CHAPMAN DEVELOPMENT LTD v. COMMISSIONER OF INLAND REVENUE

HCIA 6/2022

[2024] HKCFI 2590

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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J U D G M E N T

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A.  INTRODUCTION

1.  The Appellant (“the Taxpayer”) appeals against the decision of the Inland Revenue Board of Review (“the Board”) of 28th July 2022 (“the Decision”).

2.  The Decision relates to certain management fees (“the Management Fees”) claimed by the Taxpayer as deductions during the years of assessment 1997/98 to 2005/06 The Management Fees were charged by the Taxpayer’s associated company, Profit Gain Trading (BVI) Limited (“Profit Gain”).  The assessments under appeal are:

2.1   the additional profits tax assessments for the years of assessment 1997/98 to 2002/03;

2.2   the profits tax assessments for the years of assessment 2003/04 and 2005/06;

2.3   the first additional profits tax assessment for the year of assessment 2004/05.

B.  THE FACTS

3.  The facts are taken from the Decision and the parties’ summaries.

4.  The Taxpayer was a member of a group of companies (“the Group”), the ultimate holding company of which was Glorious Sun Enterprises Ltd (“Listco”).  Listco was listed on the Stock Exchange of Hong Kong in 1996.  Listco and its subsidiaries were engaged in the retailing, export and production of casual wear.

5.  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.

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

7.  The Taxpayer took orders for fabrics and placed them with the PRC Factories or third party manufacturers.

8.  Profit Gain was incorporated in the British Virgin Islands (“the BVI”) on 1st May 1996.  The Taxpayer and Profit Gain were at all material times associated companies, sharing common shareholders, directors, and a correspondence address.  In the notes to the financial statements published in Listco’s annual reports for 2001 to 2005, the Taxpayer, but not Profit Gain, was described as one of its principal subsidiaries.

9.  The Taxpayer appointed Profit Gain as its management agent for “all knitted and dyed fabric production to be required in China factories”, with retrospective effect from 1st April 1996 (when Profit Gain had actually not even been incorporated) by a management agreement dated 1st April 1997 (“the Management Agreement”).  The “China factories” were the PRC Factories and also third party manufacturers.  The Taxpayer was not a manufacturer itself.

10.  Under the Management Agreement:

10.1  Profit Gain was to:

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

10.1.2  “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]”;

10.1.3  “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…”;

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

10.1.5  “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”;

10.1.6  “ensure that all the goods produced under the supervision of [Profit Gain] or the production of which is contemplated by the terms of this agreement to be under the supervision of [Profit Gain] to be of top and acceptable quality as to fabric, workmanship, packing and delivery and that [Profit Gain] shall be responsible for all claims, demands, compensation price discount and legal costs and any other incidental expenses incurred or arising out of or in connection with any claim of [the Taxpayer’s] purchases in respect of the said goods”.

10.2  the Taxpayer was to pay a service fee “of HKD1.40 per lb for dyed fabrics and HK$0.30^[1] or any other rate as may be mutually agreed upon by the parties hereto”.

11.  The Taxpayer claimed that the Management Fees had been charged by Profit Gain for the years of assessment 1997/98 to 2004/05.

12.  An important feature of the case was that the sums claimed by the Taxpayer (for deduction) were not all calculated according to the written provisions of the Management Agreement.

13.  In February 2004, a tax audit was commenced in relation to the Taxpayer’s tax affairs.  After the tax audit, the Assistant Commissioner considered that part of the Management Fees claimed by the Taxpayer were not deductible under ss.16 and 17 IRO.  The Assistant Commissioner was also of the view that the appointment of Profit Gain as the management agent of the Taxpayer was a transaction carried out with the sole or dominant purpose of enabling the Taxpayer to obtain a tax benefit, and that s.61A IRO should apply.  The deduction of the Management Fees (save to the extent of the bank charges and administrative expenses incurred by Profit Gain) (“the Impugned Management Fees”) was disallowed.

14.  The Board held that:

14.1  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 of the Inland Revenue Ordinance (“the IRO”);

14.2  the Management Fees paid 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;

14.3  however, “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”^[2] (“the Transaction”) 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.

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

B.  THE APPLICABLE PRINCIPLES

16.  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.

17.  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).

17.1  The decision may be challenged for misdirection in law.

17.2  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.

17.3  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.

18.  The second and third of these relate to challenges to findings of fact.  As further explained in Kwong Mile Services Ltd v Commissioner of Inland Revenue (2004) 7 HKCFAR 275 at [31] to [34] (Bokhary PJ), findings of fact can be challenged as errors of law only where:

18.1  the decision was based on a finding of fact or inference from the facts which is perverse or irrational;

18.2  there was no evidence to support the finding;

18.3  the decision was made by reference to irrelevant factors or without regard to relevant factors such that the conclusion is contrary to the true and only reasonable one.

19.  If the fact-finding tribunal’s conclusion is a reasonable one, the appellate court cannot disturb that conclusion even if its own preference is for a contrary conclusion.  But if the appellate court regards the contrary conclusion as the only true and reasonable one, the appellate court is duty-bound to substitute the contrary conclusion for the one reached by the fact-finding tribunal: Kwong Mile Services Ltd at [37] (Bokhary PJ).

C.  THE GROUNDS OF APPEAL

20.  The Taxpayer was given leave to appeal on the following grounds.

C1.   Ground 1

21.  Ground 1 concerns the Extraneous Fees only.  It seeks to challenge the Board’s holding that they were not expenses incurred in the production of the Taxpayer’s assessable profits, and therefore not deductible under ss.16 and 17 IRO.

22.  Ground 1 asks: did the Board err in law in failing to recognise that the terms of payment of Management Fees agreed between [the Taxpayer] and Profit Gain, which are associated entities, could be established by conduct based on the facts of this case, with no additional requirement that such agreement can only be established by evidence of verbal exchanges between the parties in relation to the agreement?

C2.   Ground 2

23.  Ground 2 concerns the Management Fees Per Written Agreement.  It seeks to challenge the Board’s holding that the Transaction was one 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.

24.  Ground 2 asks:

(1)  Did the Board err in law in concluding that the Transaction had or would have had, but for s.61A IRO, the effect of conferring a “tax benefit” on [the Taxpayer] within the meaning of s.61A?

(2)  Did the Board err in law in holding that “Management Fees Per Written Agreement” (as defined in Decision [110]) should be regarded as the assessable profits of [the Taxpayer] under s.61A(2)(b) to counteract the alleged “tax benefit” which would otherwise be obtained by [the Taxpayer], and in failing to recognise that any hypothetical profits that would be earned by [the Taxpayer] in the Alternative Hypothesis arising from production management operations in mainland China would not be chargeable to Hong Kong profits tax?

(3)  In considering the matters listed in sub-paragraphs (a) to (g) of s.61A(1), did the Board err in law (i) in failing to take into account the relevant matters set out in failing to take into account the relevant matters set out in paragraphs 10(1)(a) and 10(2) of the Taxpayer’s Amended Statement of Grounds of Appeal (“the Taxpayer’s Statement”); (ii) in taking into account irrelevant factors set out in paragraph 10(1)(b) of the Taxpayer’s Statement; (iii) in failing to address the question of whether the Transaction created rights or obligations which would not normally be created between persons dealing with each other at arm’s length under a transaction of the kind in question as referred to in s.61A IRO; and (iv) in concluding that [the Taxpayer’s] submission that the Transaction is a legitimate arrangement is tainted by Profit Gain’s non-registration of its business in mainland China?

25.  The parts of paragraph 10 of the Taxpayer’s Statement referred to above are as follows.

“(1) As regards section 61A(l)(a) and (b), viz. the manner in which the Transaction was entered into or carried out as well as the form and substance of the Transaction:-

(a) The Board failed to take into account relevant matters, including inter alia:-

(i) The profits derived from Profit Gain’s production management operations in Mainland would not be chargeable to Hong Kong profits tax in any event. Thus, it was legitimate for the Gennon Group to segregate its Hong Kong-based operations and offshore operations by having the production management operations in Mainland carried out by a separate overseas company, namely Profit Gain, and the statutory purpose of section 61 A is not to attack such legitimate arrangements: Ngai Lik Electronics at §§63, 101 per Ribeiro PJ.

(ii) The Board’s finding that Profit Gain is not a mere sham or an invisible/bookkeeping entity, but a company which employed its own staff and paid salaries to its staff, and carried on real production management operations for [the Taxpayer] in Mainland (Decision §§81, 111).

(iii) The Board’s finding that the “Management Fees Per Written Agreement” were not arbitrary or excessive (Decision §111).

(iv) The Board’s finding that even though Profit Gain relied on related companies to pay some of its salaries initially, Profit Gain had made reimbursements accordingly as found by the Board (Decision §111 ).

(v) It is not unusual for related parties (i.e. [the Taxpayer] and Profit Gain in this case) to not strictly follow or enforce the terms of the Management Agreement for payment of Management Fees.

(vi) At least 4 staff of Profit Gain were recruited from outside the Gennon Group (including the industry-famous garment dyeing expert Lam CW).

(b) The Board took into account irrelevant factors, including, inter alia:-

(i) Profit Gain did not file individual income tax [returns] in respect of its staff.

(ii) Profit Gain was put under a branch called “Offshore Profits Team” in an internal document of the Gennon Group.

(iii) The work of Profit Gain’s staff was put, for example, in the name of the PRC Factories and Profit Gain’s staff represented themselves as representatives of the PRC Factories.

(iv) Profit Gain relied on its related companies to pay staff salary when it had not set up its bank account during the initial period after its incorporation.

(2)  As regards sections 61(A)(c) to (e) of the Ordinance, the Board failed to take into account relevant factors, including, inter alia even if [the Taxpayer] were to carry on the production management work operations now carried on by Profit Gain, the profits derived from such operations which took place in Mainland would not be chargeable to Hong Kong profits.”

D.  GROUND 1: DEDUCTIBILITY OF THE EXTRANEOUS FEES

D1.   The Taxpayer’s case before the Board and how the Board dealt with it

26.  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 variation agreement.

27.  The Board referred to various aspects of the Taxpayer’s witness’ evidence which were unsatisfactory.  The Taxpayer’s witness claimed, for the first time in cross-examination, that there had been an oral variation agreement.  The Board analysed the evidence at some length and rejected it.  Accordingly, it did not accept that the Taxpayer had proved any oral agreement to vary the terms of the Management Agreement.

28.  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.

29.  However, the Board rejected this argument also, given the unsatisfactory nature of the evidence.  At [108] of the Decision, the Board noted that it had been presented with different versions of evidence as to the nature of the Extraneous Fees, and the basis of how the different rates had been agreed; that Taxpayer had chosen not to call witnesses with direct knowledge of the matter to give evidence; and that the Taxpayer had instead attempted to prove these important matters by means of bare assertion or unparticularised multiple hearsay.  The Board then concluded:

“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.”

D2.   The Taxpayer’s arguments on appeal

30.  The Taxpayer complains that the Board erred in its approach to the issue of whether there was a variation by conduct.  Counsel for the Taxpayer, Mr Johnny Mok SC (leading Ms Sharon Yuen), argued that the Board wrongly required evidence that the parties had actually made a variation agreement (referring to the Decision at [89]), and evidence of verbal exchanges as to “who, when and how these ‘other agreements’ had been made”, (quoting the Decision at [90]).  It was said that it sufficed for the Taxpayer to have shown that:

30.1  the parties had entered into the Management Agreement;

30.2  the parties had provided for a charge rate in cl.3 of the Management Agreement;

30.3  Profit Gain had charged fees at rates higher than those provided for in the Management Agreement;

30.4  the higher rate charged for the Extraneous Fees was consistent with the Management Agreement (which allowed for a different rate to be fixed);

30.5  the fees were charged for services performed by Profit Gain;

30.6  Profit Gain was a bona fide commercial entity and not a sham; and

30.7  the fees so charged were paid by the Taxpayer.

31.  The argument was that this satisfied the tests in Shanghai Tongji Science & Technology Industrial Co Ltd v Casil Clearing Ltd (2004) 7 HKCFAR 79 and that the Board had overlooked all these items of conduct, as it referred (Decision at [108]) only to the charging of fees and/or payment by the Taxpayer.

32.  In his oral submissions, Mr Mok emphasised that the Decision at [90] showed that the Board had confused the concepts of a verbal agreement and an agreement by conduct, in requiring evidence of who had made the agreement, when it had been made, and how the agreement had come about.

33.  I do not agree with this reading of the Decision.  It does not seem to me that [89] and [90] were seeking to prescribe the requirements for the finding of both an oral variation and a variation by conduct.^[3]  These paragraphs were the precursor to the Board’s discussion and analysis of the Taxpayer’s case that there had been an oral variation of the rates fixed in the Management Agreement.  The Board then observed that the claim of an oral variation was new and raised in the Taxpayer’s witness’ oral evidence for the first time (see [91], [92]), set out that oral evidence, highlighting the significant parts (see [93] to [95]), and further analysed the unsatisfactory nature of that evidence (see [96] to [106]).  Then, at [107] to [108], the Board turned to deal with the new argument, raised only in the Taxpayer’s closing submissions, that there had been a variation by conduct.

34.  The Board observed that it had been presented with different versions of evidence as to the nature of the sums and the basis for agreeing charging rates different from those in the Management Agreement; that the Taxpayer had chosen not to call witnesses with direct knowledge of the matter; and that the Taxpayer had attempted to prove its case through bare assertion or unparticularised multiple hearsay.  It was in that context that the Board concluded that it could not infer simply from the charging of fees by Profit Gain and/or payment by the Taxpayer that there had been a variation of the Management Agreement.

35.  It is wrong to suggest that in [108], the Board confined its consideration only to the charging of fees by Profit Gain and payment by the Taxpayer.  In this regard, I agree with the Commissioner that the Board was not here seeking to make any positive factual findings as to the charging or payment of fees.  Rather, the Board’s point was that the charging or payment of fees, even if there had been such, could not suffice in the circumstances, given the totality of the evidence.  As the Board had just explained, it had been presented with different versions of what the payments of Extraneous Fees were for.  For example, as set out at [104], the Taxpayer’s witness had described an item of Extraneous Fees as a “bonus”, related to the performance of Profit Gain, and he had said that it was not a management fee.

36.  The witness’ evidence was obviously unsatisfactory, and the Taxpayer’s case in closing submissions shifted from that of an oral agreement to that of an agreement by conduct.  But an agreement by conduct could not be established in a vacuum, without regard to the evidence which had been given to the effect that various items of the Extraneous Fees were not, in fact, management fees at all.  In other words, the Board rejected the Taxpayer’s attempt to jettison the unsatisfactory witness evidence about an oral variation and establish a “variation by conduct” by reference to other, selected aspects of the parties’ conduct.  The Board’s point was that it would be wrong to take such a blinkered approach.

37.  I therefore do not agree with the Taxpayer’s reading of the Decision.  Not only that, I do not agree with the blinkered approach that the Taxpayer says that the Board should have taken, and continues to say should be taken.  Mr Mok submitted^[4] that there were four “tests” for the inferring of an agreement by conduct laid down in Shanghai Tongji Science & Technology Industrial Co Ltd at [36] to [40], namely that (1) the court adopted as its starting point and objective test, (2) it was necessary to identify conduct referable to the contract contended for, (3) it was not enough to show that the parties had done something more than what they were bound to do, and what they did had to be consistent only with there being a new contract implied, and inconsistent with there being no such contract, and (4) if one party acted so that his conduct, objectively considered, constituted an offer, and the other party accepted it, a contract would come into existence regardless of the first party’s state of mind.

38.  First of all, it does not seem to me that the Court of Final Appeal was saying that so long as these four “tests” are met, then a finding of an agreement by conduct must follow.^[5]  Whether or not an agreement by conduct is established in any particular case must surely be considered by reference to the totality of the evidence in that case.

39.  Given my view that the Board did not misdirect itself in law, it is not open to the Taxpayer to re-open the Board’s finding that it could not infer any variation by conduct by pointing to selected matters which support the Taxpayer’s claim of a variation and ignoring others.  I agree with counsel for the Commissioner, Mr Stewart Wong SC (leading Ms Elizabeth Cheung) that this would be an impermissible attack on the Board’s factual conclusions.

40.  In any event, I do not agree that the four “tests” have been met in the present case.  For example, given that the Taxpayer’s witness had described an item of the Extraneous Fees as a bonus and said that it was not a management fee, then even if this item had been charged by Profit Gain and paid by the Taxpayer, it would not be conduct consistent only with there being an agreement to vary the rates of management fee being charged (and therefore failing the third “test”); in fact it would be conduct inconsistent with such an agreement (or at least falling outside the agreement and therefore failing the second “test”).  It might constitute conduct consistent with there being an agreement to pay a bonus, but that would not advance the Taxpayer’s case that there was an agreement by conduct to vary the rates of the management fee charged under cl.3 of the Management Agreement.

41.  To take another example, as set out at [94], the Taxpayer’s witness had been asked about supposed charges for “thread dyeing”, which was not covered in the Management Agreement at all.  The witness said that there was no (written) agreement in relation to thread dyeing, but there were oral agreements about it, which he had heard about but was unable to give any evidence about.  Even if there had been a debit note for work in relation to thread dyeing and even if it had been paid, this would not be conduct consistent only with there being an agreement to vary the Management Agreement to include thread dyeing.  It would also be consistent with there being an oral agreement (as claimed by the Taxpayer’s witness and rejected by the Board).

42.  Furthermore, whilst the Taxpayer says that it was sufficient for it to have established the seven items of conduct set out above, in fact, they were not (or at least not all) established before the Board.  For example, the Taxpayer asserts that it had established that Profit Gain had charged fees at rates higher than those provided for in the Management Agreement.  This presupposes that the Extraneous Fees were in fact management fees, which the Board did not accept, given that the Taxpayer’s own witness had said that they were not management fees.  To take another example, the Taxpayer asserts that it had established that higher rates being charged was consistent with the Management Agreement which allowed for a different rate to be fixed.  This again presupposes that the rate was for management fees, which the Taxpayer’s witness had denied.

43.  At the hearing, Mr Mok made much of the statements by the Board in the Decision that the subject matter of the appeal concerned the management fee “paid by Taxpayer” (at [2]) and that part of the fees were “paid in accordance with the written terms of the Management Agreement” (at [109]).  It was said that the Board must therefore have made findings that the Taxpayer had paid the fees charged by Profit Gain, and these were matters overlooked by the Board as part of the conduct constituting the variation agreement.

44.  It will be apparent by now that whether or not the Taxpayer paid the amounts would not have advanced its case that the charging rates in the Management Agreement had been varied by conduct, given the unsatisfactory evidence as to what these amounts were for in the first place.

45.  As regards the charging of the amounts by Profit Gain, the Taxpayer argued that the Extraneous Fees were the subject of debit notes, and that there had been no challenge before the Board that these notes represented the amounts actually charged by Profit Gain to the Taxpayer.^[6] However, it is apparent from the Decision that the debit notes, and what they purported to represent, were the subject of challenge before the Board. For example, the Decision at [101.4] referred to a debit note of $5.4m as “an example of clear deviation from the written terms of the Management Agreement” and set out the cross-examination in relation thereto, in which the Taxpayer’s witness gave shifting evidence as to the nature of the $5.4m. I agree with the Commissioner that it is wrong for the Taxpayer to suggest that the Board made any positive factual finding that the debit notes represented the amounts actually charged.  On the contrary, the Board’s doubt about the debit notes was expressed in [86] and [87] of the Decision.

46.  I agree with Mr Wong that ultimately, the Taxpayer’s case boils down to a reliance on the fact that the Taxpayer and Profit Gain did “something more than, or something different from, what they were already bound to do under obligations owed to others”.  But this is not enough to constitute an agreement to vary the contract.  See Shanghai Tongji Science & Technology Industrial Co Ltd at [39].

D3.   Conclusion regarding Ground 1

47.  The answer to Ground 1 is “no”.  The Board did not err by failing to recognise that the terms of payment of Management Fees could be established by conduct, and did not impose any additional requirement that such an agreement could only be established by evidence of verbal exchanges.

E.  GROUND 2: APPLICABILITY OF S.61A IRO

E1.   Section 61A IRO

48.  Section 61A IRO provides as follows.

“(1) This section shall apply where any transaction has been entered into or effected after [the commencement date] … and that transaction has, or would have had but for this section, the effect of conferring a tax benefit on a person (in this section referred to as the relevant person), and, having regard to –

(a) the manner in which the transaction was entered into or carried out;

(b) the form and substance of the transaction;

(c) the result in relation to the operation of this Ordinance that, but for this section, would have been achieved by the transaction;

(d) any change in the financial position of the relevant person that has resulted, will result, or may reasonably be expected to result, from the transaction;

(e) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant person, being a change that has resulted or may reasonably be expected to result from the transaction;

(f) whether the transaction has created rights or obligations which would not normally be created between persons dealing with each other at arm’s length under a transaction of the kind in question; and

(g) the participation in the transaction of a corporation resident or carrying on business outside Hong Kong, it would be concluded that the person, or one of the persons, who entered into or carried out the transaction, did so for the sole or dominant purpose of enabling the relevant person, either alone or in conjunction with other persons, to obtain a tax benefit.

(2) Where subsection (1) applies, the powers conferred upon an assessor under Part 10 shall be exercised by an assistant commissioner, and such assistant commissioner shall, without derogation from the powers which he may exercise under that Part, assess the liability to tax of the relevant person –

(a) as if the transaction or any part thereof had not been entered into or carried out; or

(b) in such other manner as the assistant commissioner considers appropriate to counteract the tax benefit which would otherwise be obtained.

(3) In this section –

tax benefit means the avoidance or postponement of the liability to pay tax or the reduction in the amount thereof;

transaction includes a transaction, operation or scheme whether or not such transaction, operation or scheme is enforceable, or intended to be enforceable, by legal proceedings.”

49.  Section 61A is not a separate, self-contained charging provision, but it extends the scope of the ordinary charging provisions in the IRO: Shui On Credit Co Ltd v Commissioner of Inland Revenue (2009) 12 HKCFAR 392 at [26] (Lord Walker).

50.  A transaction which has a proper commercial purpose may nevertheless be one that was carried out for the dominant purpose of enabling the taxpayer to obtain a tax benefit: Commissioner of Inland Revenue v Tai Hing Cotton Mill Development Ltd (2007) 10 HKCFAR 704 at [23] (Lord Hoffmann NPJ).

51.  Three intersecting conditions must be satisfied before the power under s.61A(2) IRO to raise an assessment can be exercised.  They are that:

51.1  a transaction (broadly defined to include an operational scheme) been entered into;

51.2  such transaction has, or would have had but for this section, the effect of conferring a tax benefit on the relevant person (that is, on the taxpayer against whom the section has been invoked); and

51.3  viewing the transaction through the prism of the seven matters enumerated in s.61A(1)(a)-(g), it would objectively be concluded that it was entered into or carried out for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit.

See Ngai Lik Electronics Co Ltd v Commissioner of Inland Revenue (2009) 12 HKCFAR 296 at [34] (Ribeiro PJ).

52.  In relation to the second condition, Lord Hoffmann NPJ explained the approach for determining whether a transaction had the effect of conferring a tax benefit in Tai Hing Cotton Mill Development Ltd at [13] to [21].

52.1  Section 61A raises a straightforward question of causation and comparison.  If the effect of the transaction is that a taxpayer’s liability to tax is less than it would have been on some other appropriate hypothesis, he has had a tax benefit.

52.2  Section 61A(2)(a) confers the power to tax the taxpayer as if the transaction or any part thereof had not been entered into or carried out.

52.3  Section 61A(2)(b) confers the power to tax the taxpayer “in such other manner as the assistant commissioner considers appropriate to counteract the tax benefit which would otherwise be obtained”.  The hypothesis of an assessment under s.61A(2)(b) must therefore be not only that the actual transaction did not take place, but that some other transaction took place instead.  The tax benefit does not have to relate to some other pre-existing source of income, external to the transaction.  The Commissioner can assess the taxpayer on the hypothesis that there was a transaction which created income, but without the features which conferred the tax benefit.

52.4  The Commissioner is not entitled to make an assessment on the hypothesis that the taxpayer would have entered into an alternative transaction which attracted the highest rate of tax. But the Commissioner is entitled to adopt the hypothesis which the evidence suggests would most likely have been the transaction if the taxpayer had not been able to secure the tax benefit.

E2.   The Board’s application of s.61A IRO

53.  The particulars identified by the Commissioner for the purpose of s.61A IRO, as modified by the Board to apply to the Management Fees Per Written Agreement, were that: the transaction which had the effect of conferring the tax benefit on the Taxpayer was “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”); and the person or persons having the relevant dominant purpose were the Taxpayer and/or Profit Gain and/or Mr Lee and/or Mr Li (two shareholders of the Taxpayer).

54.  There was no dispute that the Transaction identified satisfied the first intersecting condition.

55.  As regards the second condition, there was no challenge in this appeal to the alternative hypothesis which the Board accepted, namely, that had Profit Gain not been used, the Taxpayer would have done the production management work itself (“the Alternative Hypothesis”). See Decision at [129], [134].

56.  The Board found that there was a tax benefit as the Taxpayer’s liability to tax was reduced by interposing the Transaction, which enabled a deduction of the Management Fees Per Written Agreement in the Taxpayer’s assessment to tax.  See Decision at [137] to [140].

57.  The Board considered all the circumstances objectively and concluded that the Transaction was entered into, or carried out, for the sole or dominant purpose of enabling the Taxpayer to obtain a tax benefit.  See Decision at [141] to [147].

E3.   The Taxpayer’s arguments on appeal regarding tax benefit

58.  The Taxpayer repeated its argument before the Board, which was that the Management Fees Per Written Agreement were attributable to tasks performed by Profit Gain in mainland China, so that any profits attributable to the business carried out by Profit Gain were sourced outside Hong Kong, and since under the Alternative Hypothesis it was the Taxpayer carrying out the tasks in mainland China instead of Profit Gain, the profits derived from such tasks would be sourced outside Hong Kong and not be chargeable to tax in Hong Kong.

59.  The Taxpayer argued that the Board was wrong to reject this argument on the grounds that the Taxpayer was a trader and carried out its trading activities in Hong Kong, it had declared its profits for taxation in Hong Kong, it had not suggested that its profits were offshore and non-taxable, and there was no convincing evidence that if the Taxpayer took over Profit Gain’s role, its income would have been offshore.

60.  The Taxpayer says that the Board found the following facts and that they support its argument.

60.1  The Taxpayer, Profit Gain and the PRC Factories formed three functional units, with the Taxpayer taking orders and placing them with the PRC Factories or third party manufacturers, the PRC Factories acting as the manufacturing arm, and Profit Gain providing production management services.

60.2  Profit Gain’s employees were stationed in the PRC Factories and carried out work there.  They conducted tasks undertaken in the Management Agreement.

60.3  Profit Gain was not a mere sham.  There was evidence that it had operations in mainland China.  Profit Gain was not an invisible entity or bookkeeping entity.  It performed tasks under the Management Agreement.^[7]

61.  The argument is that Profit Gain was a profit centre distinct from the Taxpayer (and from the PRC Factories), so that if the Taxpayer were to take over Profit Gain’s profit centre, its profits would have increased by the inclusion of Profit Gain’s profits as well.  Furthermore, since its overall costs and expenses would have been similar, its overall profits would have increased.  The profits attributable to production manufacturing services would not have been taxable in Hong Kong as Profit Gain carried out its operations in mainland China, its staff being stationed at the PRC Factories.

62.  The Commissioner says that this is fundamentally flawed because under the Alternative Hypothesis, there would not have been any “profits derived from [the Taxpayer’s hypothetical production management operations in the Mainland”;^[8] it is not correct for the Taxpayer to say that “[the Taxpayer’s] profits would have been increased by including as [its] own profits also the profits made by … Profit Gain”.^[9] Under the Alternative Hypothesis, there would not have been any additional income stream for the Taxpayer; it is just that it would not have to pay fees to Profit Gain.  This was demonstrated by the fact that the profits tax computations for the assessments under challenge noted that the assessments were based on disallowed deductions, rather than on any additional income of the Taxpayer.  The amounts of the disallowed deductions could not be said to be specific profits from carrying out production management work.

63.  I agree.  Under the Alternative Hypothesis, nobody would have paid the Taxpayer for the mainland operations carried out by Profit Gain.  The Taxpayer would not have earned additional profits for carrying out such operations.  The Taxpayer would have earn the same income under both the Alternative Hypothesis and the Transaction, that is, the receipts from its trading operations.  The difference between the Transaction and the Alternative Hypothesis is that under the Transaction, the Taxpayer paid away a part of its profits to Profit Gain in the form of the Management Fees.  Under the Alternative Hypothesis, the Taxpayer would be able to retain the Impugned Management Fees^[10] for itself.  The Taxpayer therefore enjoyed a tax benefit under the Transaction of claiming the Impugned Management Fees as deductions under s.16 IRO.

64.  The Taxpayer then argues that under the Alternative Hypothesis, some of the trading receipts should be treated as sourced offshore rather than onshore.  I note that before the Board, the Taxpayer’s primary argument was that there should be a different alternative hypothesis, namely, that the Taxpayer would have engaged a third party manufacturer; this was rejected by the Board (see Decision at [131] to [136]).  It argued as a fallback that even on the Alternative Hypothesis (which was then the one advocated for by the Commissioner), all the work done by Profit Gain was done in mainland China, and should be treated as non-taxable offshore income.

65.  However, whether or not the activities carried out by Profit Gain would have been profit-producing for Profit Gain or resulted in offshore income for Profit Gain – had Profit Gain been the taxpayer under consideration – does not shed light on whether those activities, if carried out by the Taxpayer, would have been the source of profits for the Taxpayer.  The Taxpayer was a trader rather than a provider of production management services.  As the Board rightly observed in the Decision at [138] and [139], the Taxpayer was at all material times a trader, carrying out its trading activities in Hong Kong, and declaring its trading profits for taxation in Hong Kong (without suggesting that part of its trading profits were derived offshore).  Under the Alternative Hypothesis, it would not be offering any additional source of income for assessment, but rather, the same trading receipts as under the Transaction.  It would have been for the Taxpayer to put forward evidence to show that under the Alternative Hypothesis, if it took over Profit Gain’s role, the source of its income (or part thereof) would somehow have changed to become offshore.  Simply saying that Profit Gain carried out activities in mainland China did not establish the source of the Taxpayer’s income under the Alternative Hypothesis as being offshore.  This is why the Board observed at [139] that there was no convincing evidence to substantiate the contention that if the Taxpayer were to take over Profit Gain’s role, its income would be wholly offshore.

66.  Related to this point was a point raised in the Commissioner’s skeleton (at paragraph 26) that the source of the Taxpayer’s trading receipts could not be affected by the management production work deemed to be undertaken in mainland China as such acts would have been ancillary, antecedent or incidental to the making of the Taxpayer’s profits.

66.1  It was said by the Taxpayer that this was a new point, not taken before the Board, and that I had so held^[11] when giving leave to the Taxpayer to appeal.  On that basis, it was said that the point was not open to the Commissioner, the Taxpayer having been deprived of the opportunity to adduce any necessary evidence.^[12]

66.2  On reviewing the leave decision,^[13] I note that what I had actually said at [33] was that “Mr Mok points out that the Board did not make any express finding that Profit Gain’s work was antecedent or incidental, and that this was not the subject of argument before the Board.”  I had relied on counsel’s explanation of what was or was not argued before the Board.

66.3  At the hearing of the appeal, the Commissioner provided an extract of its written closing submissions before the Board. The point had in fact been raised in paragraph 74(2) and the accompanying footnote 2.

66.4  In any event, as Mr Wong observed, this point does not affect the validity of the analysis above that the Taxpayer has not established that any part of its profits should be treated as sourced offshore.

67.  Mr Mok further argued that Ngai Lik showed that the Board was wrong to say that the Taxpayer needed to demonstrate that if it took over Profit Gain’s role, its income would have been offshore.  Reliance was placed on [62] to [64], where Ribeiro PJ observed that the profits of a business in Hong Kong may accrue from both Hong Kong and overseas sources, the latter being non-taxable; a taxpayer can separate the local and offshore businesses by ensuring that the overseas business is carried out by a different company; and “It therefore cannot be in doubt that the relevant manufacturing processes took place outside of Hong Kong.  Even if they were part of the taxpayer’s own business, the profits deriving from those operations would not be chargeable to Hong Kong profits tax since they would have been sourced offshore.”  The argument was that “Likewise, in the present case, both the manufacturing processes as well as the production management services performed by Profit Gain took place outside of Hong Kong.  Thus, even if they were part of [the Taxpayer’s] own business, the profits derived from those operations … would not be chargeable to Hong Kong profits tax since they would have been sourced offshore.”

68.  I agree with Mr Wong that there is no analogy with Ngai Lik. That case was not concerned with deductions made by a taxpayer.  The scheme under s.61A challenge in Ngai Lik was a transfer pricing arrangement manipulating the prices at which finished goods were sold to the taxpayer, affecting the taxpayer’s trading profits (see [51], [57], [78]). The reduction in the taxpayer’s trading profits was not because of any change in the identity of the manufacturer (cf. Taxpayer’s skeleton paragraph 32).  The tax avoidance scheme did not involve any manufacturing profits (see [56] to [67], [71], [76]).  It was in that context that Ribeiro PJ explained at [64] that even if the taxpayer made manufacturing profits (which it did not), those profits would not be chargeable to Hong Kong profits tax as they would have been sourced offshore.

69.  In his reply submissions, Mr Mok argued that the Taxpayer was taking over the manufacturing functions and therefore its profitability was being increased, because there was no longer any need to pay the manufacturer.  However, this is not the scenario under the Alternative Hypothesis.

E4.   Question 2 under Ground 2

70.  In its skeleton, the Taxpayer argued that the exercise of the s.61A(2)(b) IRO power in assessing the Taxpayer’s liability to tax had “seriously miscarried” as there was no basis to treat the profits earned by Profit Gain from its mainland operations as part of the Taxpayer’s assessable profits, as they were not chargeable to Hong Kong profits tax in the first place.

71.  Insofar as this forms part of the Taxpayer’s complaint that it took over Profit Gain’s role and that profits arising from what would have been Profit Gain’s activities were offshore, this has been dealt with above.

72.  Insofar as this is a separate complaint that the Board wrongly held that the Management Fees Per Written Agreement should be regarded as the assessable profits of the Taxpayer under s.61A(2)(b) to counteract the tax benefit, this is not in fact what the Board said.  The Board rightly observed that it was the Taxpayer’s trading profits which were to be assessed: see Decision at [138] to [139].  As already noted above, the assessments under challenge computed profits tax based on disallowed deductions, rather than on any additional income of the Taxpayer.

E5.  The Taxpayer’s arguments on appeal regarding sole or dominant purpose

73.  The Taxpayer’s argument on appeal is that even if there was a tax benefit in the form of the Management Fees Per Written Agreement, the Board failed to carry out the assessment of the “sole or dominant purpose” by reference to the seven factors set out in s.61A(1) IRO.

74.  The crux of the argument^[14] was that where it is legitimate to use a separate bona fide entity to segregate functions performed outside Hong Kong from those performed in Hong Kong, and the fees charged by the entity are not found to be arbitrary or excessive in return for real services performed by the entity using its own staff outside Hong Kong, it would be perverse, without taking these matters into account, to conclude that the sole or dominant purpose of the transactions entered into by the entity was to obtain a tax benefit.  All that the Taxpayer was doing was to take advantage of a fiscally attractive option by setting up a separate entity offshore.

75.  Reliance was once again placed on Ngai Lik, where Ribeiro PJ observed that a taxpayer could separate its local and offshore businesses by having the latter carried out by a different company or subsidiary, and (at [101]) that the statutory purpose of s.61A was not to attack arrangements made to secure tax benefits which are legislatively intended to be available to the taxpayer.  It was said that since it was legitimate for the Taxpayer to segregate its onshore and offshore activities, the Taxpayer could not have harboured any purpose of enabling itself to obtain a tax benefit.^[15]

76.  Ngai Lik does not assist the Taxpayer.  The application of s.61A IRO in the present case is not directed at challenging the source of the Taxpayer’s profits or any legitimate choice of location in arranging its business.

77.  It is also important to remember that the approach under s.61A does not involve looking into a taxpayer’s mind to see whether it “harboured” any particular purpose.  The exercise is an objective one carried out by a consideration of the matters listed in s.61A(1)(a) to (g), as the Board observed at [141] of the Decision, citing Tai Hing Cotton Mill Development Ltd at [28].

78.  The Taxpayer’s complaint is that the Board took into account irrelevant factors and left out relevant ones.  This is not a ground for appellate intervention unless it can be said that it led the Board so far astray as to reach a conclusion contrary to the true and only reasonable one: Kwong Mile Services Ltd at [33], [34].  Accordingly, as Mr Mok confirmed in oral submissions, the Board’s decision as to whether the Transaction was entered into for the sole or dominant purpose of enabling a tax benefit to be obtained cannot be overturned unless the Taxpayer can show that the decision was perverse or irrational.  It is not the court’s task to simply re-weigh the evidence to arrive at its own conclusion.

79.  Having made these general observations, I turn to the specific matters said to have been taken into account or left out of account, as set out in paragraph 10 of the Taxpayer’s Statement (reproduced earlier).

80.  The Taxpayer says that Profit Gain’s profits would not be chargeable to Hong Kong profits tax (Taxpayer’s Statement paragraph 10(1)(a)(i) and 10(2)^[16]), so that it was therefore legitimate for the Group to separate its Hong Kong-based operations from its offshore operations.  I have earlier addressed the point about the chargeability of Profit Gain’s profits.  As to segregation, whilst it is legitimate to segregate offshore operations, what happened in the present case is that the Taxpayer was supposedly charged substantial fees, resulting in a profit margin far lower than that of Profit Gain, whilst the overall profits remained within the Group, with the sums siphoned off not being subject to tax.  The Taxpayer cannot simply just say that segregation per se is legitimate and brush aside what flowed from it.  As Ribeiro PJ observed in Ngai Lik at [99(e)] as regards the factors in s.61A(1)(a) to (g):

“Paragraphs (d) and (e) require us to look at the financial effects of the particular scheme on the taxpayer and also on persons connected with the taxpayer, such as the group to which a taxpayer company belongs. It may be highly significant under para.(d) that the scheme brings about no changes to the taxpayer’s financial position whilst at the same time producing a tax benefit. Or, under para.(e), it may be significant that the scheme involves transactions among group members resulting in an unchanged financial position for the group as a whole but in the conferment of a tax benefit on the taxpayer.”

81.  As regards the factors in the Taxpayer’s Statement paragraphs 10(1)(a)(ii) to (iv) and (vi), as Mr Wong pointed out,these are all relied on for the Taxpayer’s point that the arrangement between the Taxpayer and Profit Gain was not a sham, there were real employees carrying out real operations in mainland China, and this was done at least to the extent of the Maintenance Fees Per Written Agreement.  However, unlike s.61 which catches “artificial or fictitious” transactions, with “fictitious” approximating in meaning to “sham” (Commissioner of Taxpayer Audit and Assessment v Cigarette Co of Jamaica Ltd (in liquidation)) [2012] 1 WLR 1794 at [21]), s.61A is not so constrained.  As the Board observed, a transaction that serves a commercial purpose can nevertheless be caught by s.61A.  Indeed, it may very well be the case that in order for a transaction to produce a tax benefit, it needs to be carried out, with staff being engaged and paid.

82.  Paragraph 10(1)(a)(iii) refers to the Board’s finding that the Management Fees Per Written Agreement were not arbitrary or excessive. That was a finding relevant to whether these fees were deductible under ss.16 and 17 IRO.  They had to be deductible before s.61A IRO could apply at all.  As Mr Wong submitted, this finding does not address the question of whether the Taxpayer made the payments with the sole or dominant purpose of obtaining a tax benefit.  A payment which is properly deductible under ss.16 and 17 IRO nevertheless constitutes a tax benefit; if the sole or dominant purpose is to get the benefit, then s.61A applies.

83.  The Taxpayer says that the Board also failed to take into account the fact that it is not unusual for related parties to not strictly follow or enforce the terms of an agreement, so that it was not unusual that the Taxpayer and Profit Gain did not strictly follow the terms of the Management Agreement (paragraph 10(1)(a)(v) of the Taxpayer’s Statement).  I agree with Mr Wong that this can only undermine the Taxpayer’s case.  If it were the case that the Group took a commercial decision to restructure its organisation, carrying out a segregation of business functions, and as part of doing so, arranged for the Taxpayer and Profit Gain to enter into a formal Management Agreement to regulate their dealings, then one asks why the parties then decided not to follow its terms after all; and if the intention was that the terms were not to be followed, then one asks why the Taxpayer made payments thereunder (as it says it did).

84.  The Taxpayer then says that the Board took into account irrelevant factors relating to Profit Gain, such as that it relied on related companies to pay staff salary when it had not yet set up its bank account, and that Profit Gain had not registered its business in mainland China (Taxpayer’s Statement paragraph 10(2), and Ground 2 question 3(iv)).  I do not agree that these are irrelevant.  They were relevant for consideration under s.61A(1)(a) (the manner in which the transaction was entered into or carried out) and s.61A(1)(b) (the form and substance of the transaction).  The Taxpayer does not really suggest otherwise, but rather, points to other pieces of evidence to neutralise them and to advocate for a different conclusion to be drawn.

85.  The Taxpayer then argued that as regards s.61A(1)(f) IRO, the Board failed to address the question of whether the Transaction created rights or obligations which would not normally be created between persons dealing with each other at arm’s length under a transaction of the kind in question, as the Board only said that the Transaction was not entered into on an arm’s length basis (without considering whether it would be one not normally created between persons dealing with each other at arm’s length under a transaction of the kind in question).

86.  I agree with Mr Wong that even on the assumption that the Transaction did not create rights or obligations that are not normally created between persons dealing at arm’s length, the Taxpayer does not show how this meant that the Board’s conclusion was contrary to the only true and reasonable one.

87.  Ultimately, the Taxpayer’s arguments amount to no more than inviting the court to re-weigh the evidence, placing weight on matters favourable to the Taxpayer and discounting those which are less favourable, so as to arrive at a different conclusion from the Board.  This is not a permissible approach.

E6.   Conclusion regarding Ground 2

88.  The answer to each of the three questions in Ground 2 is “no”.

F.  DISPOSITION

89.  I dismiss the Taxpayer’s appeal.  I further make a costs order nisi that the Taxpayer is to pay the costs of and occasioned by the appeal to the Commissioner, with certificate for two counsel.