The Judicial Committee of the Privy Council Decisions

Privy Council Appeal No. 1 of 1997

 

Commissioner of Inland Revenue Appellant

v.

Orion Caribbean Limited (in voluntary liquidation) Respondent

 

FROM

 

THE COURT OF APPEAL OF HONG KONG

 

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JUDGMENT OF THE LORDS OF THE JUDICIAL

COMMITTEE OF THE PRIVY COUNCIL,

Delivered the 23rd June 1997

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Present at the hearing:-

Lord Nolan

Lord Nicholls of Birkenhead

Lord Steyn

Lord Hoffmann

Lord Clyde

  ·[Delivered by Lord Nolan]

 

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1. This appeal turns upon the provisions of section 14(1) of the Inland Revenue Ordinance (Cap. 112) which provides for profits tax to be charged "for each year of assessment ... on every person carrying on a trade, profession or business in Hong Kong in respect of his assessable profits arising in or derived from Hong Kong for that year from such trade, profession or business".  By section 2 of the Ordinance the expression "profits arising in or derived from Hong Kong" is defined to include "all profits from business transacted in Hong Kong, whether directly or through an agent".

 

In Commissioner of Inland Revenue v. Hang Seng Bank Limited [1991] 1 AC 306 Lord Bridge of Harwich, delivering the judgment of their Lordships' Board, said at page 318:-

"Three conditions must be satisfied before a charge to tax can arise under section 14: (1) the taxpayer must carry on a trade, profession or business in Hong Kong; (2) the profits to  be  charged  must  be  `from  such trade, profession or business', which their Lordships construe to mean from the trade, profession or business carried on by the taxpayer in Hong Kong; (3) the profits must be `profits arising in or derived from' Hong Kong."

 

2. In reliance upon the provisions of section 14 the appellant Commissioner made assessments to profits tax on the profits of the respondent Orion Caribbean Limited (in voluntary liquidation) ("OCL") for the years of assessment 1980/81 to 1986/87 inclusive.  The profits took two forms, first the net interest gained by OCL from the borrowing and lending of money, and secondly, various fees which it received from participating in loan syndicates.  On the basis of the facts found by the Board of Review OCL accepts that the Commissioner's claim under section 14 satisfies the first two of the three conditions set out by Lord Bridge, but contends that it fails to satisfy the third condition, namely that the profits, to be taxable, must arise in or be derived from Hong Kong.  This contention was upheld by the Board of Review and by the Court of Appeal.

 

3. The Commissioner made an alternative claim for tax in respect of the interest element in the profits in reliance upon section 15(1)(i) of the Ordinance which applies to "sums, not otherwise chargeable to tax under this Part, received by or accrued to a financial institution by way of interest which arises through or from the carrying on by the financial institution of its business in Hong Kong, notwithstanding that the moneys in respect of which the interest is received or accrues are made available outside Hong Kong".  This alternative claim by the Commissioner was upheld by the Board of Review, but rejected by the Court of Appeal.  Since their Lordships have concluded that the primary claim of the Commissioner under section 14 is well founded, it is unnecessary to explore the provisions of section 15(1)(i) in detail.  OCL places some reliance upon its terms, however, for the light they are said to throw upon the scope of section 14, and for this reason their Lordships will need to return to it at a later stage.

 

4. The facts giving rise to the Commissioner's claim for tax are these.  OCL is a Cayman Islands company, created in 1979.  It is wholly owned by Orion Royal Pacific Limited ("ORPL"), a company incorporated in Hong Kong.  ORPL in turn is wholly owned by Orion Royal Bank Limited ("ORBL").  Until June 1981, ORPL was owned by a consortium which included the Royal Bank of Canada ("RBC").  After June 1981 RBC wholly owned ORBL and hence, indirectly, ORPL and OCL.

 

5. ORPL was at first a registered deposit-taking company and subsequently a licenced deposit-taking company within the meaning   of  the  Deposit-taking  Companies  Ordinance  (since repealed) and the Banking Ordinance which succeeded it.  In the late 1970's and early 1980's, ORPL was one of the main institutions or banks active in syndicated loans in Hong Kong.  It would on its own or in cooperation with other banks underwrite term loans and syndicate them among other banks in Asia and Europe.  The banking department of ORPL undertook credit analysis, loan syndication, loan management, negotiation of new loan documentation and amendments to existing agreements and loan administration.

 

6. OCL was formed in 1979.  It had three directors (whom it did not pay) and no staff.  Its function within the group, as found by the Board of Review in paragraph 4.5 of the stated case "was to serve as a vehicle for a tax avoidance scheme whereby it borrowed money on a regular basis (in currencies other than Hong Kong dollars) from (a) ORPL until late August, 1985 and (b) the Singapore branch of RBC subsequently; and on-lent (again in currencies other than Hong Kong dollars) to borrowers (recommended by ORPL and approved by OCL), thereby making a profit out of the interest differential between the borrowings and the lendings".  It was evidently intended that the profits thus realised by OCL, and the attendant fees arising from participation in syndicates, would be protected from the risk of a claim for tax under section 14, and that the interest component would be protected from liability under section 15(1)(i) which was added to the Ordinance in 1978.

 

7. The arrangements made in pursuit of this intention are set out in great detail in paragraph 4 of the stated case, and in paragraph 10 in which the decision of the Board of Review is given.  The salient features can be described more briefly.

 

8. OCL was formed with what the Board of Review describe as a comparatively small capital: it appears to have been just under US$6,000,000.  As has been mentioned, OCL had three directors but no staff.

 

9. On 18th October 1979, ORPL entered into a service agreement with OCL whereby ORPL agreed, for stated remuneration, to provide OCL with management, administrative and accounting services with respect to syndicated loans in which OCL intended to participate as a vendor.  In November 1979 ORPL sold and assigned to OCL a portfolio of 27 syndicated loans.  In addition, ORPL thereafter recommended new syndicated loan business to OCL.  Before recommending new syndicated loan business to OCL, ORPL assessed the potential borrowers' credit worthiness, sought RBC group credit committee approvals in relation thereto, negotiated the terms of approved  loans,  and  liaised  with  the  banks which formed the syndicates of lenders.  Once loans and their terms were approved ORPL would then approach OCL (or other institutions within the RBC group) offering participation as a lender in the syndicated loans.  Participation by OCL in these loans was always on an arm's length basis as to fees and other arrangements, that is to say on the same terms would be offered to banks outside the group.

 

10. On 3rd November 1982 OCL approved only one of four loans recommended by ORPL and rejected the other three.  There is no evidence to explain the reasons for the rejection.  On all other occasions, OCL's board in the Cayman Islands approved the loans as recommended, and, in doing so, relied on the evaluations of the group committees.

 

11. Having approved a loan, OCL would issue to a director of ORPL (and, after June 1981, sometimes also to an officer of RBC as an alternative) a power of attorney to execute the loan agreement on its behalf.  No evidence was adduced as to where the great majority of these loan agreements were signed.  In the case of 14 of them their places of signing were unknown; 6 of the 14 were signed in Hong Kong.  The Board of Review found, as a matter of inference, that over 40% of all the loan agreements to which OCL was a party were signed in Hong Kong.

 

12. OCL's main bank account was a United States dollar account maintained with a bank in New York, as most of its loan transactions were in that currency.  In addition, it maintained a Deutschmark account with a bank in Frankfurt, a Japanese Yen account with a bank in Tokyo, and another United States dollar account with a bank in the Cayman Islands.  OCL used its New York, Frankfurt and Tokyo bank accounts in the course of its participation as a lender in the syndicated loans.

 

13. At paragraph 4.22 of the stated case the Board of Review summarised the business activities of OCL in these terms:-

"The board of directors of OCL held its meetings in the Cayman Islands.  Its main business was to consider and approve loan participations recommended by ORPL, and its main duty was to see that the proposals would not infringe the laws of the Cayman Islands.  As for the merits of the loan, the board relied on the evaluations of the loan or credit committees of the group and approved all the recommended loans except on the one occasion mentioned ... above.  Although the loan approvals were a formality in nature, they did in our view involve a decision making process, so that the board was not a mere rubber stamp in approving the loans.  It had the power to disapprove them.  Once a loan was approved and the loan agreement signed, the  ensuing  business  of  borrowing  and  on-lending was entrusted entirely to ORPL, which took deposits on behalf of and in the name of OCL up to late August, 1985 from itself and subsequently from the Singapore branch of RBC.  It did this without seeking or having to seek prior approval or subsequent ratification from OCL in the Cayman Islands."

 

14. The Board of Review returned to the subject in paragraph 10.3 of the stated case which reads as follows:-

"It was suggested that OCL's business was participation in syndicated loans.  But that is only half the story.  With its relatively small capital, it had to borrow money (by taking deposits) from ORPL to fund its loan participations, so in fact OCL carried on the business of borrowing and on-lending money with a view to profit."

 

15. OCL relied in argument before the Board upon the fact that the service agreement prohibited ORPL from acting as an agent for OCL.  In response to that argument, the Board said at paragraph 10.3.4 of the stated case that:-

"As we have found (see paragraph 4.22 above), OCL left the business of borrowing and on-lending entirely to ORPL; the latter in fact acted at all times as OCL's agent in obtaining borrowings, that is, deposits (whether from itself or the Singapore branch of RBC) and entering into deposit-taking contracts without seeking prior approval or subsequent ratification from OCL's board in the Cayman Islands.  The inescapable conclusion is that ORPL had implied actual general authority to make the deposit-taking contracts; such contract making activities were in our view outside the service agreement and did not amount to a breach of clause 4.  Alternatively, if we are wrong in saying that these activities were outside the service agreement, then OCL and ORPL must have varied clause 4 by mutual abandonment to the extent of allowing ORPL to carry on the activities on behalf of OCL."

 

16. The Board went on to find in further sub-paragraphs of paragraph 10.3 that in, for example, the case of United States dollar loans ORPL instructed its bank in New York to pay the amount of the deposit to OCL's bank in New York for OCL's account.  ORPL, acting on behalf of OCL, also instructed OCL's bank in New York to pay the amount of the deposit to the loan agent's bank in New York.

 

17. Interest on the loan and the various fees in respect of the participation were paid by the loan agent to OCL's bank in New York.  Out of the interest received, OCL paid ORPL through its bank in New York the interest due to it.  Although there was no direct evidence, the Board heard that ORPL, acting on behalf of OCL, gave all the necessary instructions to OCL's bank for interest to be paid out of OCL's bank account to its own bank account.  All the contracts for the placing of foreign currency deposits by OCL with ORPL were made in Hong Kong, with ORPL acting on behalf of OCL and on its own behalf.  OCL's banks overseas communicated with and sent their statements, credit advices and debit advices to OCL care of ORPL in Hong Kong.  OCL's books of account were kept in Hong Kong; all accounting facilities were provided to OCL by ORPL in Hong Kong.  All the administrative support in the day to day running of OCL's business was provided by ORPL in Hong Kong, and OCL's bank accounts were operated and its cash managed by ORPL in Hong Kong.

 

18. It is to be noted that not all of OCL's relevant activities were carried out in Hong Kong.  Reverting to this point in paragraph 10.4 of the stated case the Board of Review repeated that the approval of proposed new loans by OCL's Board took place in the Cayman Islands.  So did OCL's approval to proposed amendments of existing loans.  While over 40% of the loan agreements were believed to have been signed in Hong Kong, the rest were signed overseas.  Finally, the actual transfers of money into a bank which took place pursuant to the instructions given by ORPL, on OCL's behalf, in performance of the deposit-taking contracts and loan agreements took place outside Hong Kong.  Under the international clearing house system, payments could only be made through the appropriate clearing house for the currency concerned.

 

19. The Board, concluded, however, at paragraph 10.5 of the stated case that:-

"Having considered all the facts found above and the points mentioned in 10.3 and 10.4 above, we have come to these conclusions: (1) despite the fragmented mode of carrying on business, the operations from which OCL's profits in substance arose took place in Hong Kong; (2) OCL carried on its business in Hong Kong; and (3) its profits arose from such business."

 

20. It is not in dispute that these were findings of fact which the Board were entitled to reach upon the basis of the evidence before them.

 

21. The Board of Review then turned for guidance to two recent decisions of their Lordships' Board, both concerned with the scope of the charge under section 14.  The first was Commissioner of Inland  Revenue  v. Hang  Seng  Bank Limited to which reference has already been made.  In that case Lord Bridge had said at [1991] 1 AC 306, 322:-

"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."

 

22. In the following year, their Lordships' Board returned to the subject of section 14 in Commissioner of Inland Revenue v. HK-TVB International Limited [1992] 2 A.C. 397.  In that case, after quoting the passage from the judgment of Lord Bridge in Hang Seng quoted above Lord Jauncey of Tullichettle, giving the judgment of their Lordships' Board, continued at page 407:-

"F.L. Smidth & Co. v. Greenwood [1921] 3 K.B. 583 was cited in the Hang Seng Bank case and their Lordships do not doubt that Lord Bridge had in mind the judgment of Atkin L.J.in that case and in particular the passage when he said, at p. 593: `I think that the question is, where do the operations take place from which the profits in substance arise?'

 

  Thus Lord Bridge's guiding principle could properly be expanded to read `one looks to see what the taxpayer has done to earn the profit in question and where he has done it.'  Further their Lordships have no doubt that when Lord Bridge, after quoting the guiding principle, gave certain examples he was not intending thereby to lay down an exhaustive list of tests to be applied in all cases in determining whether or not profits arose in or derived from Hong Kong.  In the Hang Seng Bank case ... the two transactions which threw up the profit, namely the purchase and resale of the certificates of deposit, both took place outside Hong Kong and this Board held that the profits  did  not  arise  in  or  derive  from  Hong  Kong, notwithstanding the fact that all the instructions to buy and sell originated in Hong Kong and that there was no independent branch office interposed between the head office in Hong Kong and the following transactions.

 

  Applying Lord Bridge's guiding principles it is clear that the first question to be determined in this appeal is what were the transactions which produced the profit to the taxpayer."

 

23. Returning to the same theme at page 409 of the report Lord Jauncey said:-

"Their Lordships consider that it is a mistake to try to find an analogy between the facts in this appeal and the example given by Lord Bridge in the Hang Seng Bank case.  The circumstances in that case involving, as they did, buying and selling in well defined foreign markets were very different from those in the present and the examples were never intended to be exhaustive of all situations in which section 14 of the Ordinance might have to be considered.  The proper approach is to ascertain what were the operations which produced the relevant profits and where those operations took place."

 

24. After citing these passages the Board of Review expressed their judgment in these terms:-

"The effect of what Lord Jauncey was saying would appear to be this: if the facts of a case do not bring it within any of the examples given by Lord Bridge in the Hang Seng Bank case, the operations test should be applied in determining the question whether the profits arose in or derived from Hong Kong.  Taking the present case as one of lending money coming within the example given by Lord Bridge in the Hang Seng Bank case, we have looked to the place where the money was lent as the test.  However, if we are wrong and the correct test is the operations test, then, since we have already found that the operations from which OCL's profits in substance arose took place in Hong Kong ... [it] would have been our conclusion that the profits in question arose in or derived from Hong Kong."

 

25. The decision of the Board of Review was upheld by the Court of Appeal.  At page 143 of the record, Godfrey J.A. giving the judgment of the court referred to the Board as having "looked to the places where the money was lent" and continued:-

"In doing so, it had in mind the observation, given by way of example, in the Hang Seng Bank case ..., to the effect that, where  a  profit  is  earned  by lending money, the profit will have arisen in or derived from the place where the money was lent.  It concluded that what the taxpayer had done here to earn the profits in question was to lend money, and that it did that offshore.  In our judgment, not only was the board entitled so to find; no other conclusion would have been open to it."

 

26. On behalf of OCL, Mr. Christopher Clarke Q.C., invited their Lordships to uphold the decision of the Board of Review and the Court of Appeal on the simple basis that where the gross income in question is interest on a loan the source of the income is located, as a matter of law, in the place where the money is advanced.  For this proposition he relied upon the example given by Lord Bridge.  He submitted that if ORPL had itself made money available by way of loan to borrowers in New York, Frankfurt or Tokyo the resulting interest would not have been taxable under section 14, and that there was no reason why OCL should be in a worse position than ORPL.

 

27. There are three difficulties inherent in this proposition.  The first is that it attributes to Lord Bridge's words, even if they are taken in isolation, a rather broader meaning than that which they naturally bear.  Lord Bridge speaks of profit earned "by the exploitation of property assets as by letting property, lending money or dealing in commodities or securities".  The reference to "property assets" in relation to the letting of property or the lending of money may have been intended to refer simply to the exploitation of property or money owned by the taxpayer.  If ORPL lent its own money to a borrower in, say, New York, then other things being equal there might be little difficulty in saying that the location of the source of the interest on the loan was New York.  If on the other hand, Lord Bridge was intending to cover, by his examples, a case such as that of OCL where the money has to be borrowed before it can be lent - like the commodities which have to be bought before they can be resold - it would be surprising if he were suggesting that regard should be had solely to the place of lending, to the exclusion of the place of borrowing.

 

28. Secondly, and more generally, the proposition that Lord Bridge was laying down a rule of law to the effect that, in the case of a loan of money, the source of income was always located in the place where the money was lent, is one that cannot stand with the opening words of Lord Bridge quoted above, nor with the explanation of his remarks by Lord Jauncey in the HK-TVB case, nor with the whole range of authority starting from the judgment of Atkin L.J. in F.L. Smidth & Co. v. Greenwood onwards, to the effect that the ascertaining of the actual source of  income  is  a  "practical  hard matter of fact", to use words

employed, again by Lord Atkin, in Liquidator, Rhodesia Metals Limited v. Commissioner of Taxes [1940] AC 774 at page 789.  No simple, single, legal test can be employed.

 

29. Thirdly even if the activities of ORPL, before the involvement of OCL, could be regarded as simple loans of money of the kind which Lord Bridge intended to exemplify, it by no means follows that the profit-making activities of OCL can be seen in the same light.  The suggestion that OCL's business was participation in syndicated loans was expressly rejected by the Board of Review at paragraph 10.3 of the stated case.  Its business in fact, as found, was borrowing and on-lending money with a view to profit.  The borrowing and on-lending, on the findings of the Board, were carried on for OCL by ORPL, acting for OCL on each side of the transaction.  If one asks what OCL did to earn the profits in question, and where OCL did it, the answer is that OCL allowed itself to be interposed between ORPL and the ultimate borrowers.  It did so by allowing itself to be used as a channel for loans of funds raised or provided by ORPL in Hong Kong and passed through OCL to the ultimate borrowers under loan agreements negotiated, approved and serviced by ORPL.  The present case is far removed from the simple type of loan transaction contemplated by Lord Bridge in Hang Seng.

 

30. For substantially the same reasons, their Lordships find no assistance in the language of section 15(1)(i) of the Ordinance on which the respondent relied and to which both the Board of Review and the Court of Appeal referred.  This provision, whose terms are set out above, may be highly relevant to loans of the kind to which Lord Bridge referred, if made by a financial institution.  It may also be permissible to read section 15(1)(i), as the Board of Review and the Court of Appeal did, as supporting the proposition that such loans, when made abroad, fall outside the scope of section 14.  But in the light of the facts of the present case, as referred to above and as summarised by the Board of Review in paragraph 10.5 of the stated case the true and only reasonable conclusion, as it seems to their Lordships, is that the profits of OCL, including the net interest and the related participation fees, arose from business transacted in Hong Kong by ORPL on OCL's behalf.

 

31. Their Lordships will therefore humbly advise Her Majesty that the appeal should be allowed, the judgment of the Court of Appeal set aside and the assessments in question remitted to the Commissioner in accordance with their Lordships' directions herein.  The respondent must pay the appellant's costs in the Court of Appeal and before their Lordships' Board.

 

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