(i) Hong Kong profits tax implications of the profits arising from the PRC Contracts
Based on s.14 of the Inland Revenue Ordinance (IRO), profits tax is charged on every person carrying on a trade, profession
or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong from such trade, profession
or business. As Smart-HK is carrying on business in Hong Kong, the first test of the two limbs is satisfied. However, whether
an amount of profit derived by Smart-HK is taxable in Hong Kong depends on whether the profit is sourced in Hong Kong,
i.e. the second test which in turn depends on the nature of the profit. According to the Departmental Interpretation and
Practice Note (DIPN) 21 (revised 2009), the broad guiding principle is ‘one looks to see what the taxpayer has done to earn
the profits in question and where he has done it’ (basing on CIR v Hang Seng Bank Ltd and CIR v HK-TVB International
Ltd). This is the so-called ‘operations test’. However, how to identify the activities that produced the relevant profits in order
to ascertain where those activities took place is a contentious issue. Various approaches have been derived from different
court cases, although it has been the view of the Inland Revenue Department (IRD) that the ‘totality of facts’ be looked at,
that is, all the activities of a business leading to the earning of the profit. However, this approach has been criticised (in cases
such as ING Baring Securities (HK) Ltd v CIR and CIR v Li & Fung (Trading) Ltd) and the courts have suggested that weighting
should only be given to those profit-generating activities that directly give rise to the profits earned, and all other activities
antecedent or incidental to the profit-generating activities should be ignored. Moreover, that the ‘activities of any person abroad
who undertakes the relevant profit generating transactions on behalf of, and on the instructions of the taxpayer, even if that
person is not an agent of the taxpayer’ should also be taken into account (ING Baring).
Given the contentious development of the source rule as mentioned above, it would not be straightforward to conclude that
the profits of Smart-HK earned from the training services sub-contracted to Smart-PRC are offshore and non-taxable. Below
is a list of arguments that may possibly be used to challenge or defend against the offshore claim:
Arguments for the offshore claim
(1) The nature of profits derived by Smart-HK from the provision of training services is service income. Based on DIPN 21,
the source of profits from the provision of a service is determined by the place where the service is performed. Since the
training services are conducted in the PRC via Smart-PRC, the profits from the provision of such services should be
sourced in the PRC and thus not taxable in Hong Kong.
(2) Based on ING Baring, the activities giving rise to the relevant gross profit earned by Smart-HK are the performing of
training services in discharge of its obligations under the PRC contracts, and these obligations are primarily the provision
of training sessions in the PRC for the customers’ staff in the PRC. All these obligations are then sub-contracted to
Smart-PRC which agrees to fulfil these obligations on behalf of Smart-HK. Smart-PRC is effectively acting on behalf of
Smart-HK and is an ‘agent’ of Smart-HK, even if there is no legal agency agreement in writing. Pursuant to the ING
Baring case, because the training services by Smart-PRC are provided on behalf of Smart-HK, they should be taken into
account in identifying the activities carried out by Smart-HK in deriving the profits and where such activities were carried
out.
(3) We assume Smart-HK has minimal involvement in the provision of the services in earning the PRC training fee revenue
except that it sends experienced trainers to assist Smart-PRC. However, no charge is made to Smart-PRC, indicating that
Smart-HK is prepared to take the responsibility to assure the quality performance of the PRC training sessions. All other
supporting activities conducted by Smart-HK in Hong Kong, including liaison with customers, arranging itinerary, etc,
are antecedent as well as incidental to the training services in the PRC. Based on ING Baring and Li & Fung, these
antecedent and incidental activities should be ignored, and thus all profits arising from the PRC contracts are sourced
offshore and should not be assessable to profits tax in Hong Kong.
