Legally speaking, tax avoidance or evasion is sometimes distinguished by a marginal concept. It is fairly common for large consortiums to deploy professional expertise to plan for tax optimization, aiming to reduce tax burden. Tricks and manners are so very varied!
For most cross-border businesses, it is a general tactic to reduce tax by a transfer pricing mechanism to shift income or profits among group companies incorporated in different countries. The aim is to allocate part (or even most) of the profits in certain place which is outside the tax jurisdication of the territory of actual operations.
Here is a representative example. A garment group had its sales and operation base located in Hong Kong. Its production plant (contract processing) was set up in the Mainland. Many years ago, the group had been earning decent net profit up to HK$100M and above p.a. The directors opined that their financial controller should derive a plan to lower the group’s exposure to Hong Kong Profits Tax.
After careful consideration, the financial controller proposed to establish a ‘management’ company in Macau and to transfer the group’s finance and accounting department to operate there.
The principal functions of the management company were :
- Issue sale invoices by the Macau company to overseas customers.
- Open bank accounts in Macau to handle in/out funds.
- Remittances to the Mainland factory were directly made from Macau.
- Most profits were dumped with the Macau company.
Subsequent to the full implementation of the above operation mode, the company in Hong Kong surely had significant drop in its net income. Nevertheless, according to the tax laws in Macau, the company’s net profit retained there did not fall into the taxation net of the city. The reason was that the management company in Macau was merely an accounting office and did not have any actual trading operation. Consequently, the group had benefited a lot from tax reduction. The directors and shareholders were totally satisfied.
However, the Hong Kong Inland Revenue Department (‘IRD’) was not unprofessional. When the annual tax submission with audited financial statements were reviewed, tax officers found out the following doubtful areas :
- Turnover growth was promising but the gross profit margin had dropped sharply.
- Some cost components in the profit and loss account fluctuated substantially and unreasonably.
- Current accounts with related companies had large unsettled balances as well as related party transactions were enormously high.
The IRD then issued query letters to the group requesting explanations to the above three principal irregularities. The financial controller did consult the group’s tax representatives. They had tried hard to answer the IRD what they considered ‘accurate’ but refused to provide other relevant evidences.
The questioning had lasted for more than a year but the IRD was not satisfied with the answers they had received. This case was finally transferred from the Profits Tax Unit to the Tax Investigation Unit, the latter had proceeded to investigate into the group’s books and records, bank transactions, personal wealth of the directors and shareholders, etc.
Until then the group’s directors realized the seriousness of the situation. They decided to employ another experienced tax accountant to be their representative to handle the affairs with the IRD. The investigation process had dragged on over another year or so. Finally, the IRD determined that the group’s tax scheme was a vulnerable one. The aim of incorporating the Macau company was primarily to avoid taxation in Hong Kong. The Department’s decision was further evidenced by the fact that the Hong Kong enterprise was still the registered corporation holding the contract processing license with the Mainland. Profits should fundamentally not be ‘retained’ in Macau.
The consequence was very serious. Apart from collecting additional taxes and penalties, the IRD with solid evidences on hand, had decided to take legal proceedings against the directors and financial controller of the group. The court had sentenced the defendants to 24-30 months jail. The end story was a tragedy!