Challenges by the Inland Revenue Department (“IRD”) to claims by businesses that profits fall outside the scope of the Hong Kong territorial tax system often require a precise identification of the activities undertaken by a taxpayer which form the true basis for the profits so as to identify the geographic source of income. In this article, we examine some of the difficulties faced by the taxpayer in the recent case of Patrick Cox Asia Ltd. v. Commissioner of Inland Revenue [2023] HKCFI 2676 in arguing that arrangements made by an agent outside of Hong Kong resulted in income from those activities being sourced outside Hong Kong. Should you have queries in respect of IRD challenges to the taxability of offshore profits or the geographic source of profits in the Hong Kong territorial tax system, please contact one of our tax lawyers.
It has often been said that Hong Kong operates a territorial source based system of taxation, meaning that taxes are payable only on income sourced in Hong Kong. Under the Inland Revenue Ordinance (“IRO”), a business is taxable only if 3 conditions are satisfied:
the business must be carried on in Hong Kong;
the profits must arise in or derive from this business; and
the profits must arise in or derive from Hong Kong
Each condition is separate. Thus, the fact that a taxpayer carries on a business in Hong Kong does not necessarily mean that profits from this business arise in or derive from Hong Kong. As the court observed in The Hong Kong & Whampoa Dock Co. Ltd. (No. 2) v Commissioner of Inland Revenue [1960] 2 HKLR 166:
“[…] the test of the source of the profits is not to be found merely by answering the question where does the [taxpayer] carry on business, and then saying that because the [taxpayer] carries on business in Hong Kong therefore Hong Kong is the source of the profits or, in other words, that those profits arose and derived from Hong Kong.”
Thus, the Privy Council noted in Commissioner of Inland Revenue v. Hang Seng Bank Limited [1991] 1 AC 306:
“[…] the profits of a business carried on in Hong Kong may accrue from different sources, some located within Hong Kong, others overseas. The former are taxable, the latter are not.”
The Patrick Cox Decision
In December 2023, the Court of First Instance issued its judgment in Patrick Cox Asia Ltd. v. Commissioner of Inland Revenue, a case in which a Hong Kong based taxpayer sought to argue that royalties it received from sub-licensing of trademarks to Japanese companies were sourced outside Hong Kong (i.e. did not arise in or derive from Hong Kong). Under the arrangements, the taxpayer entered into a cooperation agreement with an introducer. The introducer had an obligation to introduce Japanese companies to the taxpayer and paid an upfront fee to the taxpayer. Sub-licensing royalties were split between the taxpayer and the introducer.
The IRD rejected the taxpayer’s offshore income claim and assessed profits tax on the taxpayer’s share of the sub-licensing royalties. On the taxpayer’s appeal to the Board of Review, the Board of Review concurred with the IRD. The taxpayer sought leave (i.e. permission) to appeal against the decision of the Board of Review to the Court of First Instance.
Agency
The taxpayer argued that the introducer was its agent, the introductions formed the true basis for its royalty income and as the introducer carried on its introducing business activities in Japan, the taxpayer’s share of the royalty income arose in Japan. On this basis, the taxpayer argued that its share of the royalty income was sourced outside Hong Kong and was outside the Hong Kong profits tax regime.
The court rejected the argument, holding that the introducing activities undertaken by the introducer did not form the true basis for the taxpayer’s income. Instead, the taxpayer earned its income by granting sub-licenses to Japanese companies which had been introduced.
The court stated:
“the prior question is what were the profit producing activities of the Taxpayer? If such activities did not include what the ‘agent’ did, then the fact that the ‘agent’ was the Taxpayer’s agent is nothing to the point.”
The court determined that because the activity of making introductions was what the introducer had to do to perform its own obligations under the cooperation agreement, that activity was not done on behalf of the taxpayer. It was done instead by the introducer for itself to earn its profits. As the analysis of income source looks only to the taxpayer’s own activities, and the introducer’s introductions (even if done as the taxpayer’s agent) were not the taxpayer’s profit-producing activities, the court held that the introducing activity ought to play no part in the analysis on the source of the taxpayer’s income.
Analysis
The unusual feature of the arrangement in this case was the payment of the upfront fee and the sharing of royalties. This feature provides some hint that, despite the taxpayer’s attempt to characterize the introducer as its agent, in fact, the introducer was not a mere agent but a counterparty partner (in the business sense rather than the legal sense) of the taxpayer. Such a conclusion tends to support the separation of the taxpayer’s activities from those of the introducer.
Nevertheless, on a broad reading of the decision, it may be said that the court has undermined the agency concept in determining the source of income. As it seemed that the court accepted that the introducer was in fact the taxpayer’s agent, by treating the performance by the introducer of its duties as an agent for the benefit of the taxpayer principal as acts for the benefit of the introducer itself to earn its own profits, the court may have left little room to rely upon the acts of agents in assessing source of profits. The court stated at para. 36:
"The acts which BLBG [i.e. the introducer] performed were (identifying and introducing sub-licensees to the Taxpayer, and arranging for negotiations) were [sic] not carried out on behalf of the Taxpayer in performance of its obligations under the Deed of Cooperation, but rather, by BLBG in performance of its own obligations under the Deed of Cooperation. Thus the mere fact that the recital of the sub-licences stated that the Taxpayer had appointed BLBG as agent would not engage “the principle of agency”. It is putting the cart before the horse to say that since BLBG was the Taxpayer’s agent, therefore its activities should be attributed to the Taxpayer; the prior question is what were the profit producing activities of the Taxpayer? If such activities did not include what the ‘agent’ did, then the fact that the ‘agent’ was the Taxpayer’s agent is nothing to the point."
It will be difficult to find agency arrangements in which the agent does not earn its own profits from the performance of its own obligations under its agreement with the principal, which, may include, as in this case, identifying clients and arranging negotiations with clients. On this basis, invariably, it would seem that what the agent does under the agency arrangement could always be characterised as acts for the benefit of the agent itself rather than the taxpayer principal.
By disregarding all the acts done for the taxpayer by its agent, the only act of the taxpayer contributing to the taxpayer’s profits was the execution of the sub-licensing agreements in Hong Kong. As a result, it seems that it is critical for the taxpayer (or its agent) to conclude the agreements outside of Hong Kong to mount an argument that income from such business is sourced outside of Hong Kong.
Internaional Tax Practices
The taxpayer sought as well to argue that the source of the royalty fees was Japan because the trademarks in respect of which royalties were earned were registered in Japan and exploitable only in Japan and that they had no existence as property until registration. Though international tax treaties may treat income from trademarks as being sourced in the place where the trademarks are registered, the Board of Review held, and the court agreed, that the act of registering the trademarks in Japan did not produce the royalty income and was not a profit-producing activity of the taxpayer. Instead, the taxpayer earned its profits by entering into the cooperation agreement and the sub-licences in Hong Kong.