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EC Trust (Labuan) Bhd

License : LT0024

Wisma EC Trust, U0195, Jalan Merdeka,

87007 Federal Territory of Labuan, Malaysia

Tel: +6 087 453 858 / 452 858 / 453618

Fax: +6 087 453 616

© EC Trust (Labuan) Bhd Page 1 of 11

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“BASE” COMPANY LOCATION- SOURCE OF INCOME- LABUAN (MALAYSIA) COMPARED TO HONG KONG & SINGAPORE

Peter K Searle and Robert Gordon

Barristers-at-law

INTRODUCTION

A number of countries have a “territorial” system of taxation such that it is only income sourced in that country which is subject to tax there. A good example in the Asia Pacific region is Hong Kong. Such countries are not concerned from a tax perspective about residents setting up offshore base companies to derive foreign source income, as they don’t tax such income anyway. Liability to Hong Kong profits tax does not depend on remittance, only source.

Singapore is not so generous, and whilst it doesn’t tax foreign source income of companies not remitted into Singapore, it taxes Singapore companies on foreign source income remitted into Singapore, which has borne less than 15% foreign tax.

However, in HK-TVB International Ltd v CIR [1992] 2 AC 397 at 409, Lord Jauncey said:

“It can only be in rare cases, that a taxpayer with a principal place of business in Hong Kong can earn profits which are not chargeable to profits tax. Counsel for the commissioner was able to refer to three cases only in which the source of profits had been held not to be in the principal place of business of the taxpayer.”

This passage is quoted in Hong Kong Inland Revenue Department Practice Note 21 (reviewed Dec, 2009) concerning the “Locality of Profits”, at ¶ 60.The introduction to that document says:

“However, where the territorial concept is clear, its application in particular cases at times remains a contentious issue between the Department and practitioners with numerous disputes being referred to the Board of Review and the Courts.”

In an article entitled “How Simple Can Tax Law Be?: The Instructive Case Of Hong Kong”, Michael Littlewood [2005] JATTA 18, it is said:

“That so basic an issue [source] has been left to the courts is in itself instructive. So, too, is the manner in which the courts have tackled it. Despite a more or less continuous stream of litigation, radical uncertainty persists. The taxability of even routine forms of business activity remains unclear. By the standards of the rest of the developed world, the uncertainty prevailing in Hong Kong would be plainly intolerable. In Hong Kong, however, the level of uncertainty, whilst acknowledged as a problem, is not regarded as a serious one. There has occasionally been discussion of reform, but the available cures seem generally to be regarded as worse than the ailment. One reason for this is presumably the lightness of the burden. Uncertainty as to liability is of course undesirable, but there is certainty of another kind: that the worst possible outcome (from the taxpayer’s point of view) is tax at 17.5 per cent.”

Earlier, Andrew Halkyard, in an article entitled “The Hong Kong Tax Paradox”, (1998) 8 Revenue LJ 1, made the same point as to the uncertainty of source of income in Hong Kong.

As the corporate rate of taxation has progressively lowered in the high tax countries, it is increasing unlikely that the current rate of 16.5% in Hong Kong and 17% in Singapore will necessarily be accepted, when there are much lower rate alternatives.

In relation to the domestic source of income generally, the Privy Council on appeal from the Hong Kong Court of Appeal in CIR v. Hang Seng Bank Limited [1991] 1 A.C. 306 at 322 said :

"But the question whether the gross profit resulting from a particular transaction arose in or derived from one place or another is always in the last analysis a question of fact depending on the nature of the transaction. It is impossible to lay down precise rules of law by which the answer to that question is to be determined. The broad guiding principle, attested by many authorities is that one looks to see what the taxpayer has done to earn the profit in question. If he has rendered a service or engaged in an activity such as the manufacture of goods, the profit will have arisen or derived from the place where the service was rendered or the profit making activity carried on. But if the profit was earned by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities by buying and reselling at a profit, the profit will have arisen in or derived from the place where the property was let, the money was lent or the contracts of purchase and sale were effected." (per Lord Bridge) (underlining added)

That case concerned whether for Hong Kong tax purposes, profits from dealing in certificates of deposit were derived in Hong Kong, but the principles may be equally applicable to whether a trade is carried on in the UK[1], Australia[2], NZ, or Singapore.

The problem is that the general principles that are articulated in Hang Seng Bank, have been applied is arguably inconsistent ways, to different fact situations in Hong Kong, leading to much uncertainty there.

Hong Kong cases subsequent to Hang Seng Bankhave said they were applying the case, but returned to a broader “operations” test (e.g. Magna), and by 2007, reverted on the facts of the particular case, to back to “transactions” (ING Baring Securities (Hong Kong) Limited v CIR (2007) HKRC ¶ 90-195), without criticising the cases applying the “operations” test. Indeed, the Hong Kong IRD Practice Note 21 (reviewed Dec, 2009) does not attempt to reconcile the cases, but is to the effect that they are all particular examples of the “operations” test, and each case must be decided on its own facts (¶2).

PROPOSITION

The tightening common law rules on source of trading and services income that apply in Hong Kong (and Singapore) don’t apply to Labuan (Malaysia).

Hong Kong (and Singapore resident) companies that seek to avoid local source income so as to avoid their taxes of 16.5% and 17% respectively, run the risk of becoming subject to source country taxation.

In comparison, a Labuan (Malaysia) company will pay tax of 3% of its audited profit (or RM 20,000 flat tax by election) regardless of the source of income.

According foreigners comparing using a “base” company in one of those jurisdictions may find the results more predictable, and agreeable, in Labuan (Malaysia).

RELEVANCE OF DTA

As most countries tax foreign source income of residents on a world-wide basis, the determination of source is mainly relevant to whether a foreign tax credit should be granted[3].

It is also less relevant where the country of residence has a large number of double tax agreements (DTAs), as then the question of source is usually dealt with in the DTAs. Labuan (Malaysia) is entitled to the benefit of all but 10 of Malaysia’s 66 or so comprehensive DTAs (refer Appendix).

DTAsoften provide that income derived by a resident of one country which is permitted to be taxed in the other country in accordance with the taxation treaty, is deemed for all purposes of the treaty to be income arising from sources in the other country. This empowers each country to exercise taxing rights allocated to it by the treaty. Almost all treaties specify this to be the case for the purposes of providing tax credits, which ensures double taxation relief as intended.

Taxation treaties which do not contain a “source of income” article, other than one which is only for the purposes of the “relief from double taxation” article, invariably have limited source rules for particular types of income.

Under most DTAs, business income is allocated to a taxpayer’s foreign permanent establishment on the principle that it is treated as a separate entity dealing at arm’s length with the taxpayer.

As Hong Kong has a “territorial” system of taxation, and as until 1996 Hong Kong had no DTAs, the question of source was, and still is, fundamental to Hong Kong’s right to tax. Since then it has entered into about 16 DTAs, most of which were only signed in Dec 2010, and will not be operative for some time.

Until the entry into of DTAs, Hong Kong had no need to define a Hong Kong corporate resident, as it only taxed income sourced in Hong Kong, so residence of a company was irrelevant. Corporate residence is defined in Hong Kong’s DTAs as incorporation in Hong Kong, or “management & control” in Hong Kong.

If the Hong Kong incorporated company is foreign owned, and owned by residents of a country that uses central management and control as its test of where the Hong Kong company is resident, having its principal place of business outside Hong Kong, to avoid Hong Kong tax, may make it more likely to be taxable in the source country, and may raise a doubt as towhere the company’s central management and control is located[4].

DISCUSSION

Anglo trading income source rule

In Anglo-Australian jurisprudence which long pre-dates the troubling Hong Kong cases (and which has not yet taken them up), the source of income from the sale of trading stock by a simple merchant is the place where the contract of sale was entered into.[5] The source of income where the taxpayer's business involves a range of activities, such as extraction, manufacture/processing and sale is apportioned between the places at which the various activities are carried out.[6] For example, that part of the trade which is manufacturing is carried on where the manufacturing takes place[7].

For UK purposes, two forms of activity do not amount to trading in the UK, and the position in Australia should be no different:

(a)Purchasing goods or services in the UK for use in the business abroad[8];

(b)Representative offices, sales promotion, or after-sale services provided the contracts of sale and other trading activities are made or carried on abroad[9].

An intending purchaser may inspect sample goods in, for example, the Australian warehouse of an agent for an overseas manufacturer. However, if the purchaser then orders goods from the overseas manufacturer the place of the contract of sale is where the manufacturer posts a letter of acceptance: for an exposition of the rules which determine where a contract is made see the judgment of Denning LJ in Entores Ltd v Miles Far Eastern Corporation [1955] 2 QB 327at 332-4.

The precise mechanism which brings a contract into existence may be significant. Sending a catalogue from overseas to potential buyers, for example, in Australia is not a legal offer, it is an invitation to treat: Granger & Son v. Gough [1896] AC 325. As a result, an order from a purchaser is an offer and the contract will be made where the acceptance is received. In Entores Ltd v. Miles Far Eastern CorporationDenning LJ stated that where the offeror and the offeree are located in different countries and communication is not by post, but telephone, telegram, telex or some instantaneous means of communication, acceptance will only be effective when it is received[10] – not at the moment of transmission – “and the contract is made at the place where the acceptance is received”.

The decision in Entores v Miles Far Eastern Corporationwas applied by the New South Wales Supreme Court in Mendelson-Zeller Co Inc v T & C Providores Ltd [1981] 1 NSWLR 366.

Electronic commerce gives rise to special opportunities[11]. For Australian purposes, the Electronic Transactions Act 1999 (C’wth) provides that if the parties to the contract agree that the contract is accepted in a particular place (s14(5)), that will bind the parties for the purposes of Australian federal law e.g. Australian income tax. This particular provision of the Electronic Transactions Act follows the UNCITRAL Model Law on Electronic Commerce 1996 Art 14(5), which has been adopted in many countries, including China, Hong Kong[12], Singapore[13], Malaysia[14], New Zealand[15], and many US States and Canadian Provinces.

Notwithstanding the domestic source rules, a relevant double taxation agreement precludes the source country from subjecting the vendor of the goods to source country taxation unless the vendor has a “permanent establishment” in the source country with which the income is “effectively connected”.

Anglo service income source rule

The source of services income derived by a company will take into account:

  1. where the work is performed[16];
  2. where the contract to perform the work is negotiated and executed; and
  3. where payment is made[17].

Where the work is performed, is often the most important factor in determining source of services income.

However, consultancy source income may not be where the work is performed, if the work can largely, be performed anywhere[18], at least in cases where it is the provision of, for example, a written legal report, accounting statement, or architectural drawings, which is what the client ultimately pays for. In those cases, the place of entry into of the contact will be perhaps, more important in determining source.

Hong Kong

The HK-TVB case concerned the sub-licensing in Hong Kong by a Hong Kong company, of Chinese language movies to licencees outside Hong Kong for use outside Hong Kong. The granting of the licence took place in Hong Kong, and the fee was in no way dependent on the success of the use of the movie by the licencee. It was held that the source of the income was Hong Kong. The fact that the rights were only exercisable overseas was irrelevant. Lord Jauncey said:

‘This reference once again appears to equate the origin of the fees paid by the sub-licensees with the profit accruing to the taxpayer from the grant of the sub-licensing. If a manufacturer in Hong Kong sells his goods to a merchant in Manila but his profit on the transactions arises in and is derived from his manufacturing operation in Hong Kong’ (at 410).

However, after saying: “It can only be in rare cases, that a taxpayer with a principal place of business in Hong Kong can earn profits which are not chargeable to profits tax”, Lord Jauncey in HK-TVB then saidat 410:

“It is clear from the Hang Seng Bank case [1991] 1 A.C. 306 that in appropriate circumstances a company carrying on business in Hong Kong can earn profits which do not arise in or derive from the colony, notwithstanding the fact that those profits are not attributable to an independent overseas branch.”

In the Court of Appeal in Hong Kong in CIR and Magna Industrial Co Ltd [1997] HKLRD 173, Litton V-P, as he then was, approved the "operation test" at 176,quoting Lord Bridge in the HK-TVB at 407:

I think that the question is, where do the operations take place from which the profits in substance arise?

In other words, one looks to see what the taxpayer has done to earn the profits and where he has done it. Obviously the question where the goods were bought and sold is important. But there are other questions: For example: How were the goods procured and stored? How were the sales solicited? How were the orders processed? How were the goods shipped? How was the financing arranged? How was payment effected? (underlining added)

In CIR v Orion Caribbean Ltd (in vol liq) (1999) MSTC 11,031, the Privy Council found that the net interest income of a Cayman Islands subsidiary of a Hong Kong company, was sourced in Hong Kong. The parent company lent the taxpayer funds in foreign currency which were then on-lend in foreign currency at a higher rate of interest. The taxpayer was originally successful in arguing that the source of its interest income was where it lend the money. In finding that the source of the taxpayer’s interest income was Hong Kong, the Privy Council held that regard should not be had solely to the place of lending, to the exclusion of the pace of borrowing. Further, the loan agreements entered into by the taxpayer were negotiated, approved and serviced by its parent. The profits of the taxpayer arose from business transacted in Hong Kong by the parent on the taxpayer’s behalf.

In Consco Trading Company Limited v CIR (2004) HCIA 3/2003

“What Litton V-P said [in Magna Industrial about the “operations test”] is in line with the authorities and amplifies that importance that no simple or single legal test is determinative and that the examples given by Lord Bridge are not meant to be exhaustive.”

In Consco Trading, Question 1 was posed: Did the Board err in law in deciding that the source of profits of the Taxpayer was in Hong Kong without making the findings that the sale and purchase were effected in Hong Kong and in light of all the facts found by the Board?

The Hong Kong Court of First Instance answered:

“33. Thus, the Board was aware that some of the contracts for sale and purchase orders for raw material were signed in Hong Kong but some were not. The Board must have considered all these before it reached the conclusion that the profits arose or derived from Hong Kong. It is not as if the Board had never directed its mind to these factors. The Board also considered other factors, such as finance arrangement, payment for raw material and processing fees, arrangement for receipt of payment from purchasers for the finished product and pre-contract negotiations. The Board had knowledge who signed the contracts of sale and purchase and where they were signed. The Board is entitled to take a global view of the evidence, which it did. The Board carried out a weighing exercise and then concluded that the preponderance of the activities which earned the profits was performed in Hong Kong and were thus profits derived from Hong Kong. The Board applied the proper legal principles and considered the relevant facts. As the Board had knowledge of where the contracts of sale and purchase were signed, it has sufficient factual basis in support of the conclusion it reached without making any finding that the sale and purchase were effected in Hong Kong. The finding that the profits were derived from Hong Kong is a finding of fact which this Court may not interfere. The Board's careful analysis is commendable and its finding could not be faulted. Accordingly, I answer the first question in the negative.”