15(4) The role played by Smart-PRC is fundamental and crucial to the earning of the training fee by Smart-HK. In the absence
of the services provided by Smart-PRC in the PRC, Smart-HK would not have been able to earn the training fee.
(5) Since the training fees under the PRC contracts are totally offshore and non-taxable, the sub-contract fee paid to
Smart-PRC is not incurred in the production of assessable profits, and thus not tax deductible. As a result, the net
income of $200,000 is not taxable.
Arguments against the offshore claim
(1) Smart-HK is making profits out of contracting and sub-contracting activities. It is effectively earning a spread between
the training fee from the customer and the sub-contract fee paid to Smart-PRC, rather than earning a service-type of
profit from the provision of a service. The source of the spread should not be determined by the place where the service
is performed, but by the place where the contract is effected. Since the PRC contracts are negotiated and signed in
Hong Kong, the income from the contracts would therefore be sourced in Hong Kong and taxable.
(2) Depending on the terms in the sub-contract, the obligations under the PRC contracts were sub-contracted out to
Smart-PRC, suggesting that Smart-PRC is the sub-contractor engaged by Smart-HK, not an agent of Smart-HK.
Smart-PRC has its own business established in the PRC, and it takes on its own business and contract risk under the
sub-contract agreement. The sub-contracting fee paid to Smart-PRC should represent the value of the services provided
by Smart-PRC, which is 80% of the gross contract fee from the customers. This indicates that the difference, being 20%,
should represent the value or reward for the activities performed by Smart-HK in Hong Kong, including its decision and
management, liaison work and supporting activities. As a result, the difference of 20%, or $200,000, should be onshore
and thus, taxable in Hong Kong.
(3) It would seem that the obligations required under the PRC contracts are partly done in Hong Kong and partly in the
PRC. The total income should be apportioned based on each party’s contribution.
Taking the above into account, on balance, we are inclined to opine that Smart-HK is likely to be challenged by the IRD on
the offshore claim. This is not only based on the current IRD practice that all relevant facts be examined as per DIPN 21, but
also because the extent to which the Court of First Instance’s decision in Li & Fung will be affirmed by the more senior courts
upon appeal is still uncertain. We would recommend that the potential tax liabilities and penalty thereon should be reflected
in the acquisition price of the Smart-Group.
(ii) Hong Kong profits tax implications to Smart-HK of the sub-contract fee paid to Smart-PRC
Under the arrangement, Smart-HK sub-contracts the obligations under the PRC contracts to Smart-PRC, at a fee equivalent
to 80% of the gross contract fee received from the customer by Smart-HK. Assuming that the gross contract fee is taxable
pursuant to the IRO, a tax deduction can be claimed for the 80% sub-contract fee paid to Smart-PRC. Based on s.16(1) of
the IRO, expenses or outgoings will be allowed to the extent they are incurred in the production of assessable profits.
Therefore, if evidence is adequate to prove that the sub-contract fee was paid for the services provided by Smart-PRC to
enable Smart-HK to earn the gross contract fee, the sub-contract fee is prima facie tax deductible.
By virtue of DIPN 46 (issued in December 2009), the IRD has expressed its views on how, and to what extent, a transaction
between associated enterprises should be conducted. When two associated enterprises are carrying on business with each
other, the transfer price charged for the transfer of goods, services and intangible property is expected to be at arm’s length.
Two enterprises are regarded as associated if one enterprise participates directly or indirectly in the management, control or
capital of the other enterprise, or the same persons participate directly or indirectly in the management, control or capital of
both enterprises. However, DIPN 46 makes no reference to the shareholding threshold or residency. In the context of
Smart-HK, as Smart-PRC is wholly owned by Smart-HK, they would be regarded as associated enterprises in the context of
transfer pricing. The basis and quantum for the sub-contract fee payable by Smart-HK to Smart-PRC would be expected to
be at arm’s length.
A price is regarded as at arm’s length if the price transacted between the associated enterprises is comparable to the price
transacted by independent enterprises dealing with each other in similar transactions. If any deviation is found from the arm’s
length basis, a tax adjustment may be made by the IRD to bring the income or expense, as the case may be, back to the
arm’s length level. In the case of Smart-HK, it would be important to ascertain and justify with proper documentation that
the 80% sub-contract fee is commensurate with the value of services provided by Smart-PRC. The most common
methodologies, comparable uncontrolled price and cost-plus pricing, may be used to ascertain what the arm’s length price
should be. The Smart-Group should be asked to provide any information that may be available to enable a transfer pricing
review to be conducted. Should a transfer pricing review be done, efforts should be made to ensure that proper documentation
is maintained.
In the event that the 80% basis is found to be excessive, it is likely that the IRD would apply s.16(1) to restrict the amount
of tax deduction for the sub-contract fee to the amount determined as arm’s length. Although the authority to restrict the
amount of tax deduction under s.16(1) has been challenged by the court (Ngai Lik Electronics Co Ltd v CIR), it is still believed
that the IRD would follow this approach as mentioned in DIPN 46. Alternatively, the IRD may choose to rely on Article 9
(Associated Enterprises Article) of the Double Taxation Arrangement between Hong Kong and the PRC, to adjust upwards the
profits of Smart-HK according to the market price benchmarked to an independent transaction.
In a situation where the IRD considers that Smart-HK and Smart-PRC are engaged in a tax avoidance arrangement in order
to obtain a tax benefit, the IRD may impose s.61 and/or s.61A and/or s.20 to counteract the tax benefit obtained/otherwise
obtainable. In the case of Smart-HK, it is in doubt whether the sub-contract fee is deliberately overstated so as to provide
16sufficient funds for Smart-PRC to finance its investment activities in the PRC, in return for which Smart-HK shares the return
of the investment activities by way of an excessive dividend which is non-taxable in Hong Kong. Further investigation is
recommended in order to form an opinion as to whether a potential risk of s.61 and/or s.61A and/or s.20 being invoked by
the IRD exists.
