KONG TAI SHOES MANUFACTURING CO LTD v. COMMISSIONER OF INLAND REVENUE

HCAL 34/2011

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

CONSTITUTIONAL AND ADMINISTRATIVE LAW LIST

NO. 34 OF 2011

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BETWEEN

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J U D G M E N T

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I. INTRODUCTION

1.  Kong Tai seeks judicial review of the Commissioner’s profits tax assessments for financial years 1998/99 to 2008/09.  Kong Tai objected to the assessments within the month after they were made. 

2.  Kong Tai contends that the assessments were ultra vires and should be quashed. 

3.  In the alternative, Kong Tai asks for an order of mandamus requiring the Commissioner to determine Kong Tai’s objections to the assessments within a month from now. 

4.  Kong Tai further seeks an order quashing the Commissioner’s refusal to hold over Kong Tai’s tax liabilities unconditionally pending the determination of its objections.

II.      BACKGROUND

5.  Kong Tai was established in 1988 to engage in the manufacture of athletic footwear.  It conducted such business through factories in Shenzhen and (later) Dongguan under the supervision of on-site Taiwanese, Hong Kong and Mainland managers.   

6.  In the 1990s it set up offices in Taiwan and South Korea for sourcing the raw materials required for its manufacturing business.  At around that time, it also became part of the publicly listed KTP Group.

7.  Upon listing, the KTP Group established an office in Hong Kong.  That office provided book-keeping, bank account management, and trans-shipment coordination services to Kong Tai.  But since 2002 many of those functions have been performed from Shenzhen or Dongguan and the Hong Kong office has focused on maintaining investor relations, listing rules compliance, and financial reporting.

8.  The Shenzhen factory was operated under agreement with a Mainland partner.  The factory licence was held by an entity known as “Kong Tai Shoes City No.1 Factory”.  The factory was resumed by the local government in 2008.  Kong Tai has been dormant since.

9.  The Dongguan factory was owned and operated by Dongguan Hung Yip Shoes Manufacturing Co. Ltd. (DHY).  DHY was a subsidiary of Kong Tai until 2010.  DHY ceased business in 2009. 

10.  At present Kong Tai and DHY are privately-owned by Mr Lee Chi Keung.

11.  Kong Tai says that between 1993 and 2008, its sole business has been shoe manufacture.  According to Kong Tai, throughout the entire period, all key aspects of its business have been performed in the Mainland and only support services have been provided in Hong Kong.

12.  Reebok was Kong Tai’s major customer in the 2000s.

13.  In 2004 changes were made to Kong Tai’s business operation to accommodate the volume of Reebok orders.  The Shenzhen factory was upgraded.  During that renovation, Reebok orders which normally would have been fulfilled by the Shenzhen factory were sub-contracted to DHY. 

14.  At roughly the same time, the KTP Group opened a new account with Reebok in the name of Kong Tai Shoes Manufacturing (BVI) Co. Ltd.  The BVI company and Kong Tai entered into an agency agreement in 2005. The result was that Kong Tai continued to perform all Reebok orders (and enter the same in its books) for so long as Kong Tai remained in business.   

15.  Later, in anticipation of the imminent resumption of the Shenzhen factory, manufacturing activities in Shenzhen were gradually scaled down in 2007 and more Reebok orders were sub-contracted to DHY. 

16.  The BVI company closed in March 2010 when the KTP Group ceased to do business with Reebok.

17.  The Commissioner issued profits tax assessments for financial years 1998/99 to 2003/04 on 14 January 2005, 31 March 2006, 27 March 2007, 25 March 2008, 20 March 2009 and 14 January 2010 respectively.  For financial years 2004/05 to 2008/09, the Commissioner issued assessments on 8 March 2011.  Given the 6 year limitation in the Inland Revenue Ordinance (Cap. 112) (IRO) for issuing assessments, it will be seen that for 1998/99 to 2003/04, the Commissioner issued assessments just before the deadlines for so doing had expired.

18.  The Commissioner has refused unconditionally to hold over the tax assessed in any given financial year.  In respect of all tax assessments, the Commissioner has instead required Kong Tai to purchase Tax Reserve Certificates (TRCs) in lieu of paying the tax liability assessed.  The quantum of TRCs purchased for a given financial year has varied from 5% to 100% of the amount assessed for the year. Between February 2005 and May 2011, Kong Tai has had to purchase about $28.4 million worth of TRCs.

19.  As of today, the Commissioner has yet to issue a determination in respect of any of Kong Tai’s objections.  Following the grant of leave to apply for judicial review on 24 May 2011, the Commissioner has stated that determinations will be issued for 1998/99 to 2002/03 by 22 January 2012.  In relation to 2003/04 to 2008/09, the Commissioner denies that there has been delay in making determination.  In particular, for 2003/04 the Commissioner says that Kong Tai has yet to provide all relevant information requested.

III.     DISCUSSION

A.      Whether assessments ultra vires

20.  Mr Barrie Barlow SC (appearing for Kong Tai) submits that the Commissioner’s assessments are ultra vires on 3 grounds.  Those grounds are:-

(1)    The Revenue’s assessors deliberately assessed tax on Kong Tai’s profits, even though on indisputable evidence those profits were the direct result of manufacturing activities conducted outside Hong Kong, in Shenzhen or Dongguan.

(2)    The Revenue’s assessments were “protective” or “estimated” assessments made under IRO s.59(2).  Following those assessments, Kong Tai provided further information to the Inland Revenue as requested.  Upon receipt of that further information, the Inland Revenue fell under a duty to make “real” (as opposed to merely “protective” or “estimated” assessments) under IRO s.59(1), but the Inland Revenue has failed to do so.       

(3)    The Revenue’s assessors purported to apply IRO s.61A in making assessments.  That is despite the fact that the power under s.61A may only be exercised by an assistant commissioner. 

21.  In my view, none of Mr Barlow’s grounds are tenable.

22.  On the 1st ground, I do not accept that the evidence is indisputable or overwhelming that Kong Tai’s profits are sourced abroad.  There is no basis for me to come to such settled conclusion in a judicial review. 

23.  As Mr Stewart Wong SC (appearing for the Commissioner) points out, the Court only has before it a small fraction of the material relevant to the Revenue’s assessment of the source of Kong Tai’s profits.  In a judicial review, it would be wrong for me to determine the source of Kong Tai’s profits summarily.  I should not usurp the functions expressly reserved to the Commissioner and the Board of Review by the IRO.  See Yue Yuen Marketing Company Limited and others v. CIR HCAL No. 49 of 2009 (at paras. 16-19) where I have explained the necessity for circumspection in judicial reviews such as this.

24.  The Revenue observes that the Shenzhen and Dongguan factories are owned by different persons from Kong Tai.  Pending further analysis, the Revenue does not agree that all Kong Tai’s earnings are the direct result of manufacturing activities carried out by those different persons in factories outside of Hong Kong.  It is possible (the Revenue suggests) that some portion of Kong Tai’s profits directly arise from payments for services provided by Kong Tai from Hong Kong. 

25.  Until the matter (including the further information provided by Kong Tai) has been fully investigated, the Revenue says that it will not be in a position to say whether Kong Tai’s assertions as to the source of its profits are right or wrong. 

26.  The Revenue’s assessors did not accept Kong Tai’s returns for the relevant years.  As a result the Revenue’s assessors estimated Kong Tai’s liability to profits tax in the relevant years under IRO s.59(2) and issued assessments accordingly. 

27.  Those estimated assessments may sometimes be characterised in everyday loose parlance as “protective assessments”.  But the assessments are no less “real” or “genuine” despite the informal term occasionally used to describe them.  An estimated assessment under IRO s.59(2) is binding on a taxpayer, subject only to the latter objecting to the assessments within the statutorily stipulated time and the taxpayer’s objections being upheld in subsequent determinations by the Commissioner or Board of Review.         

28.  In this case, pending receipt of further information from Kong Tai, the assessors made their assessments by applying Departmental Interpretation and Practice Note No. 21 (Revised) (also known as DIPN 21).  Following DIPN 21 and solely by way of non-binding concession, the assessors apportioned Kong Tai’s profits on a 50-50 basis between the Mainland and Hong Kong.

29.  I do not think that the Revenue’s stance on Kong Tai’s profits can be regarded as unreasonable, much less outrageous.  Without in-depth examination of the evidence (including (if appropriate) hearing live factual or expert evidence), I do not see how the Court can adjudicate between Kong Tai’s assertions and the Revenue’s concerns.  But such examination is something that this Court is ill-equipped to carry out in a judicial review. 

30.  I am therefore not in a position (and so decline) to hold that the Revenue’s position is ultra vires on the evidence.

31.  Mr Barlow’s 2nd ground presupposes that an “estimated” assessment is somehow only provisional and needs to be followed by a “real” assessment upon provision by a taxpayer of further information requested by an assessor. 

32.  I do not think that is a correct reading of the IRO.  As noted above, an estimated assessment is binding on a taxpayer unless and until the taxpayer’s objections to the assessment are upheld by the Commissioner or the Board of Review. 

33.  It is for the taxpayer to object to an assessment (estimated or otherwise) under the procedure in IRO s.64. The Commissioner must then make a determination upon the taxpayer’s objections “within a reasonable time” (IRO s.64(2)).  There may be a question in the present case whether the Commissioner has acted “within a reasonable time” in determining Kong Tai’s objections.  But that is a different issue (which I shall consider in greater detail below) from the one which Mr Barlow is positing by his submissions of ultra vires.

34.  There is nothing in the IRO that requires an assessor to issue a “real” assessment following issue of an “estimated” assessment under s.59(2) upon provision of further information by a taxpayer. The so-called “estimated” assessment is a “real” assessment. 

35.  In the course of his submissions, I invited Mr Barlow to point to any provision in the IRO which suggests that an assessor must issue a second “genuine” assessment after previously having issued an “estimated” assessment.  Mr Barlow could only point to IRO s.59(1).  But I see nothing in that provision which supports Mr Barlow’s argument.

36.  IRO s.59(1) provides that an assessor shall assess a person to tax “as soon as may be after the expiration for the time limited by the notice requiring [the person] to furnish a return”.  In this case, the assessor has done precisely that by issuing estimated assessments under s.59(2).

37.  At one point, in answer to my question, Mr Barlow appeared to be questioning the propriety of an assessor making an assessment on the basis of DIPN 21.  Why (one might ask) should the requisite apportionment be 50-50 in this case, rather than at some other proportion? 

38.  However, there is nothing in Kong Tai’s Notice of Application for Judicial Review which specifically targets the 50-50 apportionment (and in consequence the Revenue’s long-established practice under DIPN 21) as irrational.  In that circumstance, Mr Wong was right to object to Mr Barlow challenging the 50-50 apportionment at the hearing before me. 

39.  Had such challenge to DIPN 21 been signalled in the Notice (as it ought to have done if the point was truly being pursued), the Revenue would have had a chance to adduce evidence in support of its standard 50-50 approach.  It would be wrong now to entertain the point in the absence of it having been mentioned in the Notice of Application for Judicial Review and in light of the Revenue being deprived of an opportunity to adduce evidence in rebuttal.

40.  In short, there is nothing ultra vires about the estimated assessments made by the Revenue in relation to Kong Tai.

41.  Mr Barlow’s 3rd ground arises from suggestions by the Revenue’s assessors that Kong Tai may have engaged in “profit shifting”. The assessors contended, on the basis of Kong Tai’s accounts, that there was evidence of Kong Tai “shifting” profits to sub-contractors outside Hong Kong (such as DHY) by causing the latter to charge Kong Tai abnormally large amounts (that is, non-market rates) for sub-contracted works.

42.  Mr Barlow submitted that these suggestions were tantamount to assessors applying the power under IRO s.61A to counteract a transaction entered into for the sole or dominant purpose of enabling a taxpayer to obtain a tax benefit.  Such power was only exercisable (Mr Barlow complained) by an assistant commissioner (or more senior officer) and, in any event, nowhere in the assessments issued to Kong Tai had it been stated that such power was being exercised.

43.  In response, Mr Wong stressed that the assessments here were all made pursuant to IRO s.59(2).  The Revenue has not (Mr Wong emphasised) sought to exercise the power under s.61A to counteract a tax benefit.  All the assessors meant by their suggestion was that, in their view, there was evidence that Kong Tai had made impermissible deductions.  If so, it was open to an assessor in calculating profits tax under IRO s.14 to disallow such deductions of alleged expenses.

44.  I agree with Mr Wong.  It is true that the assessors have accused Kong Tai of possibly engaging in “profit shifting”. They may be right.  They may be wrong.  But I do not see how one can infer from the mere fact of such accusation that the assessors have wrongfully purported to exercise a power under s.61A reserved to more senior officers.

45.  It follows that none of Mr Barlow’s 3 grounds constitute a valid basis for quashing the assessments here as ultra vires.

B.     Whether mandamus

46.  There remains the issue whether the Commissioner has acted within “a reasonable time” to determine Kong Tai’s objections.  If there has been inordinate delay, mandamus would be appropriate. 

47.  Regrettably, it seems to me that there has been inordinate delay on the Commissioner’s part.

48.  For the 1998/99 to 2002/03 assessments, the Commissioner has failed to respond to Kong Tai’s respective objections for periods of between 3.5 and 6.5 years.  By any measure, delays of such magnitude must be unacceptable.  In its evidence, the Revenue has not drawn my attention to any exceptional features in Kong Tai’s case justifying the time it has so far taken to make determinations. 

49.  The Revenue has said that it is in a position to come to determinations in relation to the foregoing financial years by 22 January 2012.  But that strikes me as the Revenue giving itself too generous a deadline. 

50.  Leave for judicial review was granted to Kong Tai on 24 May 2011. The Commissioner would have learned of the judicial review application shortly thereafter.  Given the time that had already elapsed by May 2011, one would have expected a greater sense of urgency.  In light of my decision in Yue Yuen Marketing (requiring determinations in a near identical situation to be made within 6 months), I think that the Commissioner should have proceeded with alacrity to ensure that determinations for 1998/99 to 2002/03 were at least ready within 6 months after the grant of leave. 

51.  In my judgment, for the years 1998/99 to 2002/03, an order of mandamus requiring the Commissioner to determine Kong Tai’s objections as soon as possible and, in any event, at the latest by 30 November 2011 (that is, 6 months from the end of May 2011) is warranted.     

52.  For 2003/04 to 2008/09, Mr Wong submits that there has been no delay.  This is because (Mr Wong notes) Kong Tai only objected to the assessment for 2003/04 on 9 February 2010.  It did not object to the other assessments until 7 April 2011.  Mr Wong also points out that in 2004 Kong Tai changed its operations (and possibly engaged in profit shifting) by sub-contracting more work to DHY.  This (Mr Wong says) requires further investigation.  Mr Wong observes that, in connection with the 2004 operational change, the Revenue has asked Kong Tai for more information and documentation and Kong Tai has yet fully to comply with the request.

53.  I am not persuaded by Mr Wong’s submission in relation to these later years.

54.  I do not think that the 2004 “change” constituted such a radical alteration to Kong Tai’s previous mode of transacting business.  I therefore do not believe that the “change” could justify the Revenue in taking significantly more time to come to determinations for the later financial years. 

55.  There may or may not have been profit shifting in those later years.  But investigating that question and coming to some conclusion on its effect (if any) on assessable profits should not require any particularly great length of time.  One must simply look at the evidence and come to a realistic view.         

56.  It is correct that, according to the Revenue, more information is still being sought.  However, the additional information sought has long since been identified by the Revenue in correspondence with Kong Tai.  Kong Tai may or may not fully comply with the request.  If it fails to do so and if the information required is truly material, then Kong Tai fails to comply at its peril.  The Revenue would be entitled to draw adverse inferences against Kong Tai as a result of the failure. 

57.  One can always ask for more information. But at some point, one cannot just keep asking for more.  One just has to decide. That would be in keeping with the duty to act within a reasonable time. 

58.  Consider the matter in the round. 

59.  Kong Tai has had ample chance to comply with the Revenue’s request for more information and documentation.  It may or may not have fully complied.  It must know the consequences of non-compliance to a request for material information.  Nonetheless, it now clamours for a determination since more than 2 years have passed after its objection to the 2003/04 assessment. 

60.  Whatever basis the Revenue determines for 2003/04 consequent upon the 2004 operational change, it is hard to see how the assessments for 2004/05 and onwards would proceed on some very different basis.  Presumably, a basis for 2003/04 having been determined, the quantification of assessable profits for 2004/05 and onwards should be a relatively straightforward exercise. 

61.  In those circumstances, it should be reasonable to expect the Revenue to come up with assessments for 2003/04, 2004/05, 2005/06, 2007/08 and 2008/09 within 6 months from the date of this Judgment at the latest.

62.  Consequently, I think that there should be a further order of mandamus directing the Commissioner to determine Kong Tai’s objections for the later years as soon as possible and, in any event, by 31 March 2012.            

63.  Mr Barlow submits that I should be harsher.  He suggests that there is a “systemic” disposition within the Revenue to delay making any determination for as long as possible.  This is deliberately done (Mr Barlow alleges) to force taxpayers to settle with the Revenue on the basis of a 50-50 apportionment of profits between Hong Kong and elsewhere. Cashflow having been seriously compromised by the need to buy and hold large amounts of TRCs pending the Revenue’s determination, the taxpayer has little option (Mr Barlow claims) but to go for quick settlement.  Mr Barlow decries that situation as an abuse.

64.  Delay on the part of the Revenue is apparent in the present case as well as that of Yue Yuen Marketing.  However, as I stated in the course of the hearing, 2 swallows do not make a summer.  I am unable to infer from these 2 discrete situations that there is the systemic and wilful culture of delay within the Revenue of which Mr Barlow complains.  I reject his submission that I should not merely grant mandamus, but should instead grant certiorari to signify the Court’s disapproval.  I see no basis justifying such a way of proceeding.

C.      Whether refusal to hold over tax ultra vires

65.  There is simply no evidence that the Revenue acted capriciously or irrationally in exercising its discretion to require Kong Tai to buy TRCs.  I am unable to find that the refusal to hold over tax amounted to an improper exercise of the Commissioner’s powers.

IV.    CONCLUSION

66.  There will be orders of mandamus as set out in paragraphs 51 and 62 above.

67.  The interim stay of the Commissioner’s 2011 Holdover Decision (that is, the refusal unconditionally to hold over alleged tax liabilities in respect of certain assessments) is discharged. 

68.  Kong Tai has substantially, but not completely, prevailed.  There will be an Order Nisi that the Commissioner bear 75% of Kong Tai’s costs.  In so ordering, I follow my decision in Yue Yuen Marketing to deprive an Applicant of some costs where the Applicant has made unwarranted allegations of bad faith.  In my view, the Applicant’s allegation of a systemic and deliberate culture of delay on the part of Revenue constituted such an unjustified allegation.  There was no real evidence to warrant the making of the allegation and it should not have been made.  Costs are to be taxed if not previously agreed.