A recent Court of Final Appeal decision puts to rest the question of whether a director who signs off on incorrect tax returns for a company taxpayer is personally liable in the stead of the company. It also serves as a timely reminder on bearing transfer pricing principles and laws in mind when structuring a multinational enterprise’s intragroup transactions.
The Commissioner of Inland Revenue v. Koo Ming Kown & Murakami Tadao (2022 HKCFA 18) represents the Commissioner’s final attempt to rescue s 82A(1)(a) of the Inland Revenue Ordinance (“IRO” ) as a basis to impose personal liability on a taxpayer’s officers. It arose after Nam Tai Electronics & Electrical Products Limited (the “Taxpayer”) failed to successfully challenge or pay additional taxes levied against it when the Commission disallowed expenses claimed in its profit tax returns filed in 1996/1997, 1997/1998 and 1999/2000 (the “Returns”).
Part I: directors' liability
Messrs. Koo and Murakami (the “Directors”) were directors of the Taxpayer at the relevant times and signed on the declaration at the conclusion of the Returns confirming they were true and accurate (the “Declaration”). Following a tax audit in 2002, the Inland Revenue Department (” IRD “) disallowed the Taxpayer’s claims for deductions made in the Returns and assessed the Taxpayer for additional tax. The Taxpayer did not pay the amounts assessed and was wound up by the court on the petition of the Commissioner. Subsequently, the Directors were assessed to additional tax under s 82A(1)(a) of the IRO on the basis that the Returns were incorrect by understating the assessable profits.
In summary, s 82A(1)(a) of the IRO subjects any person who without reasonable excuse makes an incorrect return by omitting or understating anything in respect of which he is required by the IRO to make a return, either on his behalf or on behalf of another person to the liability to be assessed to additional tax of an amount not exceeding treble the amount of tax which has been undercharged in consequence of such incorrect return.
The CFA upheld the Court of Appeal and Court of First Instance’s views and found the Directors not liable to additional tax under s 82A(1)(a) of the IRO as persons making the Returns on the Taxpayer’s behalf by virtue of being signers of the Returns. The CFA held that, while s 57(1) of the IRO makes the secretary, manager and any director of a corporation answerable for doing certain acts under the IRO by the corporation, it did not go so far as imposing a legal obligation on the Directors to make a tax return on behalf of the Taxpayer. It was the Taxpayer who was issued a notice by the IRD and required by it to make the Returns. The Directors’ signing of the Declaration was considered part of the process by which the Taxpayer acted to fulfil the requirement imposed on it to make a return. As a matter of statutory construction and based on the facts of the case, the Returns were required to be made, and were made, by the Taxpayer. They were not required to be made, and were not made, by the Directors on behalf of the Taxpayer. Accordingly, the Directors did not fall within the description of persons intended to be captured under s 82A(1)(a) of the IRO. In light of the CFA judgment, it is clear that several precedent Board of Review decisions that found directors personally liable for additional tax under s 82A(1)(a) for incorrect profits tax returns were incorrectly decided.
Note however, whether a tax return could be said to be “incorrect” by virtue of expense claims subsequently disallowed by the IRD is arguable. The issue was taken up by the Directors in their appeal to the Court of First Instance, which decided that the Returns were not “conclusively” incorrect. However, this question was not considered further at the Court of Appeal or Court of Final Appeal, since the question no longer arose once the courts found that the Directors ought not be personally liable under s 82A(1)(a).
Furthermore, this decision should be accorded proper context – it only concerns one form of potential liability a company’s officer may face in respect of an erroneous tax return filed by a corporation under s 82A(1)(a) of the IRO. A company’s officer could still be liable for various penalties arising out of the administration of IRO. In particular, s 82 of the IRO contains penal provisions for a person who willfully and with intent evades, or who assists another to evade, tax. S 101E of the Criminal Procedure Ordinance also provides that where an offence has been committed by a company with the consent or connivance of a director, such director shall be guilty of the like offence. Therefore, it is paramount for a company’s officers to exercise due care when preparing the company’s tax returns.
Part II: lessons on transfer pricing
Although the appeals before the CFI, CA and the CFA revolved around the personal liability of the directors who signed the tax returns of the Taxpayer, the originating tax dispute is rooted, fundamentally, in issues of transfer pricing. The case, which concerns Returns from 1996 to 1999, predated the introduction of express legislation on transfer pricing in Hong Kong. Nevertheless, the principles on which the IRD challenged the Taxpayer continue to provide useful guidance for pricing cross-border intragroup transactions.
The Taxpayer was part of a corporate group that was engaged in the manufacturing and trading of electronics. The Taxpayer’s parent company, Nam Tai Electronics, Inc (“NTEI”), was incorporated in the BVI and listed on the NASDAQ in the United States. NTEI was also the ultimate holding company of certain PRC subsidiaries that manufactured the group’s electronics products. The Taxpayer itself performed the limited function of sales coordination. In the originating dispute, the Taxpayer appealed against assessments by the IRD that disallowed tax deductible expenses claimed by the Taxpayer, being principally management fees paid to its parent company, NTEI, and other legal and professional fees paid to NTEI and its PRC subsidiaries. Its appeal was refused by the Board of Review, who held that the management fees that the Taxpayer paid to NTEI were for services directly or indirectly enjoyed by the PRC manufacturing subsidiary. The Board of Review considered that NTEI could have invoiced the subsidiary directly for the services without passing the expenses through the Taxpayer. On the evidence, it appeared that none of the challenged expenses were in the service of the generation of the Taxpayer’s profits. In the Taxpayer’s own evidence, it was admitted the claimed expenses were designed to cover the Taxpayer’s overheads. Although the Taxpayer argued the expenses were made in the service of the corporate group “as a whole” and as a single business unit, the Taxpayer itself enjoyed very little of the services that its expenses paid for.
A multinational group is not free to set its intragroup pricing policy without regard to the actual business functions of its constituent entities. The Board of Review confirmed that each company within a group must be treated separately, and one cannot attribute business expenses of one or more group members to another in computation of the other’s tax liability. Ss 16 and 17 of the IRO, which set out the law on the deductibility of expenses in assessing chargeable tax, are clear that deductions can only be made for expenses that ‘yield the assessable profits’. They must be incurred in the production of those assessable profits in the year of assessment. The relevant taxpaying entity must be looked at independently, and it is irrelevant that its expenses are for the benefit of the greater corporate group. The Board of Review also considered that the tax returns fell afoul of the general anti-avoidance provision of s 61A(1) of the IRO, which gives the IRD the power to disregard transactions whose sole or dominant purpose is to enable a taxpayer to obtain tax benefits.
Although the Returns predate the 2018 overhaul to the IRO that codified the OECD’s transfer pricing guidelines, the dispute by the Taxpayer is, at heart, about transfer pricing. Multinational enterprises with a presence in Hong Kong are reminded to ensure that the costs and profits booked by its Hong Kong-based entities under intragroup transactions must be on a fair and arms-length basis. The laws apply not only to companies within the same group, but also head offices and their permanent establishments, as well as other forms of business enterprises such as partnerships.
Part III: PRC position
China’s transfer pricing legislation is based on the arm’s length principle and incorporates the basic aspects of the OECD Transfer Pricing Guidelines.
Intra-group services should be beneficial to the relevant party receiving such services, and the following “six tests” will be used to determine the arm’s length nature of the services: “benefit test,” “necessity test,” “duplication test,” “value creation test,” “remuneration test” and “authenticity test”.
The filing of intercompany transaction computation constitutes part of the compulsory filing of annual income tax returns, even for taxpayers with nil intercompany dealings. Country by Country Reporting is also in the income tax annual filing package but is only applicable to “sizable” tax resident enterprises, namely ultimate holding companies of multinational groups with total annual consolidated group revenue of more than RMB5.5 billion.
In addition, a three-tiered framework of contemporaneous transfer pricing documentation (“TPD”), including “master file”, “local file” and “special issue file”, is mandatory for enterprises that meet different thresholds. Enterprises must prepare the relevant TPD and make relevant disclosure before the filing deadline.
China tax authorities use a ‘risk-centric’ approach to govern the transfer pricing practices of taxpayers. When perceiving such risk, they may notify the taxpayer to perform a self-assessment or directly flag it for a formal TP audit procedure. Taxpayers can also activate the self-assessment protocol and adjust the income tax return voluntarily.
Penalties for failures to fulfil transfer pricing filing and/or TPD obligations include fines of up to RMB10,000 for the failure of filing transfer pricing forms, or for the failure of producing/keeping TPD, or fines of up to RMB50,000 for the failure of submitting TPD to tax authorities (if so requested) or for submitting false or incomplete information. In cases where a formal transfer pricing audit procedure has been initiated, an interest based on the People’s Bank of China’s benchmark interest rate for RMB loans for the same period to which the tax payment is related plus 5%, will be levied on top of the underpaid tax as assessed. However, having proper TPD will shield a taxpayer from the aforementioned 5% penalty.
China tax authorities generally will not invoke the offence against tax evasion in transfer pricing dispute cases. Directors or officers signing the tax returns which result in underpayment of taxes will not be held personally liable in such cases.
In recent years, China tax authorities have been lodging less formal transfer pricing audit cases while encouraging self-assessment procedures instead.