Hong Kong court renders a favorable nontaxable offshore profit ...

20 May 2011
International
Tax Alert
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Tax
Hong Kong court renders
a favorable nontaxable
offshore profit decision
Executive summary
Li & Fung (Trading) Limited (LFT) entered into agency agreements with
its offshore customers to render services through their overseas affiliate
companies and earned commissions. Hong Kong’s Court of First Instance
(CFI) concluded that such commissions constituted nontaxable offshore
income. 1 Whether the Commissioner of Inland Revenue (CIR) decides to
appeal to the higher court and whether they would agree with the decision
of Board of Review (BOR) and the CFI are yet to be determined.
Highlights of the salient points
Brief facts of the case
LFT, a Hong Kong-based company of the Li & Fung Group, provides
services to its customers as their sourcing agent. LFT is headquartered in
Hong Kong but has affiliates in various countries. Services provided by LFT
to its customers generally include the following:
• Locating suppliers, arranging manufacturing of the relevant merchandise
by the suppliers, placing orders in the territory of the suppliers on behalf
of its customers
• Monitoring suppliers’ production schedules
• Maintaining quality control on the relevant merchandise
• Arranging shipment and assisting suppliers with the preparation of all
relevant export documentation
• Settling possible merchandise claims on behalf of its customers
1 Li & Fung (Trading) Limited v CIR HCIA (1/2010).

2
• Informing customers abreast
of new developments in the
suppliers’ markets
• Signing or countersigning
contracts/purchase orders/
commitments on the customers’
behalf
Upon delivery of the finished goods
by the suppliers to its customers,
LFT would usually receive a 6%
commission from the customers,
based on the value 2 of the
merchandise.
Where both the customers and
suppliers are located outside Hong
Kong, LFT outsources most if not all
of the above services to its overseas
affiliates under separate service
agreements between LFT and the
affiliates and compensates them
by allocating a portion of its own
commission to the affiliates.
LFT claimed that its net commission
income derived from the above
operations was offshore, and,
therefore, it should be not be
subject to tax in Hong Kong. 3
The CIR, however, rejected LFT’s
claim, determining that the net
commission income was onshore
income subject to tax in Hong Kong.
Thereafter, LFT appealed to the tax
tribunal, the BOR.
2 Freight on board.
3 This Alert focuses solely on CFI’s
decision on LFT’s offshore claims for
its net commission income.
BOR decision 4
The BOR held that LFT was, in
fact, a commission agent, selling
its services for the commission
income, and whose business was
that of undertaking, on behalf of
its own customers, the sourcing
of merchandise. The BOR applied
the legal principles as articulated
by the Court of Final Appeal in the
case of ING Baring Securities (Hong
Kong) Limited v CIR (2007) to
decide the source issue in favor of
LFT. In establishing the geographic
location or the source of a profit,
what matters are the proximate or
immediately direct profit-producing
transactions themselves, not
activities that are antecedent or
incidental to those transactions.
The BOR held that LFT outsourced
agency services to the overseas
affiliates which carried out LFT’s
profit-producing transactions
outside Hong Kong. On this
basis, the BOR ruled that LFT’s
net commission income was
earned in the place where the
overseas affiliates carried out
LFT’s instructions, regardless of
whether they did so as agents or
sub-contractors. The CIR appealed
to the CFI.
CFI’s decision
The CFI rejected the CIR’s
argument, holding that the direct
profit-producing transactions that
generated LFT’s gross commission
4 The full decision of the BOR on this
case has not yet been published.
Accordingly, any reference to BOR’s
positions is an excerpt from the
judgment of the CFI.
International Tax Alert
of 6% were sourcing and agency
activities which LFT carried out
through its overseas affiliates.
The CFI also held that, while LFT
maintained back-office or support
services for its affiliates at its
Hong Kong headquarters, the
BOR was entitled to disregard
them as merely antecedent or
incidental activities, not relevant to
determining the source of LFT’s net
commission income.
The CFI also noted that the place
where the “brains” or decisionmakers
of a business are located
is irrelevant to determining the
geographic source of a profit. The
CFI stressed that the source of a
profit is to be determined by the
nature and situs of the direct profitproducing
transactions, and not
by where the taxpayer’s business
is administered or its commercial
decisions taken.
Commentary
Taxpayers generally welcome this
decision since its holding is based
on the proper application of the
case-law principles for determining
the source of income by focusing
on the direct profit-producing
activities, rather than various
incidental business activities.
However, a determination of
source of profits is complicated;
accordingly, taxpayers need to
consult their tax advisors before
taking a position based on this
holding.

For additional information with respect to this Alert, please contact the following:
Ernst & Young Tax Services Limited, Hong Kong
• Tracy Ho +852 2846 9065 tracy.ho@hk.ey.com
• Jo An Yee +852 2846 9710 jo-an.yee@hk.ey.com
Ernst & Young, Asia Business Services, London
• Asao Takesue +44 20 7951 0655 atakesue@uk.ey.com
• Sandie Wun +44 20 7951 2261 swun@uk@ey.com
• Pradeep Narayanan +44 20 7951 9900 pnarayanan@uk.ey.com
Ernst & Young LLP, Greater China Tax Desk, New York
• Sandy Chu +1 212 773 6721 sandy.chu@ey.com
Ernst & Young LLP, Asia Pacific Business Group, New York
• Jeff Hongo +1 212 773 6143 jeff.hongo@ey.com
• Kaz Parsch +1 212 773 7201 kazuyo.parsch@ey.com
International Tax Alert
3

International Tax Services
• Global ITS, Jim Tobin, New York
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4 International Tax Alert
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EYG no. CM2390
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