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Hong Kong Board of Review Publishes Decision Concerning Offshore Profits from China and a Claimed Downward Transfer Pricing Adjustment

The Hong Kong Inland Revenue Board of Review has published a decision concerning a taxpayer's claim that profits derived from transactions with China should be considered to have arisen offshore and a claim that transactions were not at arm's length and should result in a downward transfer pricing adjustment. The case involved a company incorporated in Hong Kong (the Appellant) and its wholly-owned subsidiary in Mainland China (Company G). The two entities operated an import processing arrangement under which the Appellant would purchase raw materials from suppliers for sale to Company G and in turn purchase finished products from Company G for sale to customers. The Appellant earned its profits by selling raw materials to Company G and selling products to customers.

Following the issuance of profits tax assessments for 2007/08 and 2008/09 and additional profits tax assessment for 2002/03 and 2004/05 to 2006/07, the Appellant lodged objections with the tax authority, primarily based on the claim that for the sales to Chinese customers, the profits should be considered to have arisen offshore and not subject to tax in Hong Kong. After revised assessments were issued, the Appellant still disagreed, but a determination was issued by the Commissioner confirming the assessments.

The decision was then appealed to the Board of Review on the grounds that the profits should be considered offshore because the sales to Chinese customers were carried out by Company G and not the Appellant, and that Company G was in substance an agent of the Appellant. In addition, the Appellant argued that the assessments were excessive because the prices for the raw materials sold by the Appellant to Company G and for the finished products bought by the Appellant from Company G were not fair prices at arm’s length, and that a downward adjustment should be made.

Regarding whether the profits arose offshore, the Board held that although Company G was engaged in following up on orders with the customers and managing the sales process, these activities were simply antecedent or incidental to the Appellant’s profit-producing transactions, and therefore the source of the disputed profits could not be considered offshore. Further, if the activities resulted in Company G acting as an agent for the Appellant in Mainland China, this would have resulted in a Chinese enterprise income tax liability. However, no evidence was provided to support that the Appellant had been subject to or paid any enterprise income tax. As such, the Appellant's argument is rejected.

Regarding the downward adjustment, the Board held that an enterprise cannot unilaterally apply a transfer pricing methodology to reduce profits arising in or derived from Hong Kong. For a downward adjustment to be made, a corresponding upward adjustment must have been made by the Mainland tax authorities. Again, no evidence was provided to support that such an upward adjustment was made, and the Appellant's argument in this regard is also rejected.

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