Question

AA Ltd (Company) is a private company incorporated in Hong Kong, and wholly owned by a German company. The Company is appointed by its parent company as the sole distributor of the group products in the Far East region. In respect of the Hong Kong market, the Company appointed several local sub-agents to procure and negotiate with buyers. The sale contracts were then signed by the company on behalf of its parent company. In respect of other areas in the region, the Company appointed sub-agents in Singapore and Malaysia who sought buyers and accepted orders on the Company’s behalf. Prices were approved and sale contracts were prepared by the Company in Hong Kong. The sub-agents then arranged to have the contracts signed in the buyer’s countries. The products of all sales in Hong Kong and overseas were shipped directly to the customers from Germany. The Company did not keep stock but collected the payments from customers on behalf of the parent company. After-sale service was also done by the Company. The Company was remunerated by a "commission" on all sales and deliveries made in the Far East region. Recently the parent company invented a new product. The patent right in respect of the manufacture of the product was duly registered in Germany. Two separate agreements were signed between the parent company and two manufacturers, one in Hong Kong and the other in China for the provision of the right to use the manufacturing "know how". The negotiation and follow up work were carried out by the Company in Hong Kong. Royalties of HK$500,000 and US$80,000 are payable by the manufacturers in Hong Kong and China respectively to the parent company. The Company will receive a service fee of 1% of the royalties for the provision of training and assistance rendered to these manufacturers. Required: By reference to the information given, discuss the Hong Kong tax positions of AA Ltd. and its German parent company. Ignore overseas tax implications.

Answer 1

AA Ltd.'s income from commission and service fees for the sales and after-sale services provided is likely taxable as Hong Kong-sourced income. The German parent company's royalty income is likely offshore-sourced and not subject to Hong Kong tax unless linked to business conducted within Hong Kong. The source of the service fee income received by AA Ltd. for facilitating manufacturer agreements will depend on where the services are rendered.

Step-by-step explanation:

The Hong Kong tax positions of AA Ltd. and its German parent company primarily involve considerations of the source of income, the nature of income, and the application of the territoriality principle of taxation. For AA Ltd., its commission-based income from distributing products in the Far East region would likely be deemed Hong Kong-sourced income, taxable under the Hong Kong Profits Tax regime because the key activities that generate this income (such as appointing sub-agents, negotiating contracts, and rendering after-sale services) are conducted in Hong Kong. Meanwhile, any royalty income collected from manufacturers in Hong Kong and China is likely to be considered offshore-sourced income for the German parent company, as the provision of manufacturing 'know-how' originates overseas. However, the service fee received by AA Ltd. from facilitating this transaction might be taxable as Hong Kong-sourced income.

It's important to note that AA Ltd.'s remittance as commission and service fees would typically be computed on a net-profit basis after allowable deductions under the Inland Revenue Ordinance (IRO). The German parent company would not be subject to Hong Kong Profits Tax on royalties received from the manufacturers in Hong Kong and China unless it carries on a business in Hong Kong, and the royalty income is derived from or arises in Hong Kong. Any training or assistance provided by AA Ltd. to manufacturers will be carefully scrutinized for their nature and whether the actual services are rendered in Hong Kong to determine the source of the service fee income.