COMMISSIONER OF INLAND REVENUE v. WARDLEY INVESTMENT SERVICES (HONG KONG) LTD.

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J U D G M E N T

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1. This is an appeal from a board of review constituted under the Inland Revenue Ordinance, Cap.112 ("the Ordinance") by way of a case stated by the board under s.69 of the Ordinance. (I would add that the stated case is a model of its kind since it does exactly what s.69 requires of it. It sets forth the facts and the decision of the board and it does so without seeking to incorporate by reference the documents on the basis of which the board came to its decision.)

2. The appellant is the Commissioner of Inland Revenue ("the commissioner"). The respondent is Wardley Investment Services (HK) Ltd ("the taxpayer"). The tax at stake is considerable.

3. The facts may be summarized as follows.

4. At all material times the taxpayer was an investment adviser, engaging under management contracts with its customers in the management of customers' investment portfolios. Its functions included the arrangement through brokers of purchases and sales of securities on behalf of customers. It was remunerated by way of periodic management fees paid by the customers, calculated as a percentage of the value of the funds under management. It was entitled to receive rebates it negotiated from brokers it employed to execute transactions on behalf of the customers, and to retain such rebates for its own account as additional remuneration. Some of the transactions in relation to which the taxpayer received rebates were effected by local brokers in Hong Kong and others by overseas brokers outside Hong Kong.

5. On these facts, the parties differed as to how the rebates should be treated for the purposes of the charge of profits tax imposed by s.14 of the Ordinance (of which more later). They appear to have agreed that the rebates should be treated as "income" of the taxpayer for profits tax purposes insofar as they arose out of or were derived from transactions executed in Hong Kong. But they differed as to the rebates arising out of or derived from transactions executed overseas. They were agreed that these, too, were "income" of the taxpayer; but whereas the commissioner contended that the source of that "income" was a Hong Kong source (the contract between the taxpayer and the customer) the taxpayer contended that the source of the "income" was an overseas source (the brokers' commissions from transactions executed overseas). The board held that "the income in dispute" did not arise in and was not derived from Hong Kong.

6. I regret to say that, in my judgment, all this betrays a number of misconceptions as to the true legal position. Let me explain why.

    "Income Tax, if I may be pardoned for saying so, is a tax on income". So said Lord MacNaghten in London County Council v. Attorney General [1901] AC 26, at p.35. Likewise, profits tax is a tax on profits. Profits tax is an annual tax charged on every person carrying on a business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong from such business : see s.14 of the Ordinance. The tax is not a tax on "income". It is a tax on "profits". But it is a tax only on profits arising in or derived from Hong Kong ("Hong Kong profits") not on profits arising in or derived from a place outside Hong Kong ("offshore profits"). The problems to which this gives rise are lucidly analysed by Lord Bridge of Harwich in his speech in Commissioner of Inland Revenue v. Hang Seng Bank Ltd. [1991] 1 AC 306, at p.319. Lord Bridge, having mentioned that a distinction falls to be made between profits arising in or derived from Hong Kong ("Hong Kong profits") and profits arising in or derived from a place outside Hong Kong ("offshore profits") according to the nature of the different transactions by which the profits are generated, points out that a difficulty at once arises. The net profits of a business before taxation in any given period can only be calcuated by deducting from the aggregate income from all sources the aggregate expenses of the business of every kind. If one requires to identify the profits derived from separate transactions, one can only identify the gross profit which each transaction yields. But this gross profit becomes an item of income in the profit and loss account for the business for the period which, aggregated with all other items of income, only contributes to the net profits when all expenditure has been deducted. The practical problem to which this distinction between gross and net profits gives rise in the calculation of "assessable profits" under s.14, which must of course exclude offshore profits, is resolved by the Inland Revenue Rules made under s.85 of the Ordinance. Rule 2A(1) provides :

"No deduction shall be allowed for any outgoing or expense incurred in the production of profits not arising in or derived from Hong Kong, but where any outgoing or expense was incurred partly in the production of profits arising in or derived from within Hong Kong and partly in the production of profits arising or derived from outside Hong Kong, then, for the purpose of ascertaining the extent to which such outgoing or expense is deductible under s.16 of the Ordinance, an apportionment thereof shall be made on such basis that is most appropriate to the activities of the trade, profession or business concerned."

In this rule, the phrase "the production of profits not arising in ... Hong Kong" is clearly a reference to the gross profits arising from the offshore transactions after deducting from the offshore income only the offshore expenditure specifically referrable thereto. But in arriving at the amount of offshore profits to be deducted from the net profit of the business in calculating the "assessable profits" under s.14, it is obviously necessary, as r.2A(1) provides, that the gross offshore profits should be scaled down to bear their fair share of the general expenses of the business which contributed indirectly to earing in Hong Kong and offshore profits alike.

7. Once all this has been properly understood, it can as it seems to me, immediately be seen that the rebates are not "income" of the taxpayer at all.

8. The profits of the taxpayer arise out of and are derived from its management contracts with the customers. Under those contracts, it receives remuneration, which is its "income". Its basic remuneration is its management fees; its additional remuneration is the money, which it is entitled to keep for itself, received by way of rebates from brokers both in Hong Kong and overseas; and its total "income" is the aggregate of its basic and additional remuneration. In the computation of its assessable profits, it will be entitled to deduct all the outgoings and expenses incurred in the production of the remuneration, wheresoever they are incurred. The transactions it instructs brokers to execute on the customers' behalf do not give rise to any "income" for the taxpayer; let alone any "profit". The transactions are effected for the benefit of the customers, not the taxpayer; and the rebates would, but for the provisions of the management contracts as to remuneration, enure for their benefit also. The significance of the rebate is merely that it reduces the expense of executing the customer's transaction. The customer having authorised the taxpayer to retain the rebate for its own account, the remuneration payable by the customer to the taxpayer is increased by the amount of the saving. The only source of the "income" which the taxpayer receives, and on the basis of which its assessable profits fall to be computed, is its remuneration under its management contracts with its customers. The taxpayer obviously cannot be required to bring into account both the additional remuneration and the rebate itself; that would be to bring the same sum into account twice over.

9. An example may serve to make this clear, if it is not clear already.

10. Assume a management contract between the taxpayer and a customer under which the taxpayer's basic remuneration for a given period amounts to $1,000. Assume one transaction in that period, for the purchase of securities through a Hong Kong broker, giving rise to a commission, payable to the broker, of $50. But assume that the taxpayer has negotiated with the Hong Kong broker a rebate (or discount, or share of commission, it does not matter what the label is) of half of the commission. The Hong Kong broker pays or credits the taxpayer with $25. The taxpayer, pursuant to the provisions in that behalf contained in the management contract, retains the $25. Accordingly, the taxpayer receives total remuneration of $1,025 for the period. That is its total "income" for profits tax purposes. The rebate is already brought into account and does not fall to be brought into account a second time.

11. Now suppose the identical facts, but with the transactions in question effected by overseas brokers. The position for profits tax purposes is completely unaffected by this difference. The rebate has to be converted from the overseas currency into Hong Kong dollars, the value date being the date of the receipt by the taxpayer of the rebate. That done, the Hong Kong dollar sum becomes the additional remuneration to be brought into account by the taxpayer as part of its total remuneration and thus of its "income" for profits tax purposes.

12. It is to be observed that the rebate is in no sense a "profit" arising out of or derived from a transaction effected by the taxpayer for its own benefit. The only person who makes any "profit" out of the transaction, the sale or purchase of securities, whether effected in Hong Kong or overseas, is the broker who effects the transaction on the instructions of the taxpayer. His profit consists of the whole of his commission, less the outgoings and expenses incurred in producing it (which in his case include the rebate he has had to give to the taxpayer). The arrangement between the taxpayer and the broker, whether in Hong Kong or overseas, is in no relevant sense a profit-sharing arrangement. The taxpayer is not in any sort of partnership with the broker. The taxpayer is able, because of its muscle in the market, to obtain the services of the agent at a discounted price. There is nothing more to it than that.

13. The question raised by the stated case for the opinion of the Court, which is whether the board had erred in law in holding that "the income in dispute" did not arise in and was not derived from Hong Kong proceeds on the footing that the rebate is to be treated as "income" of the taxpayer. But if, as I hold, the rebate is not to be treated as "income" of the taxpayer at all, there is no room for any inquiry whether the "income" is sourced in Hong Kong or overseas.

14. In the circumstances, I hold that the board's conclusion was erroneous. Since the true position, as I have found it to be, is much more closely reflected in the contentions of the commissioner than in those of the taxpayer, I regard the commissioner as having largely succeeded on this appeal. I shall hear counsel on the matter if asked to do so but as at present advised I am disposed to order that the commissioner's costs of this appeal be taxed (if not agreed) and paid by the taxpayer to the commissioner.