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CG Lighting: The Court of Final Appeal Turns the Light Off on Tax Appeals (CG Lighting)

31 August 2011

On 24 August 2011 the Leave Committee of Court of Final Appeal (CFA) heard and determined the first ever contested application by a taxpayer for leave to proceed with a final appeal.

Since the inception of the Court of Final Appeal 14 years ago, it had been widely accepted by tax practitioners and the Inland Revenue itself that tax appeals over HK$1 million had an automatic right of appeal to the highest court. Not so! – said the Leave Committee in CG Lighting Ltd and Commissioner of Inland Revenue (FAMV 23 of 2011) ("CG Lighting") [1] . Tax appeals do not apparently lay "as of right", contrary to the established convention.

In a short and seemingly innocuous decision which will nonetheless have far reaching implications for tax litigation, the CFA held that the fixing of a tax liability under a tax assessment does not involve a liquidated sum and does not qualify for leave as of right.

The CFA further refused to exercise its discretion to grant leave, holding that the matter did not involve an issue of legal principle or other exceptional circumstances. In so doing, the CFA declined the opportunity to consider the correctness of the Commissioner's and the lower courts' approach to determining whether a taxpayer’s offshore activities in contract processing arrangements are antecedent or incidental for profits tax purposes, and to consider the appropriateness of the lower courts' willingness to substitute their findings of fact for that of the Board of Review ("Board").

As to the tax consequences, the CFA's decision to bring an end to CG Lighting's appeal affirms the Court of First Instance decision (which, together with the Court of Appeal's decision in Commissioner of Inland Revenue v Datatronic Ltd [2009] 4 HKLRD 675, is now the binding word on this subject) and may see the end of offshore apportionment claims for Hong Kong manufacturers with contract processing arrangements. The decision means that anything a Hong Kong manufacturer contributes offshore to the manufacturing process is likely to be consigned to an "antecedent or incidental" activity and erodes any meaningful distinction between trading and manufacturing activities in terms of the "source" of profits.

[1] Allen & Overy acted for the taxpayer in CG Lighting.

The end of CFA tax appeals "as of right"

Those familiar with appeals to the CFA will be aware that it is necessary to obtain leave to appeal to it. There are two ways for a case to be heard before the CFA: firstly, "as of right" under section 22(1)(a) of the Hong Kong Court of Final Appeal Ordinance ("CFA Ordinance"), which essentially provides for the right to appeal in any civil matter where the dispute amounts to the value of HK$1,000,000; and secondly, in the Court's discretion under section 22(1)(b) where either the dispute involves a question of great general or public importance or the Court otherwise believes the appeal ought to proceed.

In tax appeals, leave "as of right" in cases where the tax disputed amounted to HK$1,000,000 or more had long been accepted without question to apply. The Commissioner as a matter of course had consented to leave as of right in all 16 previous tax appeals that have been heard before the CFA in the 14 years since the CFA has replaced the Privy Council.

In CG Lighting, the Commissioner refused to consent, arguing for the application of a narrow construction of section 22(1)(a) in line with the CFA's apparent policy to restrict the overall number of appeals it hears.

The CFA had already placed substantial restrictions on the "as of right" ground under section 22(1)(a) by interpreting the provision as applying to liquidated sums only, [2] a restriction that is itself far from self-evident on a plain reading of the section.

In CG Lighting, the Court has now taken another policy leap, further restricting application of the "as of right" ground. In the course of hearing CG Lighting's application for leave to appeal, the Leave Committee said it had difficulty with the proposition that a tax assessment is a liquidated amount, and in its reasons rejecting the existence of a leave as of right, the Leave Committee stated:

"Monetary claims which require assessment – and are therefore unliquidated rather than liquidated – do not come within s.22(1)(a). Tax requires assessment. So tax demands do not come within s.22(1)(a). The appeal which the taxpayer seeks to bring does not lie as of right."

This reasoning appears to ignore that a taxpayer's tax liability has already been assessed by the Commissioner, unlike a claim for damages, which must be assessed by the Court. And while tax liability requires assessment, this assessment produces a liquidated sum – that is the fundamental nature of the statutory charge levied under the Inland Revenue Ordinance. It is that fixed sum which is in dispute in a tax appeal. An appeal to the Board by a taxpayer cannot alter the fact that a liquidated sum exists by virtue of the assessment that has been made – under section 71(2) of the Inland Revenue Ordinance, the tax assessed remains payable notwithstanding an appeal unless the Commissioner waives that requirement (for example, by requiring the taxpayer to purchase tax reserve certificates).

The CFA's decision can therefore only be explained on policy grounds, as on any view it is anomalous with the scheme of the Inland Revenue Ordinance.

No doubt mindful of its increasing workload, in CG Lighting the Court asked whether a court of last resort (such as itself) should be "harried" with every disputed tax case where the assessed tax in dispute is over HK$1,000,000. Consistent with the CFA’s concerns, the Commissioner had also argued that the "floodgates" of tax litigation would open if tax appeals lie "as of right". Whilst these are strictly matters for the legislature, not the Courts, a review of statistics does not support the validity of these concerns in any event. When compared to the major jurisdictions which influence our tax law, Hong Kong appears to be the only country out of New Zealand, Australia and the UK that maintains an "as of right" ground of final appeal. No doubt this was considered important at the time of sovereignty handover in 1997. Any concerns that the CFA has as to its workload should properly be addressed through legislative intervention to raise the monetary threshold under section 22(1)(a) of the CFA Ordinance, rather than for the statute to be read down in such a restrictive manner.

Further, providing taxpayers a right of appeal to the ultimate appellate court is not unusual – New Zealand tax appeals lay as of right to the Privy Council at a very low monetary threshold before its Supreme Court was established in 2004.

In any event, it is questionable whether the number of tax cases heard by the CFA justifies its concerns as to being inundated with tax appeals given that it has heard only 16 tax cases in the past 14 years. In England, the volume of tax cases heard by the House of Lords (and now the Supreme Court) in the last 14 years is almost equivalent to the number heard by our CFA. In Australia, where tax appeals to the High Court do not lie as of right, Australia’s final appellate court has considered tax issues to be of such importance that it has heard double the number of tax appeals than our CFA heard over the same period.

[2] See China Field Ltd v Appeal Board (Buildings) [2009] 2 HKLRD 135.

Tax appeals of great general or public importance

In CG Lighting, the taxpayer also argued that the CFI had seriously misapplied the offshore tax principles set out in the CFA's earlier decisions which have become the leading cases on source of profits: ING Barings Securities (Hong Kong) Ltd v CIR (2001) 10 HKCFAR 417 and Ngai Lik Electronics Co Ltd v CIR (2009) 12 HKCFAR 296. This would have brought CG Lighting's appeal within the "question of law" ground under section 22(1)(b), being an appeal of great general or public importance.

It is important to note that CG Lighting was not a tax avoidance case. The taxpayer had structured its Hong Kong and Mainland manufacturing business under a contract processing arrangement in accordance with the guidance published by the Inland Revenue Department to obtain the offshore profits tax concession. It had succeeded unequivocally before the Board.

However, the Commissioner abandoned his own departmental practice note on manufacturing profits, DIPN21, and invited the Court to disregard the expressly reasoned findings of fact by the Board. Both the Court of First Instance ("CFI") and the Court of Appeal accepted this invitation, substituting their own decision for that of the Board.

Bearing in mind that the CFA has reversed the lower court's decision in over 60% of "source" based tax appeals, there was some concern in this case that the lower courts had again misapplied the principles established by the CFA. In CG Lighting it was submitted that the CFI had disregarded the legal consequences of the taxpayer's business and the Board's finding of fact and substituted its own findings, but the CFA found that none of these matters raised a question of principle that was of sufficient importance to warrant further appeal.

Incidentally, a manufacturer's profits are the same as a trader's all onshore

Following the CFA's refusal to hear the CG Lighting appeal, the CFI decision assumes new significance. It is hard to see how DIPN21 and the concession it grants to Hong Kong companies that manufacture in the Mainland can now be maintained. Taxpayers and their advisers would be well advised to review any reliance placed on DIPN21.

In CG Lighting, the taxpayer never parted with legal title to its parts and raw materials and owned the finished product that its PRC subsidiary had assembled for a processing fee. Notwithstanding this arrangement and the Board's finding that there was no sale of the finished products to the taxpayer by its subsidiary, the CFI found this to be equivalent to a sale from a third party.

The effect of the CFI decision is that no matter how much work or activity a taxpayer manufacturer undertakes in the Mainland, in respect of goods which it owns and retains title to, that activity will nevertheless be considered "antecedent or incidental" to the profit-making activity, that is, the ultimate sale to customers. The effect of this is that 100% of the manufacturer's profits will be sourced onshore.

A new era in tax litigation

The application of important tax principles in CG Lighting had been closely followed by Hong Kong's tax practitioners. Most commentary had focused on the practical tax consequence of the Courts' decision, which may deny apportionment claims for contract processing arrangements. It is now hard to conceive of a contract processing arrangement that could withstand challenge by the Commissioner, notwithstanding the wording of his own practice note.

The CG Lighting CFA decision, however, now takes on far more significance and is likely to be relied on by the Commissioner to prevent appeals to the CFA. Overturning Board decisions is nothing new for Hong Kong's appellate courts, but denying taxpayers the automatic right to argue to restore them in the final appellate court, which is also the court most respected for its tax jurisprudence, is an unwelcome development for taxpayers. The Commissioner has for a long time now used litigation in the Hong Kong Courts as a proxy for widening the tax net by obtaining a series of decisions bringing in changes that he could not have achieved through the legislative process.

This decision ushers in a potentially new era of tax litigation in Hong Kong. The Court of Appeal whose tax decisions the CFA had previously shown a willingness to engage with and correct when necessary will now become the court of last resort for the vast majority of tax appeals.