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The Li & Fung Case

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1.

Q:

What was the business of Li & Fung (Trading) Limited ("LFT")?

 
 

A:

LFT provided services to its customers who were importers, department stores, chain stores and specialty shops located overseas for which, typically, LFT was paid 6% of the FOB value of the goods supplied to such customers. The Board of Review held that LFT was a "commission agent" and rejected the suggestion that LFT operated a "supply chain management business".

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2.

Q:

What were the issues?

 
 

A:

The first issue was whether LFT's profits relating to goods sourced from suppliers located in places other than Hong Kong, Mainland of China and Macau were offshore and so not chargeable to profits tax. The second issue was whether LFT's deduction of a marketing commission paid to its holding company incorporated in the British Virgin Islands from onshore profits was caught by the anti-avoidance provisions in sections 61 and 61A of the Inland Revenue Ordinance.

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3.

Q:

How did the Board of Review decide the issues in question 2 above?

 
 

A:

The Board of Review decided in LFT's favour on the first issue and in the Commissioner's favour on the second. Both parties appealed by way of case stated against the Board's Decision. The appeal on the second issue was settled and discontinued with the Court's consent.

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4.

Q:

What was the judgment of the Court of First Instance?

 
 

A:

There was evidence on which the Board of Review could conclude that LFT's commission was earned in the place where the overseas sourcing affiliates carried out its instructions. The true and only reasonable conclusion would not contradict the Board's conclusion. It would not be incorrect for the Board not to apportion the 6% commission by reference to the activities of the overseas sourcing affiliates and of LFT. Nor can it be said that the Board acted irrationally or that its conclusions were unsupported by the available evidence.

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5.

Q:

What was the judgment of the Court of Appeal?

 
 

A:

The judgment of the Court of First Instance was justified by the facts found by the Board of Review. The Board of Review could not be criticized for not dealing with the Commissioner's argument raised in the Court of Appeal. The Board's delay in handing down the Decision would not render the Decision unsafe. There was no basis to remit the case back to the Board to make additional findings of fact.

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6.

Q:

Have the Courts considered the entire facts of the case?

 
 

A:

No, the Courts did not have the chance to consider the entire facts of the case. Counsel for the Commissioner attempted to rely on the Harvard Business Review reports to show that some of the activities in the standard agency agreement were performed in Hong Kong. But since the point had not been taken before the Board of Review, the Court of Appeal held that it would not be right to remit the matter to the Board to enable the Commissioner to raise this new point which would probably require further evidence.

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7.

Q:

Why didn't the Commissioner appeal to the Court of Final Appeal?

 
 

A:

An appellant in ordinary civil cases may appeal to the Court of Final Appeal as of right or as a matter of discretion under section 22(1) of the Hong Kong Court of Final Appeal Ordinance. Counsel advised that the tax amount would not determine the question whether leave should be granted as of right. Counsel further advised that the decision of the Court of Appeal would be final unless it could be established that the case involved questions of great general or public importance or there were exceptional circumstances which necessitated the exercise of discretion to grant permission to appeal to the Court of Final Appeal. The Commissioner having considered the advice of Counsel decided not to appeal.

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8.

Q:

Is there any change in law on source of profits?

 
 

A:

The relevant legal principles applied by the Court of Appeal as set out in its judgment were not disputed by the Commissioner and LFT. The Court of Appeal simply reconfirmed the broad guiding principle, i.e. what the taxpayer has done to earn the profit in question and where he has done it and emphasized the importance to focus on the effective causes as distinct from antecedent or incidental activities. The judgment did not represent a change of law or overturn any judicial precedents.

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9.

Q:

Is the case of wider application?

 
 

A:

The Court of Appeal simply applied the well-established legal principles to the facts found by the Board of Review. As there is no change in law on source of profits and the case was decided on its own facts, the judgment does not have some wider application to other source cases.

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10.

Q:

Will the Department change its assessment practice regarding the taxation of profits derived from sourcing and agency activities?

 
 

A:

There is no new law or change in law on source of profits in the LFT case. Per the judgment of the Court of Final Appeal in Ngai Lik Electronics Co Ltd v CIR [2009] 5 HKLRD 334, sourcing and agency activities in Hong Kong might give rise to assessable profits. When assessing profits derived from sourcing and agency activities, the Department will continue to apply consistently the broad guiding principle, focus on the effective causes and ignore antecedent or ancillary matters.

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11.

Q:

What were the observations about agency?

 
 

A:

Whether one is acting for another or on his behalf and for his account is a factual matter. In CIR v Datatronic Ltd [2009] 4 HKLRD 675 and CIR v CG Lighting Ltd [2011] 2 HKLRD 763, the Court of Appeal held that the subsidiary was not manufacturing on the Mainland as agent for the taxpayer in Hong Kong. In Consco Trading Co Ltd v CIR [2004] 2 HKLRD 818, the Court of First Instance said that it was correct to take a global view of the evidence, including the finance arrangements, the payment for raw material and processing fees, the arrangement for receipt of payment from purchasers for the finished products and pre-contract negotiations, to conclude that the profit generating activities were performed in Hong Kong, despite the appointment of an agent for the operation of business outside Hong Kong.

In the present case, the Board of Review found that the overseas sourcing affiliates were LFT's agents. At the Court of Appeal, the Commissioner did not contend that the overseas sourcing affiliates' activities were not relevant in determining the source of profits. The Commissioner's argument was that the Board of Review and Court of First Instance had not considered the services undertaken by LFT in Hong Kong per the agency agreement that generated the gross commission of 6%.

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12.

Q:

Would sourcing and agency activities in Hong Kong give rise to profits chargeable to profits tax?

 
 

A:

The Court of Final Appeal in Ngai Lik Electronics Co Ltd v CIR [2009] 5 HKLRD 334 clearly said that sourcing and agency activities in Hong Kong might give rise to assessable profits. Companies which specialise in sourcing suppliers and charge a commission or receive some other remuneration for the service would likely be chargeable to Hong Kong profits tax.

It is trite fact that in two cases, the Court of Appeal decided that the source of profits was not in Hong Kong. However, these cases turned on their own facts, i.e. the Board of Review/Courts accepted that the profits were generated by overseas agency activities. In Magna Industrial Co Ltd v Commissioner of Inland Revenue [1997] HKLRD 173, it was held that sales profits were sourced outside Hong Kong because the sales were effected overseas through a network of independent contractors. In the present case, it was held that the Board of Review had evidence to conclude that LFT's commission was derived from sourcing and agency activities carried out through the overseas sourcing affiliates.

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13.

Q:

Did the judgment of the Court of Appeal touch upon the profits tax treatment of "supply chain management business"?

 
 

A:

In its judgment, the Court of Appeal explained the profits tax treatment of LFT as a "commission agent" and not as a "supply chain management business". The profits taxation of a "supply chain management business" will therefore continue to be dealt with under the taxation principles explained above for sourcing and agency activities.