12 March 2007
The recent Court of Appeal decision in CIR v Tai Hing Cotton Mill (Development) Limited, CACV 343 / 2005 contains a detailed analysis on the interpretation and application of section 61A, the general anti-avoidance provision, of the Inland Revenue Ordinance (Cap.112) (the "IRO") in particular with respect to the definition of "tax benefit".
Tai Hing Cotton Mill Ltd. (the "Parent Company"), a Company engaging in the cotton production business, entered into various agreements with its wholly-owned subsidiary, Tai Hing Cotton Mill (Development) Ltd. (the "Taxpayer"), by which the Parent Company's plan to redevelop 3 parcels of lands which it owned (Sites I, II & II) was carried out. A new mill was to be built on Site III whereas the redeveloped Sites I & II would be sold.
Pursuant to the one of the agreements (the "Site I and II Agreement"), which was the transaction impugned under section 61A of the IRO by the IRD in this case, the Parent Company sold Sites I and II to the Taxpayer. The consideration was made up of the following:
(1) a fixed payment of $346,309,452.06;
(2) an obligation on the Taxpayer to procure the building of the new mill on Site III with construction costs of approximately $193 million; and
(3) a "Balance Consideration", being a further sum of $400 million, which was to be subject to the Taxpayer realising net profits of that amount, together with an additional sum equal to 50% of any such profits realised by the Taxpayer from the development of the properties, to be paid after finalisation of the audited development accounts.
In order to redevelop the three Sites, the Taxpayer also entered into a joint venture agreement with a developer, pursuant to which the Taxpayer would provide the land and the developer would be responsible for financing the whole redevelopment project. The industrial building to be built on Site III was to be provided to the Taxpayer at no cost. The sales proceeds to be derived from the redevelopment of Sites I and II would be applied first to reimburse the Taxpayer and the developer in respect of the costs of the redevelopment and the balance would be shared between the two parties.
In computing its assessable profits derived from the sale of the developed properties on Site I and Site II, the Taxpayer sought to claim as deductions under section 16 of the IRO, the total land cost, as set out above, payable to the Parent Company pursuant to the Site I and II Agreement. However, the Commissioner disallowed the deduction of payments in excess of the market value of the land (which was considered as HK$800 million), on the ground that they were not payments for the land incurred in the production of profits, but rather the appropriation of profits to the Parent Company. Further and in any event, even assuming that the payments satisfied the requirements for a deduction under section 16, the Commissioner determined that the Taxpayer entered into the Site I and II Agreement for the sole and dominant purpose of enabling the Taxpayer, for and/or in conjunction with the Parent Company, to obtain a tax benefit and thus the transaction was caught by, and its effect should therefore be ignored pursuant to, section 61A (a general anti-avoidance provision) for the purpose of calculating the Taxpayer's taxable profits.
The Taxpayer appealed to the Board of Review, which overturned the Commissioner's determination. The Board made a finding of fact, amongst other things, that the consideration under the Site I and II Agreement was not excessive and was realistic from a business or commercial point of view and that the Taxpayer did not enter into the Site I and II Agreement for the sole or dominant purpose of obtaining a tax benefit. The Board's decision was, however, reversed by the Court of First Instance.
The Judgment Of The Court Of Appeal
The Taxpayer thereafter appealed to the Court of Appeal. The appeal was allowed by the Court of Appeal.
The Court of Appeal first considered whether the payments made pursuant to the Site I and II Agreement could be said to be expenses incurred in the production of profits, which were deductible under section 16. The Commissioner's main objection in this regard was that payments in excess of the market value of Sites I & II, which were calculated by reference to profits earned, were in fact an appropriation of profit. However, the Court of Appeal rejected such argument and found that given that the payments represented the acquisition cost of the trading stock, the amount of which was found by the Board of Review to be commercially realistic and not excessive, there was no basis to upset that finding of fact and to disallow the deduction.
The Court then proceeded to consider whether section 61A was applicable. In order to trigger the operation of section 61A, a "tax benefit" must have been conferred. Having considered both the Australian and the UK authorities, and also the limited number of relevant Hong Kong authorities on this point, both Rogers VP and Le Pichon JA found that the authorities support the proposition that a tax benefit for the purpose of section 61A was predicated on a liability to tax (with the proviso from Le Pichon JA that "liability" included a potential liability to tax). If the liability in question arose because of the generation of income from the employment of stock-in-trade, the capital acquisition cost of that stock in-trade was the root of the income. So the acquisition cost was the cause of the income and hence, the root of the particular profits and also the liability to tax. The incurring of the capital acquisition costs could not be said to be an avoidance of a liability to tax when it was the root cause of it. Rogers VP and Le Pichon JA found that the impugned transaction in this case did not have the effect of conferring a "tax benefit" on the Taxpayer and section 61A therefore had no application.
Although Tang VP also allowed the appeal, his interpretation of "tax benefit" under section 61A was slightly different. The Commissioner submitted that every deduction for the purpose of the calculation of assessable profits was a "tax benefit" within the meaning of section 61A. This argument did not find favour with both Rogers VP and Le Pichon JA, but Tang VP seemed to support the view that outgoings and expenses which were deductible under section 16, were covered by the definition of "tax benefit" under section 61A, as they would ordinarily have the effect of reducing the amount of tax payable.
Even though Tang VP found that there was a "tax benefit" in this case, he went on to allow the appeal on the basis that the Board of Review was entitled to make the finding that the consideration for the Sites was not excessive and was commercially realistic, and that Deputy High Court Judge Poon had no reason and was not entitled to overturn this finding. In such circumstances, it could not be said that the Taxpayer entered into the "impugned transaction" for the sole and dominant purpose of obtaining a tax benefit and thus section 61A did not apply. Both Rogers VP and Le Pichon JA were in agreement with this point.
This decision is now under appeal by the Commissioner to the Court of Final Appeal. It is anticipated that the issues raised above will be revisited and finally determined in the course of the Appeal, such that the Court of Final Appeal's decision will serve as a guideline to the interpretation and application of section 61A (in particular the definition of "tax benefit") of the IRO in the future. For further information, please contact:
Name: Elaine Y.L. Chen
Phone: +852 2843 2518
Fax: +852 2103 5467
Name: Candy L.T. Kwok
Phone: +852 2843 2544
Fax: +852 2103 5486