sub-licensee. Their Lordships therefore consider that the profits accruing to the taxpayer on the grant of sub-licences during the relevant years of assessment arose in or derived from Hong Kong and as such were subject to profits tax under section 14.”

24.  The Court of Final Appeal has adopted the principles laid down in Hang Seng Bank and HK-TVB International and further elucidated them.  In Kwong Mile Services Ltd v Commissioner of Inland Revenue (2004)  7 HKCFAR 275, the taxpayer underwrote the presale of premises being built in Guangzhou.  According to the underwriting agreement, signed in Guangzhou, the taxpayer would be liable to the developer for any shortfall in the price received below a specified threshold, but would be entitled to any excess sale proceeds beyond it.  The taxpayer appointed a company as its exclusive agent in marketing the property.  The marketing took place in Hong Kong and the binding provisional sale and purchase agreements were entered into in Hong Kong between the purchasers and the developer.  All but two of the buyers were Hong Kong residents and payments were made in Hong Kong, from which profits accrued to the taxpayer.  The Court of Final Appeal, agreeing with the courts below and reversing the Board of Review, held that what earned the profits for the taxpayer were its exertions in the form of its activities in Hong Kong (done by its agent)  in marketing the property, and that its profits arose in or derived from Hong Kong.[6]

25.  In a judgment in which other members of the court concurred, Bokhary PJ adopted the observation made in previous authorities that the question of source is a “practical, hard matter of fact”, with “hard” meaning hard-nosed in that expression’s sense of being realistic.  This also means, as explained in a later case,[7] that it is “not a technical matter but a commercial one.”  But his Lordship also added that judging the matter of source as one of practical reality does not involve disregarding the accurate legal analysis of transactions.[8] 

26.  Referring to the broad guiding principle laid down in Hang Seng Bank / HK-TVB International, Bokhary PJ pointed out that it is not meant to be a universal test for ascertaining the source of a profit, nor can there be any such test.  “Apart from the words of the statute themselves, the only constant is the need to grasp the reality of each case, focusing on effective causes without being distracted by antecedent or incidental matters”, stating that the source with which section 14 is concerned is “a quite proximate source”.[9] This aspect of the proper approach was emphasised in ING Baring Securities (Hong Kong)  Ltd v Commissioner of Inland Revenue (2007)  10 HKCFAR 17. 

27.  In that case the taxpayer carried on the business of agency brokerage in Hong Kong as a member of a group with a global business.  It acted for clients in Hong Kong which wished to deal in securities listed in Hong Kong or elsewhere, but it also acted on the instructions of other members of the group given on behalf of clients outside Hong Kong which wished to deal in such securities.  Where the taxpayer was authorised to deal on the relevant stock exchange, it carried out the trade itself.  Where it was not authorised to do so, it instructed local stockbrokers or a group company to carry out the transaction.  The commission for executing the clients’ trades, referred to as “commission income”, formed part of the profits the geographical source of which was in issue in that case.  Another part of the profits disputed was “marketing income”, being payments made by overseas group companies to the taxpayer (as a portion of the commission received)  for the introduction of clients who effected trades on overseas markets through those group companies.

28.  Highlighting the need to focus on relevant activities, Ribeiro PJ, after referring to Kwong Mile Services Ltd, stated:[10]

“ The focus is therefore on establishing the geographical location of the taxpayer’s profit-producing transactions themselves as distinct from activities antecedent or incidental to those transactions. Such antecedent activities will often be commercially essential to the operations and profitability of the taxpayer’s business, but they do not provide the legal test for ascertaining the geographical source of profits for the purposes of section 14.”

29.  His Lordship criticised the Board in that case for adopting a “highly diffuse approach” to the issue of source, for taking into account legally irrelevant activities such as the taxpayer’s research and sales service and settlement or back-office operations, and for wrongly considering it necessary to investigate every facet of the taxpayer’s business in order to engage in a qualitative assessment of the relative importance of its various operations towards the generation of the profits concerned.[11]  In the same vein, Lord Millett NPJ said that the relevant operations, that is to say, the operations from which the profits in substance arise, “do not comprise the whole of the taxpayer’s operations but only those which produce the profit in question.”[12]

30.  In addition, Lord Millett NPJ considered the effect of agency on the question of source of profits.  He noted that in law, an agent properly so called is a person who acts on behalf of the principal so as to affect the principal’s legal relations with a third party, but that many professional persons who act for clients and who are popularly described as agents are not agents in this sense at all.  His Lordship stated:[13]

“ In considering the source of profits, however, it is not necessary for the taxpayer to establish that the transaction which produced the profit was carried out by him or his agent in the full legal sense. It is sufficient that it was carried out on his behalf and for his account by a person acting on his instructions. Nor does it matter whether the taxpayer was acting on his own account with a view to profit or for the account of a client in return for a commission.”

31.  In the result, the Court of Final Appeal held that the commission income was earned by the taxpayer by executing client orders on foreign stock markets (either by itself or through group companies)  and was therefore sourced overseas.[14] As to the marketing income, Lord Millett considered it in substance an introductory fee earned where the introduction was made, i.e. where the party to whom the introduction was made was located.  Chan and Ribeiro PJJ reasoned that the introduction only took effect as a profit-generating transaction and the relevant payment became payable to the taxpayer when that client traded on the foreign stock exchanges.  Accordingly, this category of income was also sourced outside Hong Kong.[15]

The decisions below

32.  In its Decision, in relation to the source of profits the Board directed itself to focus on the operations of PCAL as opposed to the activities of other entities such as Hookedge and BLBG.

33.  In relation to the Upfront Payment, the Board considered that it was PCAL’s acquisition of the master licence from Hookedge and the use of it to enter into the Deed of Cooperation that were the profits-producing activities of PCAL.  PCAL obtained the master licence from Hookedge in Hong Kong, since it was granted in or pursuant to the board meeting of Hookedge held in Hong Kong on 26 January 2009.  As for the Deed of Cooperation, PCAL was highly involved in its negotiation and preparation through Cheng, Ricky Li and Simon Low-nang who resided in Hong Kong (even though Lee might have taken the “lead role” in the negotiations from Japan), and Cheng approved and executed it in Hong Kong, so that it was made and concluded in Hong Kong.[16]

34.  As regards the Royalties Income, the Board considered that what PCAL had done to earn the relevant profits was the acquisition of the master licence and the use of it to enter into the Deed of Cooperation and the Sub-licence Agreements.  While the Sub-licence Agreements might have been primarily negotiated by BLBG on behalf of PCAL with the Sub-licensees, PCAL had the final say on the appointment of the Sub-licensees and the terms of appointment.  The Sub-licence Agreements were signed by PCAL (through Cheng)  in Hong Kong.  It is true that BLBG procured the Sub-licensees through its work in Japan, but those activities were what BLBG did to generate its profits and did not affect the fact that the location of the profit-producing operations of the Royalties Income for PCAL was Hong Kong.[17]

35.  In her Judgment, Cheng J essentially held that the Board did not make any legal error in its Decision, as alleged by PCAL. The relevant parts of her Ladyship’s reasons will be referred to below.

Contentions on appeal

36.  Because source of profits is a question of fact and an appeal from the Board is on point of law, the court is only entitled to intervene, in the absence of a specifically identifiable error of law, where the Board’s decision is contrary to the true and only reasonable conclusion: Kwong Mile Services Ltd at §§31-37.  In assessing whether that is the case, the court needs to bear in mind, as Litton VP said in Commissioner of Inland Revenue v Magna Industrial Co Ltd [1997] HKLRD 173 at 181D (approved in Kwong Mile Services Ltd at §36), that “[t]he words ‘profits arising in or derived from Hong Kong’ in s. 14 have a wide meaning and can accommodate a variety of situations in which it could not be said to be wrong to arrive at a conclusion one way or the other.”

37.  PCAL’s contentions on source of profits may be summarised as follows:

(1)  The Deed of Cooperation governed a single joint business of licensing the Trademarks in Japan carried on by BLBG on behalf of PCAL.  BLBG was PCAL’s agent to whom the management of the licensing business was delegated.  Applying the principle of agency in the broad sense explained in ING Baring, BLBG’s operations in Japan on behalf of PCAL should be imputed to PCAL.

(2)  Although Cheng signed the Deed of Cooperation and the Sub-licence Agreements in Hong Kong, this was not where they were concluded (i.e. procured, negotiated etc).  BLBG took the lead role in concluding the Sub-licence Agreements; they were effected in Japan by BLBG on behalf of PCAL.  The composite transaction of procuring, negotiating and executing the sub-licences should be treated as a single, continuous commercial operation.

(3)  The Board and the judge relied on a number of impermissible or irrelevant factors: (a) despite the “brain analogy” had been rejected in ING Baring, the Board relied on the fact that Cheng was the ultimate decision-maker and had the final say in whether PCAL entered into a sub-licence; (b) the judge thought it relevant that there were reasons for PCAL to be incorporated in Hong Kong; (c) Li’s input in discussions relating to the Sub-licensees was taken into account by the judge even though he was a director of Hookedge; and (d) Cheng’s director’s fee from PCAL was deductible in the hands of PCAL and chargeable in Cheng’s hands to salaries tax.

(4)  No weight should have been attached to the grant of the master licence by Hookedge to PCAL in Hong Kong.  It was not a profit-making operation for PCAL.  PCAL did nothing to obtain it, and got nothing out of it unless and until it engaged in sub-licensing operations.

(5)  The use of and right to use the Trademarks are inherently territorial assets.  They can only be exploited in the jurisdiction of registration, i.e. Japan.  HK-TVB International is distinguishable because the licensed rights in that case were copyrights which, unlike trademarks, do not need to be registered and can be used without territorial limitation.

38.  The Commissioner takes issue with these contentions and essentially seeks to uphold the Decision and the Judgment.

Source of the Upfront Payment

39.  In our view it is necessary to analyse the source of the Upfront Payment and that of the Royalties Income separately, for they are income received from different payers under different contracts for different consideration.  PCAL has not done so in its submissions, as a result of which it is at times difficult to see which of the arguments advanced apply to the Upfront Payment and how.

40.  The Upfront Payment was received by PCAL pursuant to its entitlement under the Deed of Cooperation.  The Deed of Cooperation describes it as an initial fee paid by BLBG for obtaining the right to participate in the management of the Business and the sharing of profits therefrom.  The Board considered that the activities that generated this profit were two-fold, namely, PCAL’s acquisition of the master licence from Hookedge, and the use of such licence to enter into the Deed of Cooperation, both of which it considered to have taken place in Hong Kong.[18] 

41.  As a payment received from BLBG under the Deed of Cooperation, clearly PCAL’s first two contentions relying on agency and what BLBG did on its behalf (see §37(1)  & (2)  above)  are not relevant.  So far as the Upfront Payment is concerned, BLBG was the counterparty.  The sum was paid before the sub-licensing business commenced.  What BLBG is said to have done on behalf of PCAL in managing the sub-licensing business cannot sensibly be regarded as PCAL’s operations that earned this income.

42.  In its third contention, PCAL submits that the Board and the judge relied on certain irrelevant factors.  In our view Mr Julian Lam who appears for the Commissioner is correct in submitting that they were strawman arguments.

(1)  PCAL says that the Board wrongly placed weight on Cheng being the “ultimate decision-maker” and employed the “brain analogy”, which had been criticised and rejected by the Court of Final Appeal in ING Baring (at §§48 & 62).  However, what the Board in ING Baring erroneously focused upon was the place of administration of the business and the organisation structure and set-up of the taxpayer’s offices.  That is not what the Board in the present case did.  Nor did the Board reason that because Cheng was the brain of PCAL its profits were likely to be derived from where he resided.  As the judge pointed out,[19] the Board discussed Cheng’s role in the context of determining that the Deed of Cooperation was concluded by him in Hong Kong, which PCAL does not allege to be irrelevant.

(2)  As for the commercial reasons for PCAL to be incorporated in Hong Kong, the judge only referred to the fact that there were such commercial reasons in order to distinguish the case of Thorpe Nominees Pty Ltd v FCT (1988)  19 ATR 1834, which was cited by Mr Mariani in support of his argument for PCAL that one should not place weight on where the income-producing agreements were signed.  Plainly the judge did not take the existence of such commercial reasons into consideration as a matter probative itself of the source of the Upfront Payment.

(3)  PCAL submits that whether Cheng’s director’s fee from PCAL was deductible in the hands of PCAL and chargeable in his hands to Hong Kong salaries tax says nothing pertinent to the question of the locality of PCAL’s income.  This may well be correct.  But the Board only referred to Cheng’s director’s fee in the context of rejecting PCAL’s argument that in making the relevant decisions, Cheng was acting as a director of Hookedge rather than PCAL.[20] We agree with the judge that the Board did not err in doing so.[21]  Neither the Board nor the judge took Cheng’s fee or his tax position into account as a matter probative of the source of PCAL’s profits.

43.  PCAL’s fourth contention is that no weight should be attached to the grant of the master licence by Hookedge to PCAL in Hong Kong.  Mr Mariani says PCAL did nothing but had the master licence conferred on it unilaterally.  This may have an influence on the proper weight to be put on it but we do not see why the acquisition of rights in the Trademarks should in principle be ignored.  In HK-TVB International, even though the rights to grant sub-licences were also obtained by the taxpayer, apparently without making any effort, from its parent company, the Privy Council considered that one of the transactions that produced the profit in question for the taxpayer was the acquisition of the exclusive rights of granting sub-licences together with the relevant films.[22]  It should also be noted that PCAL paid licence fees to Hookedge for the master licence which is something it must have decided and agreed to do, so that PCAL was not a purely passive recipient of the licensing rights.

44.  In any event, as Mr Lam points out, this point would not avail PCAL because it accepted that what it did to obtain the Upfront Payment was to enter into the Deed of Cooperation.[23]  So far as PCAL is concerned, that it did in Hong Kong, as held by the Board having considered the steps taken by PCAL in the preparation and negotiation of the terms leading up to the signing of that agreement.[24] There is no direct challenge by PCAL against this finding.

45.  PCAL’s fifth contention is that the Trademarks were registered in Japan and could only be exploited there.  It seems to us that this point is more relevant to the Royalties Income than the Upfront Payment.  The Upfront Payment was received from BLBG under the Deed of Cooperation, not from an exercise of any rights in the Trademarks either by PCAL or BLBG.  In substance it was a payment made by BLBG to PCAL for appointing the former as the latter’s agent and delegating to the former the management of the licensing business in relation to the Trademarks with the right to receive a 60% share of the Royalties.  That appointment was done with authority emanating from Hong Kong, pursuant to a contract negotiated on PCAL’s behalf from Hong Kong and signed by PCAL in Hong Kong, and in accordance with Hong Kong law.  BLBG’s share was promised by PCAL from Hong Kong and to be paid by PCAL.

46.  Accordingly, in agreement with the judge, we consider that PCAL has failed by any of its contentions to establish any error of law in the Board’s decision that the Upfront Payment arose in or derived from Hong Kong.

Source of the Royalties Income

47.  In respect of the Royalties Income, the Board considered that what PCAL had done to earn the profits was the acquisition of the master licence and the use of it in entering into the Deed of Cooperation and the Sub-licence Agreements.[25] The Board considered that the Sub-licence Agreements were entered into or “concluded” by PCAL in Hong Kong because Cheng had “the final say” on the terms of the Sub-licence Agreements which were signed by him in Hong Kong.[26]

48.  In contrast, the Board treated the work done in bringing about the Sub-licence Agreements and in the subsequent “maintenance” of those agreements as irrelevant to the source of PCAL’s profits.  It explained in the Decision as follows:

“ 130. The focus of the Board should be on the profit-producing operations of the Royalties of the Appellant only. …

   131.  It might be the case that BLBG had the carriage of the business of procuring the Japanese Sub-Licensees in Japan is argued by the Appellant.  It is also true that the Japanese Sub-Licensees would only exploit the Trademarks in Japan.  BLBG was indeed obliged under the Deed of Co-Operation to locate, identify, refer and introduce sub-licensees to the Appellant and to co-ordinate all licensing arrangements and to manage the day-to-day running of the business etc.  These were however what BLBG did to generate its profits.  They would not affect the locality of the profit-producing operations of the Royalties of the Appellant being Hong Kong …”

49.  Cheng J did not find any legal error in the Board’s Decision.  Her Ladyship’s reasoning, which resembles that of the Board, may be seen from the following passages in the Judgment:

“ 31. It is important to note what the Taxpayer’s profits were. Under the Deed of Cooperation, the Taxpayer and BLBG were to share the royalty income from the licensing program. The Taxpayer’s profits were the 40% Royalties, that is to say, 40% of the gross royalty income (subject to a minimum guaranteed amount under cl.6.1.3). BLBG’s profits were 60% of the gross royalty income. The Taxpayer’s accounts reflected this by recording the 40% as the Taxpayer’s income, rather than 100% less BLBG’s share as expenses (Decision at [20]). The Board also recognised that the Taxpayer’s profits were confined to the 40% Royalties (Decision at [128]).

   32.  Thus, the Taxpayer had to perform its obligations (of granting sub-licences)  under the Deed of Cooperation in order to earn 40% Royalties.  BLBG had to perform its obligations (of identifying and introducing sub-licensees, etc)  to earn its share of the gross royalty income (as indeed the Board held (Decision at [131])).”

50.  In respect of PCAL’s agency argument, the judge said (at §36 of the Judgment, footnote omitted):

“ … the fact that BLBG was designated as agent under the Deed of Cooperation is irrelevant if BLBG’s activities did not produce the Taxpayer’s profits. The Taxpayer had to perform its obligations under the Deed of Cooperation (that is, grant sub-licences)  to earn its profits, and BLBG had to perform its obligations (that is, identify and introduce sub-licensees and arrange for negotiations)  to earn its profits. The acts which BLBG performed … (identifying and introducing sub-licensees to the Taxpayer, and arranging for negotiations)  were not carried out on behalf of the Taxpayer in performance of its obligations under the Deed of Cooperation, but rather, by BLBG in performance of its own obligations under the Deed of Cooperation. Thus the mere fact that the recital of the sub-licences stated that the Taxpayer had appointed BLBG as agent would not engage ‘the principle of agency’. It is putting the cart before the horse to say that since BLBG was the Taxpayer’s agent, therefore its activities should be attributed to the Taxpayer; the prior question is what were the profit producing activities of the Taxpayer? If such activities did not include what the ‘agent’ did, then the fact that the ‘agent’ was the Taxpayer’s agent is nothing to the point.”

51.  With great respect, we are unable to subscribe to this view of the true operations that generated the taxpayer’s profits.  It proceeds from two premises, both flawed in our view.  The first is that the profits in respect of the Royalties Income were earned by PCAL from the performance of its obligations under the Deed of Cooperation: thus it was said that PCAL “had to perform its obligations under the Deed of Cooperation (that is, grant sub-licences)  to earn its profits”.  But the Royalties were not paid by BLBG under the Deed of Cooperation.  They were paid by the Sub-licensees under the Sub-licence Agreements.  The relevant question is not what did PCAL do to justify the 40:60 division of income as against BLBG under the Deed of Cooperation, but what it did to earn the Royalties – and from that, the Royalties Income – paid by the Sub-licensees.  The passages quoted above from the Decision and Judgment answer the former, not the latter.

52.  Under the Sub-licence Agreements the Royalties were payable to PCAL in their entirety.  PCAL and BLBG agreed to divide them between themselves in the proportions of 40:60, but this does not affect the fact that PCAL received its own Royalties Income from the Sub-licensees (it being common ground that BLBG’s guarantee in the Deed of Cooperation was not called upon).  The 60% share is what PCAL was willing for BLBG to have in return for carrying out its duties to PCAL.  It is unnecessary to know whether the money was first paid by the Sub-licensees to PCAL who then paid 60% to BLBG or the Sub-licensees were themselves directed to make split payments. Nor does it matter whether PCAL booked 100% of the Royalties as income and 60% as an expense, or simply booked 40% as income.  The accounting treatment does not dictate the assessment of tax: Nice Cheer Investment Ltd v Commissioner of Inland Revenue (2013)  16 HKCFAR 813.  In either case the question is the geographical source of the Royalties Income received from the Sub-licensees.

53.  The second false premise is that what BLBG did was done to earn its profits and is therefore irrelevant to the geographical source of PCAL’s profits.  With respect this is a non sequitur. BLBG was not a gratuitous agent.  It had to be paid.  From its point of view, what it did was of course done for the purpose of earning its remuneration from its principal, PCAL.  But this alone does not prevent what BLBG did on behalf of PCAL from being regarded as PCAL’s operations that earned the profits from the Sub-licensees, for the purposes of considering the source of PCAL’s profits.  In ING Baring, the executing agent engaged by the taxpayer also charged its own commission, but this did not prevent its execution of clients’ trades from being considered to constitute the operations that generated the net commission income for the taxpayer.[27]  Another illustration is provided by Commissioner of Inland Revenue v Li & Fung (Trading)  Ltd [2012] 3 HKLRD 8.  There the taxpayer entered into contracts with customers whereby it was appointed a buying agent with duties such as locating suppliers and arranging for shipment, in return for a commission of 6% on the F.O.B. value of the merchandise.  The taxpayer in turn entered into contracts with overseas affiliates under which they would provide equivalent services to the taxpayer in return for 4% of the F.O.B. value.  The Commissioner argued that whereas the affiliates earned their 4% by their activities abroad, the taxpayer earned its net 2% in Hong Kong for managing its own activities and those of its affiliates from its Hong Kong headquarters.  That argument was rejected by the Board, which held that as the taxpayer had employed the local sourcing companies to act for it in carrying out transactions for customers, its profits were earned in the place where those companies carried out its instructions.  The Board’s decision was upheld on appeal by Reyes J[28] and the Court of Appeal.[29]

54.  What then, in reality and in substance, are the operations of PCAL that earned it the Royalties Income from the Sub-licensees? In our opinion they are principally threefold: first, the acquisition of the sub-licensing rights in respect of the Trademarks; secondly, the marketing of the Trademarks for sub-licensing and the negotiating and procuring of the Sub-licence Agreements; and, thirdly, the performance of the Sub-licence Agreements including the provision of know-how, the maintenance of the Trademarks, the giving of requisite consent to the Sub-licensees for matters such as product design and retail prices, and potentially taking actions against infringement of the Trademarks by third parties.

55.  As explained earlier in relation to the Upfront Payment (see §43 above), the acquisition of rights in the Trademarks is likewise part of the transactions that produced the profit relating to the Royalties to PCAL.  The acquisition of those rights had an immediate and direct connection with subsequent grant of sub-licences, both being part of the sub-licensing business carried on by PCAL.  The acquisition of the films and rights of granting sub-licences was treated in HK-TVB International as part of the relevant transactions (see pp 407F & 409B).  In Lam Soon Trademark Ltd v Commissioner of Inland Revenue [2004] 3 HKLRD 258, the Board also placed weight on the acquisition of trademarks in determining the source of profits earned from sub-licensing them, having noted that the taxpayer’s principal activities were the acquisition of trademarks and the granting of licences to use the trademarks in return for royalty income (see §§3, 10, 12, 13; pp 260H, 262C, H & I, 263B).[30]  In Hang Seng Bank the Privy Council focused not only on where the sale of the securities took place but also their prior purchase (see p 317H).

56.  The Board considered the entering into of the Deed of Cooperation by PCAL on the strength of the master licence was part of its activities done to earn the Royalties Income.[31]  In our opinion this is but an antecedent, preparatory transaction incidental to the operations that generated the relevant profit.  In particular, it represented what PCAL did for the purpose of appointing an agent to carry out those operations.  Properly examined, the Deed of Cooperation did not produce PCAL’s profit from the Royalties, but defined how much of the Royalties BLBG was to receive as its share.  The Deed of Cooperation may be the source of BLBG’s income, but that is irrelevant for determining the source of PCAL’s profit.  It follows that it is immaterial that the Deed of Cooperation was negotiated from and signed in Hong Kong on behalf of PCAL. 

57.  Instead, the significance of the Deed of Cooperation for present purposes is that BLBG was thereby engaged by PCAL to promote the Trademarks in Japan, to find and identify potential sub-licensees, to coordinate and negotiate for and on behalf of PCAL with the Sub-licensees, and generally to manage the day-to-day running of the licensing business in Japan.  Clause 5.2.3 of the Deed of Cooperation provided that BLBG was to negotiate “for and on behalf of” PCAL as licensor with the licensees in relation to the licensing of the Trademarks and the operation of the licensing business in Japan.  Thus it was expressly recorded in the Sub-licence Agreements that BLBG had been appointed by PCAL “as its agent … performing the functions of the representative of the Licensor in the Licensed Region.” 

58.  The marketing of the Trademarks and the negotiation of terms with the Sub-licensees and the procuring of the execution of the Sub-licence Agreements by the Sub-licensees, all of which appear to have been carried out in Japan, were done by BLBG for PCAL as part of BLBG’s duties to PCAL under the Deed of Cooperation.  The provision in the Deed of Cooperation that nothing therein shall be deemed to constitute either party as agent of the other is not to the point for this purpose.  As Lord Millett held in ING Baring, in considering the source of profits, it is not necessary to show that the transaction which produced the profit was carried out by the taxpayer’s agent in the full legal sense.  It is sufficient that it was carried out on his behalf and for his account by a person acting on his instructions (see §30 above).  Thus, in Kwong Mile Services Ltd, what earned the profits for the taxpayer was held to be its activities (done through an agent)  in marketing the property for sale.  Likewise, in Commissioner of Inland Revenue v Orion Caribbean Ltd [1997] HKLRD 924, 931H, the borrowing and on-lending were found to have been carried on for the taxpayer by its parent company.

59.  It is true that the Sub-licence Agreements, signed by the Sub-licensees in Japan, were signed by PCAL (through Cheng)  in Hong Kong.  As the final decision-maker, Cheng’s approval was required, though it appears neither he nor any other on PCAL’s side was much involved in the negotiation of the terms of those agreements.[32] But to place the source of profit simply with the location of the decision-maker or where the contract was signed would be to run into fallacy.  The significance of such factors depends on the context and the facts of each case.

60.  We accept that while the rights conferred by trademarks are territorial (see Commissioner of Inland Revenue v Emerson Radial Corp (1999)  2 HKCFAR 501, 507G & 508I), it does not follow, simply because the rights granted by PCAL were exercisable only in Japan, that its profit was necessarily sourced from that territory.  The notion that intellectual property rights exercisable only in one country are to be equiparated to immovable property in that country was specifically rejected in HK-TVB International, at p 408H.  The Privy Council went so far there as to say that the territoriality of such rights is irrelevant to the source of profit, though it qualified the statement by this condition: “in the absence of any financial interest in the subsequent exercise of the rights by the sub-licensee” (see p 409F).

61.  Where, as in this case, the taxpayer who has granted trademark rights overseas receives royalties as a percentage of the sub-licensees’ sales, it does have a continuing financial interest in the exercise of the rights.  Indeed one may say that there is no profit directly flowing from the initial grant of the sub-licence itself.  The taxpayer’s income derives instead from the sale in the foreign territory of each piece of merchandise bearing the mark.  In contrast to a fixed outright payment (such as the fixed fees paid by the sub-licensees in HK-TVB International, see p 404E), there is more justification to say that such royalty income is produced by the exploitation of property assets abroad.  The complication in the present case, however, is that in two of the three Sub-licence Agreements, there was a guaranteed minimum amount of royalties, expressed in Japanese yen, payable to PCAL.  To the extent PCAL’s Royalties Income was constituted by these fixed payments – and the extent is unclear from the evidence – the “exploitation of property assets” argument will lose much of its force.

62.  Nevertheless, as explained above, the marketing and procurement activities leading to the eventual grant of the sub-licences by the execution of the Sub-licence Agreements were predominantly carried out on behalf of PCAL in Japan.

63.  The third group of relevant operations consist in the performance of PCAL’s post-grant obligations under the Sub-licence Agreements such as the provision of know-how and the running of the licensing programme in Japan including promotion of the Trademarks in Japan with the object of increasing sales and therefore the amount of royalties.  This aspect does not appear to have received any attention at all in the Board’s Decision. The Deed of Cooperation continued to operate after BLBG had found and secured sub-licensees for PCAL.  The Sub-licence Agreements expressly acknowledged BLBG to be the agent appointed by PCAL “performing the functions of the representative of the Licensor”.  The Board was aware that BLBG was obliged under the Deed of Cooperation “to co-ordinate all licensing arrangements and to manage the day-to-day running of the business etc”, but ignored these activities in determining the source of PCAL’s profit on the ground that they were what BLBG did to generate its profits.[33]  We have explained above why this is fallacious in the context of the procuring of the Sub-licence Agreements.  That analysis applies with even greater force in relation to the performance of the Sub-licence Agreements, because BLBG was engaged to carry out, inter alia, the operations that PCAL had to do to fulfil its obligations towards the Sub-licensees.  Whether BLBG was paid a fixed fee or a percentage of the Royalties does not matter.  As illustrated by Commissioner of Inland Revenue v Li & Fung (Trading)  Ltd (see §53 above), in effect the taxpayer there engaged or acted through its overseas affiliates in performing the services which it had contracted to provide to its customers.  Its source of profit was held to be abroad where the affiliates carried out their activities.

64.  It follows from the above that in our view the Board erred in law in the determination of the source of PCAL’s Royalties Income (1) by failing to take account of BLBG’s activities in marketing the Trademarks, securing the Sub-licensees and procuring the Sub-licence Agreements; (2) by failing to take account of BLBG’s activities in servicing the Sub-licence Agreements after they were entered into; (3) by failing to take into consideration that the Royalties were payable not on the grant of the sub-licences but only on the exercise of the licensed rights in Japan as a percentage of the Sub-licensees’ sales (subject to the point about guaranteed minimum royalties); and (4) by taking into account the irrelevant fact that the Deed of Cooperation was negotiated by the taxpayer from Hong Kong and signed by it in Hong Kong.  It follows that that part of the Decision and the Judgment must be set aside.

65.  It does not, however, necessarily follow that PCAL’s Royalties Income must in its entirety be regarded as having a source outside Hong Kong.  There is after all the undisputed fact that the master licence was acquired by PCAL in Hong Kong.  We have given the matter anxious consideration, since the assessment related to years long past, but as the court has not been addressed on the question of apportionment, as at present advised and assuming apportionment is open to the Board, we are not prepared to say that the Board, proceeding on correct principles, would be traversing outside the range of tenable conclusions if it were to hold that a small part of the Royalties Income should on an apportionment be held taxable as having arisen in or derived from Hong Kong.  The source of profits is a question of fact.  The appeal from the Board is limited to questions of law (see section 69(1)). Unless the court reaches the view that a different conclusion is the true and only reasonable one, it cannot substitute that conclusion for the Board’s (see Kwong Mile Services Ltd at §37).  We would accordingly order a remitter on this issue.

Whether the Upfront Payment is a capital receipt

66.  There is no dispute that receipts of a capital nature are not assessable to profits tax.  Reciprocally, in ascertaining profits chargeable to tax, no deduction is allowed in respect of expenditure of a capital nature (see section 17(1)(c)).  A payment which is a capital expenditure for the payer is not necessarily a capital receipt in the hands of the payee.  Nevertheless, the exercise in determining the nature of a payment, whether a receipt or expenditure, is sufficiently similar for the cases on one exercise to provide guidance for the other: see Inland Revenue Commissioners v John Lewis Properties plc [2003] Ch 513 at §72. 

67.  In its Decision[34] the Board referred to Chow J’s decision at first instance in China Mobile Hong Kong Co Ltd v Commissioner of Inland Revenue [2020] HK CFI 1649 at §§15-18 – an expenditure case – for the relevant principles.  In her Judgment[35] Cheng J referred to the Court of Appeal’s decision inthe China Mobile case,[36] as well as John Lewis Properties plc, supra, and British Dyestuffs Corporation (Blackley)  Ltd v Commissioners of Inland Revenue (1923)  12 TC 586 at 596, and set out the following summary of principles which we do not understand either side to dispute:

“ 60.1  Whether a payment is capital or revenue in nature is a question of law, which must be answered in light of all the circumstances which it is reasonable to take into account, and the weight to be given to a particular circumstance in a particular case must depend on common sense rather than on a strict application of any single legal principle.

   60.2  The question must be answered from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured employed or exhausted in the process.

   60.3  Although there is no single decisive test, the courts have held that a number of factors may usefully be taken into account:

60.3.1  whether the payment is made once and for all, or is going to recur every year;

60.3.2  in the case of an item of expenditure, whether it is made with a view to bringing into existence an asset or advantage for the enduring benefit of a trade; a benefit is enduring for this purpose if it is of a permanent quality or has sufficient durability, it does not have to be everlasting; length of time, although not a deciding factor, does in practice shed light on the nature of the advantage sought and the longer the duration, the greater the indication that a structural solution was being sought;

60.3.3  in the case of an item of expenditure, whether it relates to the cost of creating, acquiring or enlarging the permanent structure of which the income is to be the produce or fruit, or instead represents the cost of earning that income itself or performing the income-earning operations;

60.3.4  in the case of an item of receipt, whether the transaction is in substance a parting by the taxpayer with part of its property for a purchase price, or a method of trading by which it acquires the particular sum of money as part of the profits and gains of that trade;

60.3.5  the value of the asset assigned;

60.3.6  the fact that the payment causes a diminution in the value of the assignor’s reversionary interest; and

60.3.7  whether the disposal of the asset is accompanied by a transfer of risk in relation to it.”

68.  With reference to the 5 indicia referred to in John Lewis Properties plc at §§80-87 (equivalent to items 1, 2, 5, 6 and 7 in §60.3 of Cheng J’s Judgment quoted above), PCAL submits as follows.  First, the initial term of the Deed of Cooperation was 3.5 years, with a conditional option to renew for another 1.5 years.  Secondly, PCAL transferred to BLBG a contingent right to income under the Deed of Cooperation, a right capable of subsisting as a capital asset.  The exclusive right to act as licensing agent for the Trademarks in Japan and to receive a portion of the Royalties was valuable to BLBG.  Thirdly, there was a temporary diminution in the value of the master licence because the interests of PCAL in the Trademarks was impaired to the extent stipulated in the Deed of Cooperation, in that it stood to receive only 40% of the Royalties and could not appoint another licensing agent in Japan.  Fourthly, the Upfront Payment was a lump sum payment.  Fifthly, there was a transfer of risk since BLBG assumed a substantial portion of the risk in the licensing business in Japan by giving PCAL a guarantee on its Royalties Income to the tune of US$750,000 per annum.

69.  PCAL submits that the Upfront Payment was made for BLBG to “buy in” to a portion of PCAL’s Japanese licensing business and act as the exclusive agent for PCAL in Japan.  It was made under the Deed of Cooperation which defined the structure of PCAL’s business and its “permanent profit-making apparatus”.  By the payment BLBG acquired an enduring interest in PCAL’s only capital asset, i.e. the Trademark sub-licensing business as a whole.

70.  We are not persuaded by PCAL’s arguments.  Whilst the Upfront Payment was a non-recurrent payment received by PCAL at the outset, the agreed cooperation was for only 3.5 years (with an option for BLBG to renew for another 1.5 years subject to satisfactory performance and the gross royalty income reaching a stipulated level).  In our view whilst this is not a yearly income, an arrangement of this kind for a mere 3.5 years (with a possible extension of 1.5 years)  falls to be regarded as an ordinary incident of the trading operations of a firm.  On no proper use of language can it be regarded as a “permanent” structure of PCAL’s profit-making operations or as giving BLBG an “enduring” interest in the Trademark.

71.  PCAL relies on what was said in Van Den Berghs Ltd v Clark (Inspector of Taxes) [1935] AC 431 at 442:

“ The three agreements which the appellants consented to cancel were not ordinary commercial contracts made in the course of carrying on their trade; they were not contracts for the disposal of their products, or for the engagement of agents or other employees necessary for the conduct of their business; nor were they merely agreements as to how their trading profits when earned should be distributed as between the contracting parties. On the contrary the cancelled agreements related to the whole structure of the appellants’ profit-making apparatus. They regulated the appellants’ activities, defined what they might and what they might not do, and affected the whole conduct of their business. I have difficulty in seeing how money laid out to secure, or money received for the cancellation of, so fundamental an organization of a trader’s activities can be regarded as an income disbursement or an income receipt.”

72.  But the facts of that case must be borne in mind in understanding and seeking to apply the dictum.  As Lord Reid said in Regent Oil Co Ltd v Strick [1966] AC 295, 312:

“ I think that much of the difficulty has arisen from taking too literally general statements made in earlier cases and seeking to apply them to a different kind of case which their authors almost certainly did not have in mind – in seeking to treat expressions of judicial opinion as if they were words in an Act of Parliament. And a further source of difficulty has been a tendency in some cases to treat some one criterion as paramount and to press it to its logical conclusion without proper regard to other factors in the case.”

73.  Van Den Berghs Ltd is a case where the taxpayer was an English company that carried on the business of manufacturing and trading in margarine and like products.  In 1908, it entered into an agreement with a competitor, a Dutch company, which bound them mutually for the future to work in alliance and to share their profits and losses in accordance with an elaborate agreed scheme.  There were detailed provisions on the cooperation required, including mutual undertakings not to enter into like agreements with third parties, and restrictive covenants to be given by their respective directors and managers.  The agreement was varied by two further agreements made in 1913 and 1920 respectively and extended to remain in force until 1940.  But when disputes occurred and the parties went to arbitration, they eventually came to a settlement in 1927 whereby the three agreements would be determined as from the end of 1927 in consideration of £450,000 paid by the Dutch company to the taxpayer.  In holding the sum of receipt to be capital in nature, Lord Macmillan observed that the taxpayer gave up its rights for 13 years ahead under the agreement which did much more than merely embody a system of pooling and sharing profits but “related to the whole structure of the [taxpayer’s] profit-making apparatus”.  As Lord Reid said in Regent Oil Co Ltd v Strick at p 317F, those facts were very strong.

74.  The facts of the present case are quite different.  We are not concerned with a wholesale acquisition or surrender of rights under an agreement that constitutes the entire operational structure of the taxpayer for anything like 13 years.  The passage quoted above has to be approached in the context of its facts.  It may be taken as indicating the kind of considerations that may be relevant (see Van Den Berghs Ltd at pp 438-439), but we agree with the judge[37] that one cannot derive from that case a rigid proposition that a payment to enter into a contract that is not concluded in the everyday course of the taxpayer’s trade but forms part of a taxpayer’s profit-making structure regulating its activities and defining what it might and might not do is necessarily capital in nature.  Van Den Berghs Ltd may be contrasted with Anglo-Persian Oil Co Ltd v Dale [1932] 1 KB 124, where the taxpayer paid a large sum in 1922 to terminate the agents who were appointed in 1914 to manage its business in Persia and the East for a term of 10 years, with the result that the taxpayer would thereafter deal directly with their customers in that area.  The payment was held to be a revenue expense because the cancellation “merely effected a change in its business methods and internal organisation, leaving its fixed capital untouched.”[38]

75.  The Deed of Cooperation is the mechanism entered into by PCAL in the course of its business for the exploitation of its rights in the Trademarks.  It would not be accurate to view the transaction as the sale by PCAL of a pre-existing right to receive 60% of certain royalties to be received and the Upfront Payment as the price.  There were mutual obligations under the Deed of Cooperation the performance of which was essential to the success of the business from which royalties were to be earned.  BLBG was required to perform a whole host of tasks with a view to securing sub-licensing arrangements of the Trademarks in Japan.  As the judge pointed out, there is no basis to assume that PCAL would have earned the same amount of royalties with or without BLBG’s participation.[39] The 60% was an agreed allocation, no doubt reflective of the effort and contribution BLBG was expected to make.

76.  It is also in our view not accurate to regard PCAL as having parted with a capital asset.  To say that PCAL transferred to BLBG an asset, i.e. a contingent right to income, which is a chose in action, does not take the analysis very far, since any right to payment is a chose in action.  It is argued that the Upfront Payment was consideration paid for the exclusive right to act as licensing agent, but according to clause 7.1 of the Deed of Cooperation the consideration for exclusivity was BLBG’s guarantee of PCAL’s Royalties Income.  Nor did PCAL transfer any of its rights under the master licence to BLBG. 

77.  The cases relied on by PCAL do not add anything to the analysis based on general principles, as they are not analogous.  John Smith & Son v Moore [1921] 2 AC 13 concerned whether the price paid by the taxpayer for acquiring certain contracts for purchasing coal from collieries at advantageous prices as part of the coal-trading business acquired, was a deductible expense.  As Lord Reid said in Regent Oil Co Ltd v Strick, supra, at p 323A, all that John Smith & Son decided was that, if a new trader acquires goods for reselling, those goods are stock in trade; but if he acquires rights to buy such goods those rights cannot be treated as part of the stock in trade with which he begins trading.  In Murray (Inspector of Taxes)  v Imperial Chemical Industries Ltd [1967] 1 Ch 1038 the taxpayer granted exclusive licences under certain patents for the manufacture of a synthetic material and received, in addition to royalties, lump sums for entering into certain “keep-out” covenants which bolstered up the exclusive licences.  On the facts, the agreements were held to be in substance dispositions of the whole interest of the taxpayer in the patents and so the lump sum payments were considered capital.  Wolf Electric Tools Ltd v Wilson (Inspector of Taxes) [1969] 2 All ER 724 concerned shares received by the taxpayer in return for the transfer of two capital assets, namely, confidential industrial information relating to its manufacture of electric power tools, and its connection with India through its agent (i.e. its goodwill in India).  It was held that the taxpayer effectively gave up its business in India in return for the shares in question which fell to be regarded as a capital receipt. 

78.  In contrast to these cases, PCAL received the Upfront Payment because it decided to exploit its rights in the Trademark through cooperating with BLBG, not because it was disposing of the whole or any part of its capital asset, or transferring its business, to BLBG.

79.  As is obvious from the Deed of Cooperation, the Upfront Payment was only part of the income for PCAL.  It would also receive 40% of the Royalties, with the benefit of BLBG’s guarantee in the specified amounts.  For their own commercial reasons the parties decided to structure the payments to PCAL in the way provided.  BLBG’s guarantee in favour of PCAL’s share of the Royalties represented an allocation of market risks, but there is no suggestion that the guaranteed Royalties Income is capital in nature because of any “transfer of risk”.  The Upfront Payment (in contrast with periodic payments)  protected PCAL from the counterparty risk of BLBG defaulting.  In this sense an element of risk allocation is always involved in an upfront or advance payment, but this is not determinative of its nature.  In terms of transfer of risk, the Upfront Payment is plainly quite different from the lump sum received by the taxpayer in John Lewis Properties plc from a bank in return for assigning to the bank for a period of five years the right to receive rents for properties payable by a group company.

80.  PCAL submits that there was a temporary diminution in the value of its interest in the master licence because it was impaired by the Deed of Cooperation.  This seems to us a mere assertion without evidential basis.  The Upfront Payment was amply exceeded by just one year’s guaranteed Royalties Income for PCAL.  In addition to such guaranteed income, the Deed of Cooperation gave PCAL the benefit of BLBG’s expertise and services in promoting the Trademark and securing sub-licensing arrangements.  It cannot be assumed without evidence that the value of the master licence subject to and with the benefit of the Deed of Cooperation (after the Upfront Payment)  would necessarily be lower in any significant way than the “raw” value of the master licence.

81.  Accordingly, we reject PCAL’s contention on this issue.

Conclusion and disposition

82.  For the above reasons, our conclusions are that (1) PCAL has failed to demonstrate any error of law in the Board’s conclusion that the Upfront Payment had a Hong Kong source; (2) the Board’s determination that PCAL’s Royalties Income was sourced in Hong Kong is erroneous in law; and (3) the Upfront Payment was revenue and not capital income.  We shall accordingly allow the appeal in part, set aside the Decision and the Judgment in relation to the source of the Royalties Income, and remit that matter back to the Board for determination and consequential adjustment of the assessment as appropriate in the light of the judgment of this court.

83.  As PCAL had raised certain quite discrete and substantial issues both below and in this court on which it has failed, we make an order nisi that the Commissioner do pay half of PCAL’s costs of the appeal in this court and one-third of PCAL’s costs in the Court of First Instance.