Case Detail

HCIA 3/2010

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO 3 OF 2010

_________________________

BETWEEN

	COMMISSIONER OF INLAND REVENUE	Appellant
	and
	LI & FUNG (TRADING) LIMITED	Respondent

_________________________

HCMP 541/2011

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

MISCELLANEOUS PROCEEDINGS NO 541 OF 2011

(ON AN INTENDED APPEAL FROM HCIA NO 3 OF 2010)

_________________________

BETWEEN

	COMMISSIONER OF INLAND REVENUE	Appellant
	and
	LI & FUNG (TRADING) LIMITED	Respondent

_________________________

CACV 86/2011

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

CIVIL APPEAL NO 86 OF 2010

(ON APPEAL FROM HCIA NO 3 OF 2010)

_________________________

BETWEEN

	COMMISSIONER OF INLAND REVENUE	Appellant
	and
	LI & FUNG (TRADING) LIMITED	Respondent

(Heard Together)

_________________________

Before : Master Levy in Chambers

Date of Hearing : 2-3 December 2013

Date of Handing Down Ruling : 4 March 2014

__________

R U L I N G

__________

A. The preliminary objection

1. In these taxation proceedings, there are altogether 3 bills of costs filed by Li & Fung (Trading) Limited (“LFT”), the party entitled to the payment of the costs of these proceedings, in respectively nos. HCIA3/2010, HCMP541/2011 and CACV86/2011. The party liable to pay the costs in these proceedings is the Commissioner of Inland Revenue (“Commissioner”).

2. A preliminary objection based on Order 62 rule 22(5), Rules of the High Court, was raised in the Commissioner’s List of Objections to the bills. In the objection, the Commissioner asked the taxing authority to deduct globally a percentage of the costs to be taxed in each of these bills of costs on the ground of LFT’s alleged undue delay.

B. The material facts

3. To put the matter in context, it is necessary to briefly summarize the material facts (which are largely undisputed) of these proceedings taken from the detailed chronology of events attached to the Skeleton Submissions of Mr Gilchrist, solicitor for LFT.

4. Broadly stated, the underlying disputes of the parties in these proceedings arose from the Commissioner’s assessment of LFT’s profits tax for various financial years. LFT disagreed with the said assessment, and took the matter further to the Board of Review, against which decision, the Commissioner later made an application for “Stated Case”. The “Stated Case” application was subsequently remitted to the Court of First Instance. This application formed the subject matter of the proceeding in action no HCIA 3/2010 filed on 1 April 2010.

5. After Reyes J dismissed a summons by the Commissioner in HCIA 3/2010 on 28 March 2011, the Commissioner filed an Originating Summons, no. HCMP 541/2011, for leave to appeal to the Court of Appeal, which was later dismissed with costs on 1 April 2011.

6. Proceedings in HCIA 3/2010 were disposed of on 18 April 2011 by Reyes J who ordered the dismissal of the Commissioner’s “Stated Case” application with costs.

7. The Commissioner appealed against Reyes J’s dismissal by filing an appeal, no CACV 86/2011 on 16 May 2011, which appeal was later dismissed by the Court of Appeal on 19 March 2012 with costs.

8. By the deadline date for the application for leave to appeal to the Court of Final Appeal on 16 April 2012, the Commissioner had not filed any application. Thus, by this date, these proceedings were completely concluded.

9. Between April 2012 and October 2012, subsequent to the conclusion of these proceedings, the parties’ legal representatives- according to the correspondence and telephone attendance records Mr Gilchrist submitted to the court – were engaging in “without prejudice” discussions to settle on a global basis of all the outstanding issues concerning the tax assessments and other related tax matters and proceedings.

10. On 4 February 2013, LFT sent to the Commissioner draft bills of costs in respect of the costs orders made in its favour as set out above.

11. On 15 February 2013, LFT filed the Notices of Commencement of Taxation together with the three bills of costs of these proceedings to have the costs awarded to it under the above costs orders taxed.

C. The lengths of delay

12. Relying on Order 62 rule 22(1) which requires a receiving party to commence taxation proceeding within 3 months, the Commissioner’s law costs draftsman (“LCD”) submitted that – based on the calculation of 3 months being the period from the date of the costs orders having been made in these proceedings and the date LFT should have commenced taxation – there have been delays of 22 months, 23 months and 11 months respectively of the bills filed in HCIA 3/2010, HCMP 541/2011 and CACV 86/2011.

13. The LCD, relying on the global percentage deductions for undue delay having been previously made by taxing masters[1] , urged the court to impose the Order 62 rule 22(5) sanction by globally reducing 25% of the costs to be taxed in the bills of costs in both HCIA 3/2010 and HCMP 541/2011 and 10% in CACV 86/2011.

14. The LCD’s calculation of delays by counting from date of the making of the orders nisi (in respect of the costs orders made in HCIA 3/2010 and CACV 86/2011) is not entirely correct. It is because according to Order 62 rule 22(9) sub-sub rules (a) (ii) (in respect of a costs order made in the Court of First Instance) and (b) (ii) (in respect of a costs order made in the Court of Appeal), the “completion date” as specified in Order 62 rule 22(1) should be counted from the date of the making of the costs order absolute (not from the date of the order nisi).

15. Accordingly, the lengths of delay (in respect of the costs orders made in HCIA 3/2010 and CACV 86/2011) – when properly computed in accordance with Order 62 rule 22(9) – should have been, as shown in the table below, 18.5 months and 7.5 months respectively in HCIA 3/2010 and CACV 86/2011. As for HCMP 541/2011, though the date of the order used for the calculation was indeed the date of the order absolute, the LCD has somehow appeared to have rounded up the actual period of delay of 22.5 months to 23 months.

Case No
Date of Absolute Order
Date when taxation should have been commenced under rule 22(1)
Length of Delay

HCIA 3/2010
2/5/2011
2/8/2011
18.5 months

HCMP 541/2011
1/4/2011
15/7/2011
22.5 months

CACV 86/2011
2/4/2012
2/7/2012
7.5 months

D. Reasons for the delay

16. Mr Gilchrist, in his Skeleton Submissions, provided two reasons to justify LFT’s delay in commencing taxation:

(1) First, there had been on-going proceedings. It was contended that as a result of the Commissioner’s bringing of the appeal, there was thus a possibility that the appeal court would reverse the previous costs orders having been made. It would not have been, Mr Gilchrist submitted, commercially sensible for LFT to incur extra costs for commencing taxation before the ultimate costs liabilities could be finally determined[2].
(2) Second, the parties had been engaging in settlement discussions after the disposal of these proceedings in April 2012. Undisputedly, a successful settlement would have obviated any need for taxation.

17. For these two reasons, Mr Gilchrist contended that there had not been any undue delay in commencing taxation. The court, it was submitted, should not impose any sanction when the taxation proceedings have in fact been commenced within the 2-year limitation period and in full compliance with the procedures and rules.

18. If, however, LFT, were found to have unduly delayed the commencement of the taxation proceedings, Mr Gilchrist urged the court to exercise its discretion not to impose the sanction by taking into account all the relevant circumstances of the case “to achieve a just result”[3].

19. These proceedings, it was submitted, are subject to a proper consideration of the rules made under the Civil Justice Reform (“CJR”). Relevantly, the new Order 1A rule 2 requires a court to give effect to the underlying objectives as well as of a party’s conduct, such as the kind espoused by Chief Justice Ma in Wing Fai Construction Co Ltd (in liquidation) v Yip Kwong Robert[4] , a striking out application heard by the Court of Final Appeal (which is to be further discussed in §48 below).

E. Discussion – whether there is “undue” delay

E.1 Order 62 rule 22

20. Under Order 62 rule 22(1), if a party entitled to costs fails to commence taxation proceedings within 3 months after the completion date, a taxing master is empowered to:

(1) On application, compel a receiving party to expeditiously commence taxation by disallowing the commencement of taxation in the event that the taxation is not commenced within the specified time (rule 22(3)).
(2) impose a sanction for undue delay (irrespective of whether an order has been made under rule 22(3)) by: (a) making such order as he thinks fit as to the costs of any application or as to the costs of the taxation; (b) disallowing any part of the costs to be taxed pursuant to the costs order; and (c) disallowing interest or reducing the period for which interest is payable or the rate at which interest is payable in relation to the taxed costs or any part of those costs (rule 22(5)).

E.2 Any undue delay

21. Whatever way the “completion date” for taxation is to be computed, there is little dispute that LFT has not commenced taxation within the 3 months’ time as stipulated in Order 62 rule 22(1). But before the sanction provisions under rule 22(5) are to be engaged, any such delay must be “undue”, which must be inexcusable or inordinate.

E.2.1 On-going proceedings excuse

22. Whether a particular delay is excusable will depend on the facts of each case. The existence of other on-going litigation between the same parties had been held before the CJR not an excusable reason (See: The Bank of New York[5]). But post-CJR, an on-going arbitration could be a justifiable reason (See: Zebra Industries (Orogenesis Nova) Ltd[6]).

23. Neither of these cases, in my judgment, can provide much guidance to me as to what circumstances would constitute undue delay which is by and large case-sensitive. The categories of excuses hence should not be viewed in a strait- jacket.

24. In this case, the on-going proceedings essentially refer to the appeal brought by the Commissioner to the Court of Appeal with the justification having been based on the possibility of the Court of Appeal overturning the previous costs decisions, which might have the consequence of reversing the previous costs orders. In essence, whether the existence of a connected on-going proceeding would justify delaying the commencement of a taxation proceeding, in my view, depends on the facts of each case. When it is considered that there is a real likelihood that the outcome of an on-going matter in the same proceedings such as a pending appeal – subject to other considerations such as the time likely to be required for the disposal of the pending proceedings, the nature of such proceedings etc – may likely impact on the ultimate costs liabilities of the parties, it may be reasonable to withhold taxation proceedings until the conclusion of the on-going proceedings. If however, the on-going proceedings may only result in the setting-off of costs liabilities against each other, it would unlikely be a sufficient excuse for delaying the taxation proceedings.

25. In this case, the tax disputes between the parties were first remitted to the Court of First Instance in April 2010 by the commencement of HCIA proceedings, which were disposed of within a year in April 2011. Within the fairly short time frame of one year, there had been proceedings filed by the Commissioner for an application for leave to appeal against an interlocutory order, and later in May 2011, for the substantive appeal in the Court of Appeal. In such a case, the parties must have conducted the proceedings in very tight time schedules.

26. The issues involved in these proceedings also appear to have been particularly complex as reflected by the representations of both parties involving the engagements of eminent Queen’s Counsel and local counsel. Under such circumstances, LFT, in my judgment, was justified in focusing on the preparation of the appeal, which might produce an outcome of reversing the lower court’s costs orders having been made in HCIA3/2010 in its favour. In the circumstances, given the tight time schedules, the complexity of the proceedings, and the appeal by the Commissioner, I’d be inclined to accept that LFT was justified to wait until the conclusion of the appeal before commencing taxation proceedings in both actions HCIA3/2010 and HCMP541/2011.

E.2.2 Settlement negotiations excuse

27. When the time for a further appeal expired on 16 April 2012, LFT would then have been under a duty to take steps to commence taxation proceedings in respect of the costs of the three actions if costs could not be agreed.

28. LFT however sought to excuse itself for the delay based on the alleged negotiations of costs between the parties.

29. One of the underlying objectives under Order 1A rule 1(e) is to facilitate the settlement of disputes. If there had indeed been negotiations for the settlement of the costs, this would be within the spirit of the CJR, and will likely be a good excuse for withholding taxation proceedings for the purpose of saving costs and expenses.

30. Coming back to LFT’s explanation, Mr Gilchrist, whilst accepting that the documents and correspondence that he had submitted to this court do not directly allude to any negotiations on costs, he contended however that the parties’ negotiations for a global settlement were intended to have also included costs.

31. Since the only documents LFT relied on in support of the alleged negotiations for costs are the correspondence and the telephone attendance records Mr Gilchrist produced at the taxation hearing, I can only examine these documents to find out if such contention can be supported. From the documents that I have read, the only oblique reference to costs is found in the highlighted part of a sentence in the 1st draft settlement proposal entitled “Framework of Settlement Proposal” having been enclosed with the letter dated 11 September 2012 from Clifford Chance (for LFT) to the Department of Justice (for the Commissioner). The highlighted part of that sentence appears under a sub-heading described as ‘Principles’ and is in Item 2 of the draft proposal, which highlighted part reads, “An amicable settlement will no doubt save time, costs and resources of both parties and bring certainty and finality to the revenue of the Government of the HKSAR and the tax affairs of LF Group [LFT] in line with CACV 86/2011 and, where appropriate, BR39/04.”[7]

32. Despite having found a reference having been made to one of these proceedings, case no. CACV 86/2011, in the highlighted part of the said sentence, I am however unable to find or infer from it any reference to costs. All I can read from the highlighted part of that sentence is a reference to the benefit of a settlement, and that a settlement would be in line with the decision of the Court of Appeal. The other part of the said draft proposal, Item 3, all relate to tax matters or other outstanding proceedings relating to tax matters between the parties, but there was nothing on costs.

33. Having carefully read the highlighted part of the sentence in Item 2 of the draft settlement proposal and the rest of the documents, I cannot find any documents showing that there had been any negotiations on costs of these proceedings as Mr Gilchrist’s asserted.

34. For these reasons and in the absence of any evidence to support Mr Gilchrist’s contention that the settlement negotiations have or were intended to have included the costs of these proceedings, I am unable to accept LFT’s reason for the delay on the ground of the alleged negotiations for costs.

35. In my judgment, therefore, LFT should have - within the three months as from around mid-April 2012 (the expiry of the appeal period) to mid-July 2012 – actively negotiated costs with the Commissioner, and if there was no prospect of agreement, commenced taxation.

36. LFT neither negotiated costs (as I have found) nor commenced taxation in respect of the costs of these proceedings within the required period of three months in accordance with Order 62, rule 22(1).

37. I do not find the three bills of costs in these proceedings are particularly complicated though the amounts claimed are substantial. When costs could not be agreed, LFT should have without delay instructed a law costs draftsman to draw up the bills, but LFT has clearly failed to do. Had LFT done so, it could have filed the bills within the 3 months by mid-July 2012. By the time LFT commenced taxation on 15 February 2013, there had already been undue delay of 7 months. I do not accept Mr Gilchrist’s that the fact that taxation was commenced within the time limit of 2 years could amount to a good excuse.

38. Before deciding if any and what sanction is to be imposed for the proper exercise of the court’s discretion, I should however consider all the relevant factors of this case.

F. Exercise of discretion

39. One of the factors that Mr Gilchrist asked me to take into account is the Commissioner’s conduct in having failed to apply for immediate taxation, as it would have been entitled to under Order 62 rule 22(3).

40. It was contended that a party’s conduct, as having been firmly established in the striking out application in the Court of Final Appeal decision of Wing Fai Construction Co Ltd, supra, is a relevant consideration under CJR.

41. Given the complete inaction on the part of the Commissioner in taking the necessary step to counteract the delay it is now complaining of, Mr Gilchrist therefore contended that the Commissioner’s conduct is opportunistic and it should not be allowed to reap the benefit of LFT’s delay.

42. These taxation proceedings took place after the commencement of the CJR; hence the relevant CJR rules apply. Under this regime, not only is a court required under Order 1A rule 2 “to give effect to the underlying objectives” of the CJR rules when exercising any of its powers with “the primary aim in exercising the powers of the Court to secure the just resolution of disputes in accordance with the substantive rights of the parties”, the parties and their legal advisers are also required to assist the court to further the underlying objectives (Order 1A rule 3).

43. In the circumstances, I agree with Mr Gilchrist that the Commissioner’s conduct is one of the relevant factors that I should also take into account.

44. As discussed in section E.1 above, if a receiving party delays in commencing taxation within 3 months, a receiving party may face two consequences, one of which is an order of immediate taxation upon an application by a paying party under Order 62 rule 22(3) by ordering that unless the receiving party commences taxation proceedings within a specified period or the amount due is agreed between the parties, the costs order shall be wholly discharged. Such similar provision, before the CJR, was previously regarded as a protection available to a paying party[8].

45. Before CJR, similar powers of ordering taxation and sanctions for undue delay were also provided in the former Order 62 rule 22. Previously, the time allowed for commencing taxation was only one month and the sanctions a court could impose were not as so well defined as they are under the present Order 62 rule 22(5). These changes, it is believed, have been designed to – as stated in the Consultation Paper on Proposed Legislative Amendments for the Implementation of the CJR (April 2006), at p8 – meet the objective of CJR of ensuring that “a case is to be dealt with as expeditiously as is reasonably practicable and to facilitate settlement of disputes”.

46. Ensuring a case is dealt with as expeditiously as it reasonably practicable and to facilitate the settlement of disputes are two of the underlying objectives specified in Order 1A rule 1(b) and (e). Apart from the duty of the court to give effect to the underlying objectives, Order 1A rule 3 (as discussed in §42 above) imposes a duty on parties and their legal advisers to further the underlying objectives. Thus, the Commissioner and LFT would now be subject to this new duty, which, in the present case, requires them to negotiate costs to facilitate settlement and in the event that costs could not be agreed, to take reasonably practical steps in ensuring that the taxation proceedings are to be dealt with expeditiously.

47. LFT, being the receiving party, has the carriage of the action. It thus bears the ultimate responsibility of ensuring that taxation proceedings be commenced expeditiously within three months as required by Order 62 rule 22(1). In having failed to do so, LFT and/or its legal advisers have failed to give sufficient regard to the duty of furthering the underlying objectives in ensuring the expeditious disposal of the taxation proceedings.

48. Whilst LFT bears the ultimate responsibility in commencing taxation without delay, the Commissioner, as the paying party, is also required to take the necessary step to further the underlying objectives upon the LFT’s delay, which would be, in the present case, to resort to the protection accorded to a paying party under Order 62 rule 22(3) by making an application to compel LFT to commence taxation. The Commissioner’s inaction is, in my view, analogous to the conduct of the applicant (i.e. the defendant) in Wing Fai Construction Co Ltd, supra, whose conduct had been described by Ma CJ as having adopted the attitude of “letting sleeping dogs lie” by sitting “idly by and do[ing] nothing, in the hope that sufficient delay would be accumulated so that some sort of prejudice can then be asserted”[9].

49. Before the CJR, when there was then no statutory duty imposed on a party in civil proceedings to further the underlying objectives, the taxing authority had refused to deprive a paying party’s right of benefits for its inaction (See: the Bank of New York[10]), for it had been held that[11], prejudice (to the paying party) was not a prerequisite for the exercise of the court to impose sanction for undue delay for the reason that interest was to run from the date of the costs order until payment. Thus, any delay was found to have caused prejudice to the paying party[12].

50. True that it may be that due to the delay, a paying party will be required to pay more interest on the taxed costs, the receiving party’s delay however is not entirely without benefit to a paying party for the latter would have “nevertheless enjoyed an advantage in keeping hold of its money in the meantime”[13].

51. The parties (not just one party in a proceeding), as already discussed, are required by Order 1A rule 3 to assist the court to further the underlying objectives. The widened scope of Order 62 rule 22, however, has seemingly after the CJR led to a surge of objections in taxation proceedings by a paying party basing on a receiving party’s undue delay under Order 62 rule 22(5). Yet, on the other hand, there have been very few applications made under Order 62 rule 22(3) by the paying party to compel a receiving party to commence taxation. This phenomenon is, probably, due to a misguided view held by a paying party in believing that the duty imposed by Order 1A rule 3 only applies to a receiving party.

52. Such view, after the CJR, may no longer be supported. As the discussions above have shown, the obligations under Order 1A rule 3 apply to parties, not just one party, to the proceedings. If therefore, when a paying party, in appropriate cases, has chosen to lie idly by without an explanation, and later take advantage of the accumulated delay of the receiving party in commencing taxation proceedings, a taxing authority may take into account of such conduct in the exercise of a court’s discretion under Order 62 rule 22(5).

53. In this case, apart from relying on the period of LFT’s delay, the Commissioner has neither written to LFT to discuss the costs nor resorted to the protection having been accorded to it against the latter’s delay under Order 62 rule 22(3). In my judgment, the Commissioner’s lack of explanation for its inaction makes it just for me to also take into account its conduct.

54. Next, I should also take into account the length of undue delay, which according to my finding, has been a relatively short period of 7 months. If sanction were to be imposed, I must however, for the following reasons, reject the global percentage deduction the LCD advocated in this case.

(1) First, the delays ranging from 8 months[14] to 5 years[15] in the cases referred to by the LCD were much more serious than the present proceedings.
(2) Secondly, all of the said cases but one[16] was pre-CJR decisions. Prior to the CJR, there was no time limit for commencing taxation. The new Order 62 rule 22(7) now imposes a time limit of 2 years for the commencement of taxation. As a consequence of the new time limit, excessive delays longer than 2 years will unlikely occur, and the sanctions of global deductions previously imposed by the court may not be an applicable guide.
(3) Thirdly, before the CJR, the type of sanction a taxing master was empowered to impose for undue delay under the old Order 62 rule 22(3) was much narrower in scope, which only provided the taxing authority to disallow any item contained in a bill of costs. Reducing a specified percentage of taxed costs – as shown by the cases mentioned in § 13 above – had been commonly adopted by taxing masters under the old Order 62 rule 22(3). The global deduction approach, when considered in the light of the widened scope of the sanction powers now available in the new Order 62 rule 22(5), may, in some cases, appear rather arbitrary, or even unjust.

55. The sanctions now available are much wider in range, which include not only a disallowance of the taxed costs, but also a deduction of a period of interest on the costs to be taxed.

56. Having considered all the relevant factors discussed above, I should, in order to mark the court’s disapproval of LFT’s undue delay, exercise the discretion to impose sanction. However, the proper sanction to be imposed, in my judgment, should also appropriately reflect the Commissioner’s similar disregard of its duty to assist the court in furthering the underlying objectives of the CJR as already discussed above.

57. For the foregoing reasons I do not consider it appropriate to sanction LFT by a global deduction of the costs to be taxed. In my judgment, given the Commissioner’s conduct, I should exercise my discretion to deprive LFT of its interest on such costs for only a period of 5 months rather than the full period of undue delay of 7 months in order to achieve a just result.

58. In conclusion, I shall disallow interest on the costs to be taxed in each of the three bills for 5 months from around mid-July 2012, say 15 July 2012, to around mid-December 2012, and say 15 December 2012.

Order and directions

59. In respect of the Commissioner’s preliminary objection, it is ordered that there shall be no interest from 15 July 2012 to 15 December 2012 on the costs to be taxed in each of the three bills of costs filed in these proceedings.

60. As for the costs of this objection, I will hear submissions at the resumed taxation hearing that has been adjourned part-heard. Since some of the remaining items to be taxed concern arguments on whether the costs claimed by LFT in respect of the costs having been incurred for the application for the admission of overseas counsel are recoverable , I direct counsel from the Department of Justice should attend the adjourned hearing in respect of this objection as I have noted in this objection that the LCD, though highly experienced, has not been able to render sufficient assistance to me concerning some of the submissions Mr Gilchrist made. Thus, in the future, it would be highly preferable - and indeed necessary in some cases – for solicitors to attend a taxation hearing whenever an objection, such as the present one, involves substantial legal submissions.

	(Katina Levy)
	Master of the High Court

Mr H Wu, LCD & Mr Brian Gilchrist, of Clifford Chance, for the respondent

Mr O Lee, LCD & Ms M Tong, costs clerk of Department of Justice, for the appellant

[1] (1) Attorney General v Commodore Electronics Ltd. [1994] 1 HKC 660;

(2) Lim Ho Kwan v Urban Council, unrep., HCMP 1662 of 1988;

(3) The Bank of New York v Adrienne Marsh Lefkowitz, unrep., Civil Appeal Nos.190 of 1993 and 33 of 1995;

(4) Review of Taxation, unrep., HCA 6086 of 1994 et al.;

(5) Dollarwell Investments Ltd v Donald Koo Hoi Yan, unrep., HCA 12307 of 1995;

(6) PBM (Hong Kong)Limited v Tang Kam Lun, Allan & ors., unrep., HCA 12138 of 1997 & HCA 13316 of 1997 ; and

(7) Zebra Industries (Orogenesis Nova) Ltd. v Wah Tong Paper Products Group Limited, unrep., HCA 1551 of 2004 & HCMP 2044 of 2008.

[2] Zebra Industries (Orogenesis Nova) Ltd. v Wah Tong Paper Products Group Limited, unrep., HCA 1551 of 2004 & HCMP 2044 of 2008.

[3] Wing Ming Garment Factory Ltd v Incorporated Owners of Wing Ming Industrial Centre& Others, Unrep., HCA8805/1993 & CACV27/2008, Recorder Jat SC ([2012] 1 HKC 290)

[4] [2012]1HKLRD 589.

[5] The Bank of New York v Adrienne Marsh Lefkowitz, unrep., Civil Appeal Nos.190 of 1993 and 33 of 1995 at p.4.

[6]Zebra Industries (Orogenesis Nova) Ltd. v Wah Tong Paper Products Group Limited, unrep., HCA 1551 of 2004 & HCMP 2044 of 2008

[7] BR39/04 relates to the proceedings before the Board of Review which decision became the subject proceedings of HCIA3/2010 and CACV86/2011.

[8] The Bank of New York v Adrienne Marsh Lefkowitz, unrep., Civil Appeal Nos.190 of 1993 and 33 of 1995 at p.5.

[9] Wing Fai Construction Co Ltd (in liquidation), supra. per Ma CJ at §75(8).

[10] The Bank of New York v Adrienne Marsh Lefkowitz, unrep., Civil Appeal Nos.190 of 1993 and 33 of 1995.

[11] Lim Ho Kwan v Urban Council, unrep., HCMP 1662 of 1988.

[12]Ibid. at §23.

[13]Attorney General v Commodore Electronics Ltd. [1994] 1 HKC 660 at 663D, per Master Gould.

[14]Review of Taxation, unrep., HCA 6086 of 1994 et al.

[15]Lim Ho Kwan v Urban Council, unrep., HCMP 1662 of 1988.

[16]Zebra Industries (Orogenesis Nova) Ltd. v Wah Tong Paper Products Group Limited, unrep., HCA 1551 of 2004 & HCMP 2044 of 2008

HCIA 1/2010

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 1 OF 2010

(transferred from the Board of Review Hearing No. B/R 39/04)

____________

BETWEEN
	LI & FUNG (TRADING) LIMITED	Appellant
and
	COMMISSIONER OF INLAND REVENUE	Respondent

____________

AND

HCIA 3/2010

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

INLAND REVENUE APPEAL NO. 3 OF 2010

____________

BETWEEN
	COMMISSIONER OF INLAND REVENUE	Appellant
and
	LI & FUNG (TRADING) LIMITED	Respondent
____________
	(Heard together)

Before: Hon Reyes J in Court

Date of Hearing: 6 April 2011

Date of Judgment: 18 April 2011

_______________

J U D G M E N T

_______________

I. INTRODUCTION

1. The Taxpayer (LFT) is wholly-owned by LFBVI (a BVI company).

2. There were two issues in LFT’s appeal against the Commissioner’s assessment of profits tax. The first was whether LFT’s profits relating to goods sourced from suppliers located in places other than Hong Kong were offshore and so not chargeable to profits. The second was whether LFT’s deduction of a 2% marketing commission (paid to LFBVI) from onshore profits was caught by the anti-avoidance provisions in ss.61 and 61A of the Inland Revenue Ordinance (Cap.112) (IRO).

3. The Board decided in LFT’s favour on the first issue and in the Commissioner’s favour on the second. Both parties appealed by way of case stated against the Board’s Decision. It has been agreed that the Court’s consideration of the second issue be deferred, pending remittal of certain matters to the Board.

4. Consequently, the present appeal hearing only concerned the first issue. On that, the Board stated the following question for my determination:-

“Whether, on the facts found by the Board, the true and only reasonable conclusion contradicts the Board’s conclusion at paragraphs 86 and 95 of the Decision, namely, that all of LFT’s disputed profits were sourced outside Hong Kong and no apportionment would arise?”

5. Under IRO s.14 tax is chargeable on profits arising in or derived from a trade, profession or business carried out in Hong Kong. LFT paid profits tax on its profits relating to goods sourced from suppliers in Hong Kong. LFT disputed the Commissioner’s assessment of tax on profits relating to goods sourced from suppliers outside of Hong Kong. In paragraphs 86 and 95 of its Decision, the Board held that “the disputed profits were all sourced outside Hong Kong and there is no question of apportionment”.

II. BACKGROUND

6. LFT provides services to its customers in connection with the manufacture, sale and purchase of goods. Such services include finding suppliers to manufacture and then sell goods to LFT’s customers as buyers. LFT manages the sourcing and manufacturing processes to ensure that satisfactory goods are supplied to its customers. Upon delivery of the finished goods to its customers, LFT is usually paid a commission (6% of the total FOB value of the customer’s export sales).

7. LFT normally enters into contracts with customers for the provision of LFT’s services. Under those agreements LFT is appointed as the buying agent of LFT’s customer (identified as the principal). A typical agency agreement lists the following as the specific services to be provided by LFT to a customer:-

“(a) Locate suppliers, arrange manufacture, place orders in the Territory [of the supplier] on behalf of the Principal under the Principal’s standard terms & conditions of trading. The Agent shall have no authority to place an order for goods without having first received written authorisation from the Principal.
(b) Keep close contact with the Suppliers to ensure that production is running according to the delivery schedule set by the Principal for each item.
(c) Maintain quality control on merchandise including inspection and on a random basis to ensure that items being produced conform to the Principal’s requirements.
(d) Arrange for the shipment of the Merchandise under instruction of the Principal, including assisting the Supplier where necessary with the preparation of all relevant export documentation.
(e) Attempt to settle possible merchandise claims on behalf of the principal.
(f) Endeavour to keep the Principal advised from time to time of new developments in markets of the Territory which may be of interest to the Principal.
(g) Sign or countersign contracts/ purchase orders/ commitment on Principal’s behalf.”

8. LFT, the sellers who manufacture goods, and LFT’s customers who buy the manufactured goods from the sellers, are all independent of each other.

9. Many of LFT’s services are provided outside Hong Kong through local offices. The local offices usually have their own staff. In most cases, the local offices are LFT affiliates. LFT engages or acts through these local affiliates or sourcing companies in performing the services which LFT has contracted to provide to its customers.

10. LFT has entered into contracts with its affiliates under which the latter have in turn undertaken to perform certain services. A typical agreement identifies the services to be provided by an affiliate as follows:-

“(a) to research and locate suppliers for products and goods which the Company [LFT’s customer] may require from time to time and generally to coordinate the supply of and demand for products provided by the Company between suppliers and customers and to advise the Company in respect of sourcing of products;
(b) to furnish continuous information concerning products availability, market conditions, and, in particular, information concerning the Company’s suppliers and advise on matters of pricing;
(c) to arrange and obtain samples of products from suppliers and to assist the Company’s suppliers with any problems relating to the exportation or application for export license of goods;
(d) to assist and advise on methods of transporting, storing and delivery of goods from the Company’s suppliers and to provide advice regarding packaging systems and materials most suitable for goods;
(e) to assist the Company in investigating and settling any claims and complaints against products or goods supplied;
(f) to arrange for the packaging and shipping of the goods or products as shall be purchased by the Company and/or its customers and to act on and in accordance with the instructions of the Company in connection with such matters;
(g) to provide inspectors to monitor quality control of products offered by the Company whenever such quality control services are required by the Company ...;
(h) to do such other acts and things as the Company and [LFT] shall from time to time mutually agree.”

11. In consideration for an affiliate’s services, LFT paid the latter a percentage (say 4%) of the FOB value of total export sales by LFT’s customer.

12. LFT has its headquarters in Hong Kong with many of its most senior staff based here. LFT enters into agency agreements with its customers as a result of the efforts of its senior staff.

13. In computing liability to Hong Kong tax, LFT excluded from its profits the commission earned on orders from overseas customers which were handled by non-Hong Kong based LFT affiliates. LFT took the view that such commission was foreign source income and so not chargeable to Hong Kong profits tax.

14. In contrast, the Commissioner argued before the Board that LFT’s profit was the difference between the 6% which it received from its customers and the 4% which it paid to its affiliates. The Commissioner suggested that LFT operated a “supply-chain management business”. In consequence, whereas LFT’s affiliates earned their 4% for activities abroad, LFT (the Commissioner reasoned) earned 2% for managing its own activities and those of its affiliates from LFT’s Hong Kong headquarters.

15. The Board did not accept the Commissioner’s case.

16. The Board held that LFT was “a commission agent”. LFT’s business was “that of undertaking, on behalf of its own customers, the sourcing of merchandise for its customers”. In short, LFT “sold services for commission”.

17. On the basis (among others) of the contracts between LFT and its local affiliates, the Board further found that the latter were LFT’s agents. The Board rejected the Commissioner’s suggestion that the affiliates were sub-contractors whom LFT had employed to perform services which LFT had agreed to perform for its customers.

18. The Board noted that “LFT employed the local LF [Li & Fung] sourcing companies to act for LFT in carrying out transactions for [LFT’s] customers”. It followed from this that “LFT’s profits were earned in the place where the LF sourcing companies carried out LFT’s instructions, whether they [the LF sourcing companies] did so as agents or principal”.

19. More particularly, “LFT contracted to render a service to its customers, and its net commission, after paying the local LF sourcing companies 4%, arose in the place where it rendered it [the service], i.e., offshore”. The Board emphasised that the focus had to be on “establishing the geographical location of LFT’s profit producing transactions themselves as distinct from activities antecedent or incidental to those transactions”.

20. The Board continued (at Decision, para. 84):-

“The profit producing activities or services started from the placement of orders by LFT’s customers with suppliers, continued throughout the whole process of the production of the merchandise until the successful conclusion of the orders by shipments of the merchandise to the customers and in some cases continued further until the conclusion of follow-up services. It was through those transactions or activities that LFT earned its commissions and charges which were payable only after the completion of the shipment of the merchandise. LFT employed the local LF sourcing companies to act for LFT in carrying out these profit producing activities or services. It mattered not whether the local LF sourcing companies were LFT’s agents or sub-contractors. We find as a fact that all the profit producing/making activities/transactions took place outside Hong Kong. We further find that the geographical source of LFT’s net commission representing the difference between the commission it paid to the local LF sourcing companies which performed the sourcing services and the larger commission which it charged to its own customers arose outside Hong Kong.”

21. In coming to its conclusions, the Board stated that it was applying the principles articulated by the Court of Final Appeal (CFA) in ING Baring Securities (Hong Kong) Ltd. v. CIR (2007) 10 HKCFAR 417.

III. DISCUSSION

A. Law

22. In ING Baring, the CFA criticised an approach to profits tax which fixed the geographical location of a taxpayer’s profits by reference to “activities antecedent or incidental to those transactions”. Ribeiro PJ commented (at para. 38):-

“Such antecedent activities will often be commercially essential to the operations and profitability of the taxpayer’s business, but they do not provide the legal test for ascertaining the geographical source of profits for the purposes of s.14.”

23. In support, the CFA (among other cases) cited Commissioner of Income Tax, Bombay Presidency and Aden v. Chunilal B Mehta of Bombay (1938) LR 65 Ind App 332, a decision of the Privy Council on appeal from British India. In Mehta, the Privy Council stated (at 345) that:-

“[t]o determine the place at which ... a profit arises not by reference to the transaction, or to any feature of the transaction, but by reference to a place in India at which the instructions therefor were determined on and cabled to New York is ... to proceed in a manner which cannot be supported”.

24. The CFA stressed in ING Baring that, to determine the source of a profit, one must first identify the transaction which directly gives rise to the profit. If that transaction takes place in Hong Kong, then the profit generated may be charged with profits tax under IRO s.14. Otherwise, the transaction will have taken place offshore and profits tax will not be chargeable. The latter will be the result even though a taxpayer is present or normally resident in Hong Kong at the time when the transaction takes place.

25. Ribeiro PJ expressed the foregoing more vividly by rejecting (at para. 48) any resort to a “brain” metaphor (that is, reference to where the “brains” or decision-makers of a business are located) for the purposes of determining the geographical source of a profit:-

“Use of a ‘brain’ analogy or the place of administration of the business as criteria for ascertaining the geographical source of profits is plainly inconsistent with the decisions in Mehta and Hang Seng Bank. In a case like the present, source is determined by the nature and situs of the profit-producing transaction and not by where the taxpayer’s business is administered or its commercial decisions taken.”

26. This meant (Ribeiro PJ commented) that in ING Baring the Board of Review had embarked on a costly but ultimately pointless (“legally irrelevant”) exercise. Specifically, the Board had been wrong:-

“to investigate every facet of the Taxpayer’s business so that it could engage in a qualitative assessment of the relative importance of its various operations, choosing ‘the more important things done’ towards the generation of those profits as the criteria for determining geographical source”.

27. In Ngai Lik Electronics Co Ltd. v. CIR (2009) 12 HKCFAR 296 the CFA repeated what it had said in ING Baring.

28. Ngai Lik bought goods which its offshore subsidiaries manufactured in the Mainland. Ngai Lik onsold those goods to customers in Hong Kong. Ngai Lik also engaged in sourcing and agency activities in support of its offshore manufacturing subsidiaries. The Commissioner charged Ngai Lik for profits arising from manufacturing and trading activities.

29. Ribeiro PJ (at para.69) acknowledged that, where a person received payment (such as commission) for sourcing and agency activities carried out in Hong Kong, that payment might be chargeable with profits tax.

30. But in Ngai Lik, Ribeiro PJ was “unable to see how any profits derived from the taxpayer’s sourcing and agency activities can properly be described as manufacturing profits or used as a basis for treating part of the fellow subsidiaries’ profits as the taxpayer’s profits”. Instead, Ribeiro PJ thought that Ngai Lik’s sourcing and agency activities were “at most ancillary to the offshore manufacturing operations which actually produced ‘manufacturing profits’ which arose only upon disposal of the manufactured goods”.

31. It followed that the source of the Ngai Lik Group’s manufacturing profits (as opposed to profits obtained from sourcing or agency activities) could not be Hong Kong.

B. Commissioner’s reformulated case in this appeal

32. Mr. Benjamin Yu SC (who appeared before me (but not the Board) on behalf of the Commissioner) reformulated the Commissioner’s case. Mr. Yu did not press the submission that LFT was carrying out a “supply-chain management business”. Instead, Mr. Yu argued that the Board had erred in not apportioning the gross profit of 6% which LFT received from its customers.

33. LFT’s profit of 6% (Mr. Yu contended) was earned as a result of activities carried out both in Hong Kong and abroad. Insofar as non-Hong Kong based affiliates were involved, Mr. Yu accepted that some of LFT’s profit had an overseas source. On the other hand, insofar as LFT managed and supervised its affiliates from Hong Kong, part of LFT’s profits (Mr. Yu argued) must have had a Hong Kong source.

34. Mr. Yu submitted that LFT’s profits could not have been generated through the activities of LFT’s affiliates alone. The management and supervision of those affiliates (Mr. Yu said) were key factors in producing profits. Mr. Yu stressed that, without the element of management and supervision provided by LFT from Hong Kong, merchandise could not have been delivered to LFT’s customers and commission could not have been earned.

35. Mr. Yu criticised the Board for failing to consider each of the activities (a)-(h) set out in the standard agency agreements between LFT and its customers. Had the Board done its job properly, it would have appreciated that, as a matter of fact, activities (a)-(d) required certain matters to be done or resources to be maintained in Hong Kong to enable a 6% commission to be successfully earned.

36. According to Mr. Yu, the Board wrongly applied ING Baring.

37. It was necessary (Mr. Yu concluded) for the Board to have apportioned the 6% to reflect what the affiliates did abroad and what LFT performed here. Mr. Yu was content for apportionment to mirror the way in which LFT split its 6% commission, with 4% being attributable to the offshore activities of LFT’s affiliates and 2% being attributable to LFT’s activities in Hong Kong.

38. I am not persuaded by Mr. Yu’s argument.

C. Analysis of Commissioner’s reformulated case

39. In my view, the Board did precisely what the CFA says the Board had to do. As required by ING Baring, the Board had to (and did) identify the activities giving rise to the relevant gross profit.

40. Here (the Board held) what generated LFT’s gross commission of 6% were sourcing and agency activities which LFT carried out through overseas local affiliates. The latter affiliate companies (acting on behalf of LFT) assisted LFT’s customers in placing orders with offshore sellers, supervised the manufacturer by those sellers of goods to the specifications of LFT’s customers, and arranged for the shipment of the finished goods from the sellers to LFT’s customers. It was those activities (the Board found) which directly led to the payment of a gross commission of 6%. Those activities took place outside Hong Kong. Without those activities (in particular, the successful delivery of merchandise to LFT’s customer), no commission of 6% could have been earned.

41. There was ample evidence on which the Board could come to the conclusion which it did. For instance, Agreed Fact 4 in the appeal hearing states:-

“Through a network of sourcing offices around the world, LFT organised and arranged the manufacture of soft goods (such as garments) and hard goods (such as fashion accessories, gifts, handicrafts, home products, promotional merchandise, toys, sporting goods, footwear and travel goods).”

42. It is true that LFT maintained back-up or support services for its affiliates at its Hong Kong headquarters. But the Board was entitled to disregard the same as merely (in the words of Ribeiro PJ in ING Baring) “antecedent activities” which although “commercially essential to the operations and profitability of [LFT’s] business ... do not provide the legal test for ascertaining the geographical source of profits”.

43. Mr. Yu sought to make good his characterisation of LFT’s 6% commission as having both an overseas and a Hong Kong source. He attempted this by running through each of the activities (a)-(h) mentioned in the standard agreement between LFT and a customer.

44. In respect of activities (f) and (g) (respectively, keeping a customer informed of market developments and signing contract-related documents for a customer), Mr. Yu accepted that those activities took place entirely outside Hong Kong. Activity (h) is simply a general catchall provision.

45. In respect of activity (a) (locating suppliers, arranging manufacture, and placing orders for a customer), Mr. Yu suggested that senior staff would not only have supervised the local affiliates from Hong Kong, but the local affiliates would themselves have relied from time to time on the intimate regional knowledge and experience possessed by senior staff based in Hong Kong.

46. In respect of activity (b) (ensuring that production of merchandise runs smoothly and on time), Mr. Yu relied on the presence in Hong Kong of senior staff who “monitored the performance of the overseas sourcing companies to make sure that everything was done efficiently” (Agreed Fact 8). Mr. Yu also referred to the manner in which (according to an excerpt from an interview of LFT’s Victor Fung in the September 1998 issue of Harvard Business Review recorded in Agreed Fact 9) LFT serviced its customer Gymboree. According to Victor Fung, LFT’s Gymboree division was one of its largest and LFT devoted a separate office within the Li & Fung building in Hong Kong to providing Gymboree with the requisite technical and merchandising support.

47. In respect of activity (c) (maintaining quality control), Mr. Yu again pointed to the overall supervisory work done by senior staff in Hong Kong.

48. In respect of activity (d) (arranging shipment of merchandise), Mr. Yu pointed to the evidence of William Fung (an LFT and LFBVI director) that “the payment process was centralised in Hong Kong”. He also cited the evidence of John Heaviside (a representative from Mackays, an LFT customer) that “payments arranged by LF to the suppliers were provided ‘centrally’ from LF”. Thus, Mr. Yu inferred that merchandise shipments to customers must initially have been paid on behalf of the latter through LFT’s Hong Kong office.

49. In respect of activity (e) (assisting in investigating and settling claims), Mr. Yu referred to Agreed Fact 5(8). That states: “When problems were encountered which they could not solve themselves, G2s [Grade 2 staff] would seek guidance and direction from the G1s [Grade 1 staff].” Mr. Yu suggested that, where a local affiliate was unable to settle a claim, it would undoubtedly seek help from LFT’s senior staff in Hong Kong.

50. Mr. Yu’s argument seems to me to be precisely the “brain analogy” which the CFA criticised in ING Baring. Mr. Yu denies this.

51. According to Mr. Yu, his submission differs from the brain analogy by focusing on the availability in Hong Kong of senior personnel (“a human database”) on whose experience and knowledge junior staff of local affiliates would inevitably have to refer. But I am not persuaded that there is any real difference with the brain analogy. To my mind, Mr. Yu is saying no more than that at the material times LFT’s senior administrative staff based in Hong Kong oversaw the activities of various overseas affiliates within the Li & Fung group. That fact alone (the CFA has said in ING Baring and Ngai Lik) is not an appropriate criterion for ascertaining the geographical location of a profit.

52. Mr. Yu complains that the Board failed to analyse what specific operations were involved in carrying out activities (a) to (e). The Board (Mr. Yu contends) therefore failed in its duty to make findings as to which specific operations within those activities (a) to (e) took place in Hong Kong and which did not. Absent such findings, it was impossible (Mr. Yu suggests) for the Board to conclude as it did.

53. I disagree.

54. For the Board to have embarked on the investigation indicated by Mr. Yu would have been to engage in what the CFA described in ING Baring as a “legally irrelevant” exercise. It was not the Board’s function to investigate every facet of LFT’s operations and then decide which matters were qualitatively the most important towards making a profit. What instead had to be done was what the Board actually did. That was to discern in a practical manner those activities of LFT which directly (as opposed to indirectly) led to the production of profits.

55. In my view the Board’s findings and conclusions on the source of LFT’s profits are unassailable. There is no basis for saying that the Board ought to have apportioned the 6% commission in the way Mr. Yu suggests. Nor can it be said that the Board acted irrationally or that its conclusions were unsupported by the available evidence.

56. I would answer “No” to the question posed by the Board for this Court’s determination.

IV. CONCLUSION

57. The Commissioner’s appeal against the Board’s conclusion on the source of LFT’s disputed profits fails. There will be an Order Nisi that the Commissioner pay LFT’s costs of the appeal in relation to the source of LFT’s disputed profits. Costs are to be taxed if not agreed, with certificate for two counsel.

58. Before leaving this matter, I should touch on two matters.

59. First, the hearing before the Board ended on 19 January 2006. But the Board did not hand down its Decision until 12 June 2009, nearly 3 years and 6 months later.

60. I fully appreciate that Board members give up their valuable time in order to render voluntary public service for little or no remuneration. But it seems to me that, by any standard, a delay of 3½ years in handing down a Decision must be unacceptable.

61. A Board should endeavour to hand down its Decision within a reasonable time after a hearing. The parties to the proceedings (especially, the Taxpayer) are entitled to know where they stand in a dispute as soon as reasonably possible.

62. In the normal course of events, I suggest that it would generally be reasonable to expect a Board to hand down a Decision within 6 months of a hearing. There may be circumstances where a longer time frame might be justified. But such situations must be exceptional.

63. Second, a substantial part of the Decision consisted of a summary of the evidence given by LFT’s many factual witnesses. There was little indication in that summary what evidence the Board was accepting and what (if any) evidence the Board was rejecting. It was unclear whether the Board intended the summary to represent its findings of fact.

64. A summary of what witnesses say in the course of some hearing is of little help by itself. What is more important is for a Board to identify precisely what findings of fact it is making.

65. On occasion the parties will have differing versions of what happened in the course of key events. In that case, a Board may wish to summarise the evidence adduced by each party in support of their competing versions. However, the Board should not stop there. The Board should go on to specify which parts of each side’s evidence it accepts and why.

(A. T. Reyes)
Judge of the Court of First Instance
High Court

Mr. Benjamin Yu, SC and Mr. Eugene Fung, instructed by the Department of Justice, for the Appellant in HCIA 3/2010 and the Respondent in HCIA 1/2010

Mr. David Goldberg, QC and Mr. Stewart K.M. Wong, instructed by Messrs Clifford Chance, for the Appellant in HCIA 1/2010 and the Respondent in HCIA 3/2010

(I) Appeal by the appellant of HCIA3/2010 dismissed by Court of Appeal. Please refer to HCMP541/2011 dated 20 April 2011 (II) Please refer to CACV86/2011 for the relevant appeal(s) to the Court of Appeal.

COMMISSIONER OF INLAND REVENUE v. LI & FUNG (TRADING) LTD

Related cases with same parties

Files (2)

Case No	Date of Absolute Order	Date when taxation should have been commenced under rule 22(1)	Length of Delay
HCIA 3/2010	2/5/2011	2/8/2011	18.5 months
HCMP 541/2011	1/4/2011	15/7/2011	22.5 months
CACV 86/2011	2/4/2012	2/7/2012	7.5 months