Hong Kong Court holds profits from interposed trading business are not taxable

Hong Kong’s Court of First Instance (CFI) overturned the decision of the Board of Review (BOR) and ruled, on 20 April, that the trading profits of an interposed Hong Kong company were not taxable in Hong Kong in a case where the company had a Hong Kong bank account and registered address but no physical operations or staff in Hong Kong.

In Newfair Holdings Ltd v Commissioner of Inland Revenue (2022 HKCFI 1133), the taxpayer was a company incorporated in Hong Kong and wholly owned by a Dutch company. Newfair had a registered office in Hong Kong with no physical operations and did not employ any staff in Hong Kong. The taxpayer maintained a bank account in Hong Kong to receive revenue and pay suppliers.

Newfair’s business model involved sourcing goods from two suppliers, both incorporated in Hong Kong with manufacturing businesses in Mainland China, and reselling the same goods at a mark-up of 35% to its sole customer, another group company based outside Hong Kong.

Newfair had entered into a master purchase agreement (MPA) with a supplier and a master sale agreement (MSA) with a customer; both were negotiated and executed by the taxpayer’s ultimate shareholders outside Hong Kong. All relevant activities were conducted by group employees outside Hong Kong and the goods were shipped directly from the suppliers to the customer without passing through Hong Kong.

The IRD and Newfair were in dispute about whether the taxpayer should be subject to tax in Hong Kong under section 14 of the Inland Revenue Ordinance (IRO). Three conditions must be satisfied before a charge to tax can arise under Section 14:

• The taxpayer must carry on a trade, profession, or business in Hong Kong.
• The profits to be charged must be from the trade, profession or business carried on by the taxpayer in Hong Kong.
• The profits must be profits arising in or derived from Hong Kong.

The BOR determined that the taxpayer was carrying on a business in Hong Kong and therefore the profits were sourced and taxable in Hong Kong. The taxpayer appealed to the CFI.

The CFI overturned the BOR’s decision, holding that Newfair did not have a business in Hong Kong, its profits did not arise from commercial operations in Hong Kong and therefore it was not subject to profits tax in Hong Kong in the relevant years of assessment.

In coming to its decision, the CFI agreed that the tax law imposes tax liability on what an entity does, rather than what it is. The interposition of Newfair as an intermediary entity was not in itself a commercial operation that generated taxable profits, and the operation of the Hong Kong bank account was administrative in nature and did not amount to profit-producing operations.

The fact that all the commercial operations relevant to the production of Newfair’s profits were performed outside Hong Kong and that the MPA and MSA were executed offshore, were relevant in determining that the profits did not have a Hong Kong source.

“In ruling that the profits of an interposed Hong Kong company did not have a Hong Kong source and were not therefore subject to profits tax in Hong Kong, the CFI has stuck to the strict definition of territorial taxation,” said a Consultant at Sovereign Trust (Hong Kong) Ltd. “While Hong Kong is supportive of international tax cooperation in combating tax avoidance, legal principles have to be applied appropriately to the facts of each case.”