CHAPMAN DEVELOPMENT LTD v. COMMISSIONER OF INLAND REVENUE

HCIA 6/2022

[2023] HKCFI 893

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 6 OF 2022

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D E C I S I O N

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A.  INTRODUCTION

1.  By a summons of 26^th August 2022, the Applicant (“the Taxpayer”) applies for leave to appeal under s.69 of the Inland Revenue Ordinance (Cap.112) (“the IRO”) against the decision of 28^th July 2022 (“the Decision”) of the Board of Review (“the Board”).

2.  The Decision relates to certain management fees (“the Management Fees”) paid by the Taxpayer to its related company, Profit Gain Trading (BVI) Limited (“Profit Gain”) during the years of assessment 1997/98 to 2005/06. The main issues in dispute between the parties relate to the deductibility of the Management Fees under ss.16 and 17 IRO and whether the entering into of a management agreement with Profit Gain pursuant to which the Taxpayer paid such fees was a transaction carried out for the sole or dominant purpose of enabling the Taxpayer to obtain a tax benefit.

B.  THE BACKGROUND

3.  The following brief background is taken from the Decision.

4.  At the material time, the Taxpayer’s principal activity was the manufacturing and trading of fabric and yarn and the provision of trade related services.

5.  The Taxpayer held majority shareholding interests in two mainland entities (“the PRC Factories”), which were the manufacturing arm of the Taxpayer.

6.  The Taxpayer took orders for fabrics and placed them with the PRC Factories or third party manufacturers. Profit Gain provided production management services.

7.  The Taxpayer appointed Profit Gain as its agent for fabric production with effect from 1^st April 1996 by a management agreement dated 1^st April 1997 (“the Management Agreement”). Under the Management Agreement:

7.1  Profit Gain was to:

7.1.1  “provide production sources and outlets in China factories to [the Taxpayer] which may be suitable for the production and delivery requirements of [the Taxpayer]”;

7.1.2  “provide production management services, technical support and liaison services to the concerned China factories in connection with the production orders to be so placed by [the Taxpayer]”;

7.1.3  “provide quality control and inspection service for the dyed and knitted fabrics in China factories on behalf of [the Taxpayer] … and … will sign the inspection certificates…”;

7.1.4  “conduct such market research as may reasonably required in China factories on market trends, new items, sources of supply, price and quality”;

7.1.5  “inspect all commercial and customs documents on behalf of [the Taxpayer] to ensure that they accurately reflect the transaction and are drawn in the proper manner as required by the regulations of both the exporting and importing countries”.

7.2  the Taxpayer was to pay a service fee at a certain fixed rate “or any other rate as may be mutually agreed upon by the parties hereto”.

8.  The Board held that:

8.1  the Management Fees which were not paid in accordance with the written terms of the Management Agreement (which the Board termed the “Extraneous Fees”) were not expenses incurred in the production of the Taxpayer’s assessable profits, and therefore not deductible under ss.16 and 17 IRO;

8.2  the Management Fees paid by in accordance with the written terms of the Management Agreement (which the Board termed the “Management Fees Per Written Agreement”) were deductible under ss.16 and 17 IRO;

8.3  however, the entering into of the Management Agreement and the payment of the Management Fees thereunder was a transaction was entered into or carried out for the sole and dominant purpose of enabling the Taxpayer to obtain a tax benefit within the meaning of s.61A IRO.

9.  The assessments were confirmed, and the Taxpayer’s appeal dismissed.

C.  THE APPLICABLE PRINCIPLES

10.  An appeal against a decision of the Board of Review may be made only on a ground involving a question of law: s.69(1) IRO.

11.  An intending appellant must first obtain leave to appeal: s.69(2) IRO. Under s.69(3)(e), no leave will be granted unless the court is satisfied that:

11.1  a question of law is involved in the proposed appeal, and

11.2  the proposed appeal has a reasonable prospect of success, or that there is some other reason in the interests of justice why the proposed appeal should be heard.

12.  For this purpose, a proposed appeal has a reasonable prospect of success if it is “reasonably arguable”; it is not necessary to show that the proposed appeal will “probably” succeed; it is not a high threshold. See China Mobile Hong Kong Co Ltd v CIR [2018] 2 HKLRD 146 at [16], [21].

13.  The ways in which a decision of the Board may be challenged are limited, as explained in CIR v Inland Revenue Board of Review [1989] 2 HKLR 40 at 56F-H, 57F-H (Barnett J).

13.1  The decision may be challenged for misdirection in law.

13.2  An inference or the final conclusion of the Board may be attacked on the basis that the primary facts do not admit of an inference drawn from them, or that the primary facts or inferences, or a combination of them, do not admit of the final conclusion. Where the facts can reasonably admit of the Board’s conclusion, however, its decision should not be disturbed.

13.3  A finding of primary fact may be challenged on the basis that there was no evidence in support of the finding. Alternatively, it may be contended that the Board should have made findings of other relevant facts.

D.  GROUND 1: AGREEMENT BY CONDUCT

14.  The Board found that there were various types of Extraneous Fees which were not calculated according to the written provisions of the Management Agreement. The Board accepted that the Taxpayer was entitled to agree different charging terms with Profit Gain, but found that the Taxpayer failed to discharge its burden of proof in showing that there was in fact any such agreement to vary.

15.  The Board referred to various aspects of the Taxpayer’s witness’ evidence which were unsatisfactory. Accordingly, it did not accept that the Taxpayer proved any oral agreement to vary the terms of the Management Agreement.

16.  In closing submissions, the Taxpayer shifted its case, arguing that the conduct of the parties demonstrated what rates they had mutually agreed on from time to time. The Board nevertheless allowed the Taxpayer to argue a case based on variation by conduct.

17.  However, the Board rejected the argument, given the unsatisfactory nature of the evidence. The Board noted that the Taxpayer chose not to call witnesses with direct knowledge of the matter to give evidence. The Board concluded that “We could not infer simply from the charging of the fees by Profit Gain and/or the payment by the Taxpayer as evidence that the parties had “varied” or “supplemented” the terms of the Management Agreement. The Taxpayer simply failed to prove this suggestion.”

18.  The Taxpayer says that the Board erred in law in failing to recognise that the terms of payment of the Management Fees agreed between the Taxpayer and Profit Gain could be established by conduct on the facts of this case, with no additional requirement that such agreement could only be inferred from evidence of verbal exchanges between the parties.

19.  The Taxpayer emphasises that the Board found that:

19.1  Profit Gain was not a mere “sham”, “invisible entity” or “bookkeeping entity”;

19.2  Profit Gain had performed its tasks under the Management Agreement.

20.  In written and oral submissions, counsel for the Taxpayer, Mr Johnny Mok SC (leading Ms Sharon Yuen) further pointed out that:

20.1  the Extraneous Fees (similarly to the remainder of the Management Fees) were the subject of debit notes;

20.2  no challenge had been made before the Board that the debit notes represented the amounts actually charged to the Taxpayer; and

20.3  the Commissioner did not dispute that the Management Fees had indeed been paid (or substantially been paid).

21.  The submission was that the amounts must therefore have been paid for the work carried out by Profit Gain under the Management Agreement. Insofar as they could be criticised for being excessive, this was relevant to whether s.61A IRO applied, but not to the deductibility of the expenses under s.16 and s.17 IRO.

22.  Reliance was placed on Shanghai Tongji Science & Technology Industrial Co Ltd v Casil Clearing Ltd (2004) 7 HKCFAR at [36] to [46] for the proposition that a contract could be inferred by conduct by applying an objective test, even when nothing was said or written. It was said that in the circumstances, the Board was wrong to conclude that it could not infer simply from the fact of the charging of the Management Fees and their payment by the Taxpayer that there had been any agreement to vary the charging rates.

23.  Counsel for the Respondent (“the Commissioner”), Ms Elizabeth Cheung, submitted that:

23.1  the Taxpayer is attempting to challenge the Board’s factual finding that no agreement was reached between the parties regarding the Extraneous Fees;

23.2  the proposed ground of appeal has no reasonable prospect of success; and

23.3  the proposed ground of appeal is academic. Even if the Extraneous Fees were deductible under ss.16 and 17 IRO, they would still be disallowed under s.61A IRO.

24.  On the first point, Ms Cheung points out that:

24.1  the Taxpayer’s case and evidence at the hearing was that there were oral agreements covering the Extraneous Fees, but the evidence in this regard was unsatisfactory and rejected by the Board;

24.2  it was only in closing that the Taxpayer raised the argument of variation by conduct;

24.3  the Board accepted that a contract could be inferred from conduct, but considered that the Taxpayer had failed to prove that this had happened in the present case.

25.  On the second point, Ms Cheung submits that none of the factors identified by the Taxpayer was consistent only with there being a contract to vary the terms of the Management Agreement.

26.  I remind myself that the Taxpayer is only seeking leave to appeal at this stage, and the test is whether the proposed appeal is reasonably arguable, and that this is not a high threshold. Having heard the parties’ respective submissions, it seems to me that it is reasonably arguable that the Board made an error of law rather than an error of fact, given the findings that it made, and the state of the evidence relating to the debit notes and the fact of payment as highlighted by the Taxpayer and set out above. Given this view, it would not be appropriate for me to go further into the merits of the proposed appeal at this stage.

27.  As to the point that the proposed ground of appeal is academic, this falls away in the light of my views in relation to the proposed appeal relating to s.61A IRO, to which I now turn.

E.  GROUND 2: APPLICABILITY OF S.61A OF THE ORDINANCE

28.  There is no dispute between the parties that the transaction in question which has to be considered for the purpose of s.61A IRO is the entering into of the Management Agreement pursuant to which the Taxpayer paid the Management Fees Per Written Agreement as well as each and every payment made thereunder (“the Transaction”).

29.  The Board found that if the Taxpayer had not used Profit Gain’s services, the appropriate alternative hypothesis to adopt was that the Taxpayer would have done the production management work itself; it would not have paid itself management fees, and the result would have been a larger amount of assessable profits; thus the Transaction conferred a tax benefit on the Taxpayer.

30.  The Taxpayer argues that even if this were the appropriate alternative hypothesis to adopt, all of the work carried out by Profit Gain was carried out in mainland PRC, so that profits derived from such work would not have been chargeable to Hong Kong tax. It followed that it was also wrong for the Board to hold that the Management Fees Per Written Agreement should be regarded as the assessable profits of the Taxpayer so as to counteract the tax benefit under s.61A(2)(b) IRO.

31.  The Taxpayer says that where the Board went wrong was in paragraphs 138 and 139 of the Decision. The Board said that the Taxpayer was a trader and had declared its profits for taxation in Hong Kong, and had not raised a challenge that its profits were not taxable in Hong Kong by reason of them being derived offshore. It went on to say that the appeal was about the tax affairs of the Taxpayer and not Profit Gain, and that there was no convincing evidence to substantiate the contention that if the Taxpayer took over Profit Gain’s role, the income would have been wholly offshore. Mr Mok submitted that this was not, in fact, the Taxpayer’s contention; the point was that if the Taxpayer had carried out Profit Gain’s role, as posited under the alternative hypothesis, the profits relating to such work would have been offshore and not assessable in Hong Kong. The Board therefore (it is alleged) failed to deal with the alternative hypothesis.

32.  The Commissioner says that the challenge to the Board’s finding regarding a tax benefit is one of fact only, and not reasonably arguable. Ms Cheung submitted that paragraphs 138 and 139 of the Decision should be understood as the Board taking the view that even if the Taxpayer had carried out Profit Gain’s work in mainland PRC, such work would merely have been antecedent and incidental to the Taxpayer’s profit-making activities as a trader, so that the Taxpayer would not have been considered as being engaged in the provision of production management services as well. Accordingly, the Taxpayer’s income would have rightly been continued to be treated as derived from Hong Kong.

33.  Mr Mok points out that the Board did not make any express finding that the Profit Gain’s work was antecedent or incidental, and that this was not the subject of argument before the Board.

34.  In my view, the Taxpayer’s proposed ground of appeal is reasonably arguable.

35.  I do not propose to go on to set out the parties’ arguments relating to the further issue of whether the Board erred when it considered whether the Transaction was entered into for the sole or dominant purpose of enabling the Taxpayer to obtain a tax benefit. These were addressed at some length in the parties’ written submissions. The points being argued overlap with, or are related to, the points already canvassed above (for example, whether the profits from mainland production management operations would be assessable to tax in Hong Kong), and are also reasonably arguable.

F.  GROUND 3: DELAY

36.  The Taxpayer says that the delay between the hearing before the Board and the Decision rendered the Decision unsafe.

37.  Delay alone cannot succeed as a ground of appeal in the absence of it being shown that there are omissions, errors, misunderstandings, inconsistencies and the like which invalidate the tribunal’s findings, render the judgment unsafe, and which have led to injustice to the appellant. The errors must be attributable to the delay. To overturn an otherwise sound judgment simply for delay would amount to a greater injustice than the delay itself. See Mak Kang Hoi v Ho Yuk Wah (2007) 10 HKCFAR 552 at [57], [59], [60].

38.  I agree with the Commissioner that no proper question of law has been formulated under this ground. Simply asking whether delay rendered the Decision unsafe and led to injustice fails to identify the error of law complained of.

39.  I further agree with the Commissioner that the Taxpayer’s arguments under this ground merely regurgitate some of the complaints advanced under Ground 3, and fail to identify any error that is attributable to the delay.

40.  I do not consider that the Taxpayer has identified any question of law which is reasonably arguable under this ground.

G.  DISPOSITION

41.  Leave is granted to the Taxpayer to appeal on grounds 1 and 2, in respect of the questions of law identified in paragraphs 6A and 10A of the Taxpayer’s Amended Statement of Grounds of Appeal dated 3^rd October 2022.

42.  I further make a costs order nisi that the costs of and occasioned by the application for leave be in the cause of the appeal, with certificate for two counsel.