The Current State of Hong Kong Taxation
CUHK Faculty Seminar
December 9, 2009
Prof. Jefferson VanderWolk
Hong Kong has a limited tax regime, which is both territorial and schedular:
Salaries Tax (section 8, IRO) on income arising in HK from an
Profits Tax (section 14, IRO) on profits arising in HK from a trade or
Property Tax (section 5, IRO) on rent from property in HK
IRO has not changed fundamentally since its enactment in 1947. The territorial and
schedular nature of the regime was typical of colonial tax regimes. The cross-border
nature of much of the business conducted in HK has put pressure on the territorial source
The source of income is a matter of commercial reality, a “hard, practical matter of
Income arising in HK – what does it mean? Privy Council decisions on cases from
Australia, Hong Kong and other Commonwealth jurisdictions stressed that the source of
income is a “hard, practical matter of fact” requiring examination of the commercial and
economic reality. The CFA has endorsed this.
The courts have consistently cited the so-called “operations test”: “Where do the
operations take place from which the profits in substance arise?” or “What did the
company do to earn the profits and where did it do it?” The Privy Council used these
formulations and they have been adopted by the CFA.
In recent years, the CFA has clarified how to determine the source of profits under
the operations test. Profits arise where the “effective cause” occurred, not where
“antecedent or incidental” activities occurred.
HK-based taxpayers often earn income from activities occurring outside HK. Cases over
the years have established that income arises where the economic action is, not where the
controlling decisions are made, eg:
The HK & Whampoa Dock Company case (1960): service fee from the repair and
towing to HK of a ship grounded on the Paracel Islands by a tugboat sent from
HK; held, the income arose wholly outside HK
The Hang Seng Bank case (1990): income from the purchase and sale of debt
securities in overseas markets through agents in those markets; held, the income
arose wholly outside HK (Privy Council)
The ING Baring Securities case (2007): commission income from executing
customers‟ purchases and sales of securities in overseas stock markets through
agents in those markets; held, the income arose wholly outside HK (CFA)
The IRD has always given greater weight to presence in HK than to activities ex-HK.
In both Hang Seng Bank and ING Baring Securities (and many other cases), the
Commissioner of Inland Revenue argued that, because the taxpayer controlled the
business from its HK office, made all decisions in HK, and had no operations of its own
outside HK, all of its profits arose in HK. The Privy Council and the CFA rejected this.
The CFA in ING Baring said that profits arise in fact from the performance of contracts,
not from entering into contracts or deciding to enter into contracts.
Should the acts of agents and contractors be taken into account?
In ING Baring, the CFA said yes. Lord Millett explained that, although the activities of
commonly controlled companies could not be attributed to the taxpayer merely because
they were commonly controlled, the activities contracted out by the taxpayer to others,
whether or not commonly controlled, must be taken into account in determining the
source of the taxpayer‟s profits. In Lord Millett‟s words:
In considering the source of profits, however, it is not necessary for the taxpayer
to establish that the transaction which produced the profit was carried out by him
or his agent in the full legal sense. It is sufficient that it was carried out on his
behalf and for his account by a person acting on his instructions. Nor does it
matter whether the taxpayer was acting on his own account with a view to profit
or for the account of a client in return for a commission.
The IRD has not accepted the CFA’s analysis.
The IRD has taken the position that the principle stated by Lord Millett is not applicable
to anyone other than securities brokers. The IRD posted a series of questions and
answers regarding the ING Baring case on its website in 2008, including the following:
Q8 What were the [CFA‟s] observations [in ING Baring] about agency and the
A8 When examining the business of stockbrokers, [the CFA] said that it was not
necessary to establish that the transaction, which produced the profits, was carried
out by the taxpayer or his agent in the full legal sense. It was sufficient if a
person acting on his instruction carried out the transaction on his behalf and for
his account. [The CFA] did not say that the act of any person carried out
overseas should be readily attributed to a taxpayer in Hong Kong in transactions
other than those in securities in an overseas market. [The CFA] rejected the
proposition that „commercial reality‟ dictated that the source of profits of one
member of a group of companies could be ascribed to the activities of another.
The statement in italics is misleading, as the CFA simply said that the acts of a contractor
or agent on behalf of a HK taxpayer must be taken into account in determining where the
HK taxpayer earned its profits. The CFA spoke in general terms.
Hong Kong-based companies that manufacture goods through subsidiaries in
China have a particular interest in this issue. Here is what the IRD had to say to them:
Q9 Do the observations in A8 above have relevance to import processing
A9 In an import processing arrangement, goods are normally purchased from a
subsidiary situated in the Mainland and sold overseas. Some argue that the profits
should be assessed on a 50:50 basis on the ground that the goods are
manufactured by the subsidiary on behalf of the Hong Kong taxpayer in the
Mainland. Such an argument would not be accepted by the Department because
of the Court of Final Appeal’s rejection that the activities of one member of a
group of companies could be ascribed to another member. [emphasis added]
This is a blatant misrepresentation of what the CFA said. Far from rejecting the stated
proposition, the CFA actually adopted it, on the basis that the fellow group member was
acting on the taxpayer‟s behalf and under the taxpayer‟s instructions.
On December 4, 2009, the IRD issued Departmental Interpretation and Practice
Notes No. 21 (Revised), which includes statements substantially identical to those in
The IRD’s position has been upheld by the Board of Review and the Court of
Appeal, without any recognition of the CFA’s answer to the question of whether to
take account of the acts of agents and contractors.
Amazingly, the IRD‟s misrepresentation of what the CFA said in ING Baring has been
accepted by the Inland Revenue Board of Review in several cases. For example:
Case No. D16/08: The Board held that a HK-based company‟s profits from
contracts performed outside HK arose entirely in HK. The facts were
straightforward. The taxpayer company had its sole office in HK. Employees in
that office negotiated and concluded two contracts for the supply and installation
of marble and granite facings for a new building or buildings under construction
in Beijing. The taxpayer subcontracted the work to a controlled subsidiary in
China. The taxpayer‟s employees monitored the subsidiary‟s performance and
joined employees of the subsidiary on visits to unrelated suppliers outside HK.
All of the work involved in grinding and cutting the stone, and assembling and
installing the finished product at the customer‟s building site, was done outside
HK by the subsidiary. The taxpayer received the customer‟s fee and paid part of
it to the subsidiary under the subcontract.
The Board of Review took the view that the subsidiary‟s activities could
not be attributed to the taxpayer for the purpose of determining the source of the
taxpayer‟s profits from the contracts. The Board relied on the same dictum of the
CFA in ING Baring that the IRD relied on in A9 of the FAQ, namely, that a group
company‟s acts should not be attributed to another group company simply
because they are part of the same group. The Board did not consider whether the
subsidiary‟s acts should be attributed to the taxpayer under the CFA‟s analysis in
ING Baring regarding agents and contractors acting on behalf of the taxpayer.
Case No. D42/08: The taxpayer‟s profits arose from the manufacturing and sale of
finished goods. The sales were made to customers outside HK. The
manufacturing was done by a subsidiary in „Country B‟ (undoubtedly China).
The subsidiary was an equity joint venture entity (EJV) with an unrelated
minority shareholder who was able to give the EJV import and export licenses
necessary for the conduct of the business. The taxpayer, a HK company that
owned the majority of the EJV, entered into a contract with the EJV under which
the taxpayer provided raw materials, product and packaging designs, machinery,
technical support, and overall management of the production process, and the EJV
delivered finished goods to the taxpayer in HK. In a typical transaction, the
taxpayer would receive an order from an overseas customer for particular goods,
and the taxpayer would then order necessary raw materials from suppliers located
both in and outside HK. The taxpayer would send the raw materials to the EJV
by way of a sale at cost. The EJV would manufacture the goods using machinery,
designs, etc. supplied by the taxpayer, and would deliver the finished goods to the
taxpayer by way of a sale to the taxpayer at cost. The taxpayer would then ship
the goods to its customer overseas. The EJV paid management fees to the
The taxpayer claimed that half of its profits arose outside HK. The IRD
disagreed and assessed tax on all of the taxpayer‟s profits. The Board of Review
upheld the assessments. The Board, noting that the taxpayer‟s representative
“seeks to ascribe the source of the appellant‟s profits to the activities of the
appellant‟s subsidiary, the JV,” said that “such contention has been authoritatively
rejected by the Court of Final Appeal in ING Baring.” The Board cited the
passage from ING Baring in which the court stated that the operations of a group
member are not attributable to other members of the group by virtue of the fact
that they are in the same group. As in D16/08, the Board turned a blind eye to the
CFA‟s attribution of a group member‟s activities to the taxpayer in ING Baring.1
In Datatronic Limited v. Commissioner of Inland Revenue, the Court of Appeal
held that the taxpayer was taxable on all of its profits from the sale of goods
manufactured in China by a controlled subsidiary.2 The facts were substantially
similar to those in D42/08. The court took a formalistic view and said that the
taxpayer could not be considered to have earned any part of its profits from
Much could be said about the Board‟s contemptuous treatment of the submissions made by the taxpayer‟s
representative in D42/08 and its obvious bias toward the government‟s representative.
 4 HKLRD 675, CACV 275/2008 (July 15, 2009).
manufacturing because, as a legal matter, the taxpayer derived its profits from the
resale of finished goods that it had purchased from its manufacturing subsidiary.
Like the Board of Review in D16/08 and D42/08, the Court of Appeal
cited the portion of Lord Millett‟s judgment in ING Baring concerning group
companies but did not refer to the portion concerning agents and contractors.
The taxpayer in Datatronic applied for leave to appeal to the CFA but
subsequently withdrew its application. Therefore, at present Datatronic is the only court
case on the source of profits earned by HK companies from the manufacture of goods
through controlled subsidiaries outside HK. This will encourage the IRD to continue to
make source determinations without taking into account the activities of contractors
acting on the taxpayer‟s behalf, in defiance of the CFA‟s guidance in ING Baring.
One case has been decided by the Board in favor of the taxpayer. The IRD has
appealed to the Court of First Instance.
A glimmer of hope exists for HK companies engaged in contract manufacturing in China.
The Board of Review held, in D51/08, that an undetermined portion of the taxpayer‟s
profits arose outside HK, on facts substantially identical to those in D42/08. The Board
noted that D42/08 had been decided in favor of the IRD on very similar facts, but made
no further reference to it. The Board said:
We believe that in a case, like here, where the operation is a multi-facet (sic) one,
this Board must have regard to the practical commercial reality. Such reality
dictates that the Taxpayer‟s participation in the production process was as much a
part of its profit-producing transaction as the obtaining of a purchase order.
Plainly, part of the Taxpayer‟s profit-producing transactions was located in the
Mainland and therefore its contention that part of its profits was sourced from
outside Hong Kong and not chargeable to profits tax is correct.
The Board remitted the case to the IRD to determine how much of the taxpayer‟s profits
should be treated as arising outside HK. The IRD has appealed against the Board‟s
decision, and the Court of First Instance is scheduled to hear the case in April 2010.
Current practice regarding the source of employment income for Salaries Tax
purposes is even more problematic.
Inland Revenue Ordinance, s 8: Salaries Tax applies to “income arising in or derived
from Hong Kong … from any office or employment.” Under s 8, income arising in HK
includes “income from services performed in Hong Kong,” unless the employee works in
HK for fewer than 61 days during the year, in which case all of the income from the
employment will be treated as arising outside HK.
If the statute were written symmetrically, it would provide that all the income
from an employment is income arising in HK if the employee spent fewer than 61 days
working outside HK during the year. Logic and common sense would then dictate that,
for cases in which the employee spent more than 60 days in HK and more than 60 days
outside HK during the year, the employee‟s income from the services performed in HK
would be income arising in HK, and the income from the services performed outside HK
would be income arising outside HK.
The statute, interpreted in light of the commercial-reality principle and common
sense, would appear to require time-based apportionment of income. But the law
has developed differently.
Unfortunately, the statute was not written symmetrically, and the law has developed
badly. Numerous disputes arose over the years between the IRD and taxpayers who had
worked outside Hong Kong for more than 60 days during the year of assessment. The
Board of Review rendered inconsistent decisions based on a variety of different factors
over the course of many years. By the mid-1980s, the law on the source of employment
income was extremely unclear.
The Government announced in early 1987 its intention to amend section 8 to
clarify that time-based sourcing of employment income was required if the employee had
worked outside HK for more than 60 days during the year. However, the proposed
amendment was shelved after the High Court decided its first-ever case on the source of
employment income, Commissioner of Inland Revenue v. Goepfert, 2 HKTC 210 (1987).
The Goepfert decision was flawed, but the Government liked it.
In Goepfert, the taxpayer argued that, because his contract of employment was legally
sited outside HK, his income was taxable only to the extent it derived from services
performed in HK. The IRD argued that all of his income was taxable in HK because he
performed the majority of his services in HK. Not surprisingly, the taxpayer won. But
the decision turned out to be a victory for the government, because it would enable the
IRD to assess tax in the future on income derived from services performed outside HK.
The court relied on English case law involving a differently worded statute and held
that employment income arises at the situs of the contract of employment, rather than at
the place where the employee works. Three factors were mentioned as relevant to the
situs of the contract: (1) the place where the contract was negotiated and concluded, (2)
the place where the employer is resident, and (3) the place where the employee is paid.
But the court also said that all facts and circumstances – except for the location of the
employee‟s work – should be taken into account in making the determination of contract
The judge and counsel for both parties appear to have been laboring under the
mistaken idea that the IRO had been amended in 1971 to include the provision that
includes income from services performed in HK in the phrase “income arising in or
derived from HK,” implying that the phrase was originally intended to mean that income
from employment arises from something else. In fact the provision had been in the IRO
from the beginning and was simply relocated to section 8 in 1971.
The judge did not need to adopt the situs-of-the-contract test to reach the conclusion
that the taxpayer‟s income should be apportioned. He could have simply adopted a
place-of-services test and reached the same result. But his misapprehension of the
legislative history led him to believe that a place-of-services test was not possible.
Realizing that the court had handed it a gift, the Government abandoned its clarifying
legislation, citing the court‟s contrary conclusion and also noting the likelihood that the
clarification would probably have resulted in a loss of tax revenue.
The failure to enact the clarifying legislation was a mistake.
In hindsight, it is clear that the government ought to have stuck to its policy decision
in 1987 and amended the statute to require time-based sourcing, for two reasons.
First, the Goepfert decision was flawed. The court misunderstood the statutory
provisions it was interpreting, and relied on irrelevant case law for a ratio
decidendi that conflicts with the most basic principle of law regarding the source
of income, namely, that it is a “hard, practical matter of fact.” Nothing could be
further from a hard, practical matter of fact than the concept of the legal situs of
an employment contract, which rests on other vague concepts such as the
residence of a corporation.
Second, the decision has not clarified the law in practice. Many cases have gone
to the Board of Review during the past 20 years, and the IRD has issued a series
of muddled and confusing practice notes. The IRD and the Board of Review have
adhered to the Goepfert analysis, except that no weight is given to the place of
payment. Only one case has made it to the Court of First Instance (Lee Hung-
kwong v. CIR, HCIA 3/2005) where the Goepfert analysis was followed, with
particular stress being placed on the residence of the employer. The question of
the employer‟s residence is often contentious, particularly for employees who are
transferred to a Hong Kong company from another company in the same
multinational group. The IRD and the Board usually reject time-apportionment
claims. The amount of tax at issue is never large enough to justify a further
appeal to the courts.
The international business community sometimes gets involved, as Ahn Sang
Gyun’s case illustrates.
In the case of Ahn Sang Gyun (Case No. D32/07, Nov. 13, 2007), the Board of Review
made a dubious finding regarding the residence of the employer, Goldman Sachs (Asia)
LLC (“GSALLC”). Ahn was a Korean national, living in Korea when he was recruited
to work for GSALLC in the region, based in HK. He spent most of his time working
outside HK but worked in HK for more than 60 days during the year of assessment. The
Board upheld the IRD‟s assessment of tax on all of Mr. Ahn‟s employment income on the
grounds that (1) his employment contract was at least partially negotiated and concluded
in HK and (2) his employer, GSALLC, was resident in HK. This latter finding depended,
in turn, on a finding that GSALLC was centrally managed and controlled in HK.
In fact, there was plenty of evidence showing that GSALLC was actually
controlled in New York. Several directors of GSALLC testified that all transactions
proposed by the HK office had to be approved by New York-based decisionmakers. The
Board was more impressed by the fact that GSALLC had made representations in
regulatory filings that it was controlled by its directors, a majority of whom were based in
HK. The Board‟s concluding statements on the residence issue are perplexing:
It is … quite clear that [GSALLC] through its various teams would submit
various business proposals to various committees in [New York] for their
consideration. … It is also quite clear from the evidence that we have heard that
[GSALLC] did put forward time and time again proposals to [New York-based
managers] for their review and consideration. Hence, considering all matters and
having carefully reviewed the evidence, we find it as a matter of fact that
[GSALLC] was plainly resident in Hong Kong.
If the HK directors had control, why did they keep asking New York for permission to do
things? The Board‟s conclusion was surprising, to say the least. Understandably,
GSALLC was not pleased with it. The Board‟s finding on this issue would make it
difficult, if not impossible, for any employee of GSALLC that spent at least 61 days in
HK in a given year to avoid paying HK tax on his or her entire salary and bonus. It was
decided that Mr. Ahn should appeal to the Court of First Instance.
Goldman Sachs and HK’s top tax counsel were unable to get past the obstacles in
the “case stated” procedure for tax appeals.
For appeals from the Board of Review to the courts, the IRO requires the Board to state a
case. The Board formulates one or more questions of law to be answered by the court,
and sets out a report of the facts found by the Board. In its statement of the case with
respect to Mr. Ahn‟s appeal, the Board formulated four questions of law and omitted
from its report several statements made by witnesses regarding the exercise of control
from New York. Taxpayer‟s counsel applied to the court for an order to amend the
statement of the case so as to include more specific questions of law as well as the
The application was denied (see Ahn Sang Gyun v. CIR, HCIA 4/2008, Feb. 25,
2009). The court took the view that a factual inference by the Board of Review could not
be reviewed on appeal unless the appellant claimed that the inference was unsupported by
any evidence, no matter how slight. The court also indicated that the Board‟s judgment
as to which facts to include in the statement of the case was not reviewable. Thus, the
Board, having made a highly dubious inference regarding the location of GSALLC‟s
central management and control, was able to frame the statement of the case in such a
way that the court would be virtually certain to uphold the Board‟s decision. A right of
appeal on this basis is little better than no right of appeal at all.3
The source of employment income needs to be clarified sensibly.
Recall that section 8 of the IRO imposes tax on employment income arising in Hong
Kong, including income from services performed in Hong Kong if the employee spent at
The Court of Final Appeal has noted in dictum that the case stated procedure, which is required by statute,
is problematic and ought to be replaced by a general right of appeal on questions of law. See Lee Yee Shing
v. Commissioner of Inland Revenue, FACV No. 14 of 2007 (Jan. 31, 2008) at para. 109. Nearly two years
later, the case stated procedure is still in place. As for the Ahn Sang Gyun case, the appeal was abandoned
due to the perception that the chance of success was extremely dim.
least 61 days in Hong Kong during the year. The statute says nothing about the
employer‟s central management and control or the negotiation and conclusion of the
employment contract. It is fundamental that the source of income is a “hard, practical
matter of fact” rather than a theoretical or formalistic matter. In Profits Tax cases
involving income from services, it is uncontroversial that the profits arise where the
services are performed. Nothing in the Salaries Tax provisions of the IRO requires any
divergence from that practical and realistic approach to the sourcing of income from
personal services, other than the re-sourcing rule applicable in cases where the employee
spent less than 61 days in Hong Kong during the year of assessment. Why, then, should
Salaries Tax be imposed on income from work done outside Hong Kong?
The source determination should be based on where the services are performed.
Such a source rule would improve the law by making it clear, easily administered, and
based on reality (and thus impossible to avoid through formalistic devices).
Whenever time-based apportionment has been recommended in the past, the
Government has backed away due to the fear of revenue loss. The same seems to be
Time-based apportionment of employment income was recommended by an Inland
Revenue Review Committee in 1968 and again in 1987. In December 2008, the Hong
Kong General Chamber of Commerce and the Hong Kong Institute of Certified Public
Accountants both called for section 8 to be amended to provide for the sourcing of
employment income based on where the services were performed.4 A submission to
Government along the same lines was made by the Joint Liaison Committee on Taxation
in 2007. Yet there is no sign that any action will be taken.
The current approach to determining the source of profits and the source of
employment income is bad for HK, because it is inconsistent with the rule of law and
is perceived to be unfair.
The overly aggressive approach of the IRD, and the support of that approach by the
Board of Review and the courts, is not good for HK. The rule of law requires both that
the judiciary interpret statutes in a rational, reasonable way, and that administrative
agencies follow the courts‟ interpretations. The prevailing interpretation of section 8
regarding the source of employment income fails the test of reasonableness. In the
Profits Tax area, the willful neglect of the CFA‟s recognition of the acts of agents and
contractors as important in determining the source of profits violates the principle of
judicial supremacy in statutory interpretation.
From a practical perspective, it is bad for HK if businesspeople believe that the
taxes imposed on their business and on themselves are higher than they ought to be under
the law. The Government touts HK‟s territorial tax limitation but then imposes tax on
income arising outside HK. The chairman of the Federation of Hong Kong Industries has
said that the IRD‟s approach to the source of profits will encourage manufacturing
See HKICPA, “Turning challenges into opportunities: Budget proposals 2009-10,” 13 Journal of Asia-
Pacific Taxation 139 (2009) and HKGCC, “Chamber‟s Response to 2009/10 Budget,” 13 Journal of Asia-
Pacific Taxation 197.
companies to move their head offices out of HK in favor of China or other countries in
the region such as Singapore.5 Singapore has already succeeded in attracting a
substantial amount of business away from Hong Kong with tax incentives in areas such
as investment management, commodities trading, and private banking. The risk of losing
additional business to Singapore is very real. The Hong Kong government needs to take
action to improve its tax law and administration.
Fixing these problems would reduce the amount of revenue collected.
As noted earlier, various groups have advocated amending section 8 to provide for time-
based apportionment of employment income in all cases in which the taxpayer spends at
least two months working both in and outside HK. The Government has not embraced
this proposal, presumably because it would involve a loss of tax revenue. Similarly, the
Government‟s unwillingness to accept the CFA‟s analysis of the source of profits in cases
involving agents or contractors outside HK is undoubtedly motivated by a concern that
HK‟s tax base is already narrow and should not be narrowed any further.
The existing tax base is already too narrow.
HK has an unusually narrow tax base. Only about half of the working population pays
any Salaries Tax, and about half of all Salaries Tax revenue comes from the top one
percent of salary earners. Profits Tax revenue is vulnerable to the business cycle,
particularly in the local real property market. The Government has maintained surpluses
primarily by selling land.
Therefore, a broad-based tax is needed.
There is a consensus that the tax base should be broadened in the medium to long term.
In 2006 the Government recommended adopting a Goods and Services Tax on both retail
and wholesale transactions, but the public response was overwhelmingly negative, so the
proposal was dropped. The need for base-broadening has not gone away, however.
A carbon tax could be designed so as to broaden the base and improve the
environment, with little administrative cost.
HK could easily raise revenue from an extremely broad base of payers by imposing a
carbon tax in the form of an import duty on fossil fuels such as coal and natural gas.
These are imported by only a handful of companies – mainly HK Electric, CL&P, and
Towngas – and most of the cost could be passed on to consumers through amendment of
the Schemes of Control that govern their pricing. A portion of the tax cost should remain
Denise Tsang, “Manufacturers claim hundreds of firms hit by unfair tax rule,” South China Morning Post,
Sept. 23, 2009, p. B1, quoting Cliff Sun, chairman of the FHKI. In the same article, a Big Four tax partner
is quoted as saying the issue is “whether substance should override form or the other way round.” Given
that the courts‟ oft-repeated formulation of the operations test is “Where do the operations take place from
which the profits in substance arise?”, it is quite clear that substance should override form in the
determination of the source of profits.
with the importers in order to encourage them to invest in clean energy technology.
Appropriate relief should be given to low-income households by way of direct subsidies.
The revenue from the carbon tax could be used to offset revenue loss from the
amendment of section 8 and adherence to the CFA’s analysis of the source of profits.