Hong Kong Tax News Flash 

The taxpayer was a company incorporated in Hong Kong and was part of the Shui On group.  A complicated debt defeasance scheme was entered into among the taxpayer, a number of companies in the group and two unrelated bankers.  The commercial reality of the scheme is to obtain a refinancing of a loan previously borrowed to finance the development of a building of the group.  However, instead of getting a refinancing directly from a bank, the above mentioned scheme involving a circular flow of funds was entered into and as a result, the taxpayer incurred an expenditure on acquiring the right to receive the interest stream of a loan borrowed by a fellow subsidiary from a bank for acquiring the building from the parent company.  The expenditure on acquiring the right together with the related legal and professional fees paid by the taxpayer was described in the taxpayer's account as "deferred expenditure".  The taxpayer sought to deduct the amortisation of the deferred expenditure in the relevant years of assessment.

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Profits tax assessments under section 61A were raised on the taxpayer in the relevant years of assessment to deny its deduction claim of the amortisation of the deferred expenditure.  In her determination, the Commissioner of Inland Revenue ("CIR") expressed the opinion that "the charging of the "deferred expenditure" in the taxpayer's accounts was clearly part and parcel of a composite tax avoidance scheme entered into by the relevant persons to obtain a tax benefit".  For this reason, the CIR did not accept that the deferred expenditure was incurred to produce any chargeable profits and did not think that the conditions for deduction in section 16(1) of the IRO were fulfilled.

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The grounds of appeal put forward by the taxpayer to the Board were summarised as follows:

1. The taxpayer was a finance company and what it did (i.e. money borrowing and on-lending, buying and selling of financial assets) was no more than a facet of the trade typically carried on by a finance company.  As such, the deferred expenditure constituted expense incurred to acquire trading stock and therefore should be deductible under section 16(1); and
     
2. The CIR was incorrect in applying section 61A to transactions entered into by the taxpayer as there was no benefit accrued to the taxpayer or if tax benefit did result from the transactions, the sole or dominant purpose was not to obtain such benefit.

At the hearing, the legal counsel representing the taxpayer further advanced the following argument:

• Section 61A was a charging section.  Since the assessments were made under section 61A and the CIR had not advanced any alternative to the section 61A assessments, it was not open to the CIR to argue that the taxpayer was liable under section 14, section 16 and section 17 in her determination after assessments had been made under section 61A.

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Although the Board of Review considered the argument put forward by the legal counsel for the taxpayer at the hearing was not covered by the original grounds of appeal and hence was not open to the taxpayer, the Board decided that this argument was incorrect.  It held that although the original assessments were issued under section 61A, section 61A is not itself a charging provision and it does not preclude the CIR from considering whether the deferred expenditure was deductible under section 16(1).
    
On the issue of deductibility of the deferred expenditure under section 16 and section 17, the Board held that the deferred expenditure was paid to acquire the contractual right to receive monies to last for years and it was a cost to acquire a permanent income-producing structure.  Therefore, the deferred expenditure was capital in nature and non-deductible under section 17(1).  In view of the above decision, the Board found that there was no need for it to deal with section 61A but went on to consider the section in case it was wrong on the sections 16 and 17 issue.  The Board concluded that the taxpayer was conferred a tax benefit as the debt defeasance scheme reduced the amount of tax payable of the taxpayer.  Having considered the seven matters specified in section 61A(1), the Board held that the dominant purpose of the scheme was to enable the taxpayer to obtain a tax benefit.
   
The Court of First Instance ("CFI") upheld the Board's decision and agreed with the Board that (1) the CIR was not barred from advancing an assessment on some basis other than section 61A  because the assessments in the present case were actually raised under section 14 of the IRO and section 61A is merely a tool to help determining the assessable profits (i.e. it is not a charging section itself); (2) the deferred expenditure was a non-recurring or once and for all payment and therefore was of a capital nature and not deductible under section 17(1); and (3) alternatively, the taxpayer entered into the scheme for the sole or dominant purpose of obtaining a tax benefit for itself under section 61A.
   
The taxpayer's main argument in its appeal to the Court of Appeal ("COA") was that as the Board had decided that the deferred expenditure was not deductible, the tax benefit had ceased and therefore, the section 61A assessments were invalid and had to be annulled.  The taxpayer also argued that the six-year statutory time bar would mean that the CIR could not raise an assessment other than one under section 61A.  Similar to the CFI, the COA considered that section 61A is not a separate section to assess tax but a section empowering the CIR to ignore or adjust the effect of a transaction in particular circumstances.  Given the circular flow of funds and the disputed deductions in the current case, the COA held that the CIR was clearly entitled to apply section 61A to counteract the tax benefit obtained by the taxpayer as a result of the deferred expenditure if the amounts had been deductible under section 16 and had not been disallowed under section 17.

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The CFA unanimously dismissed the taxpayer's appeal on the following bases:

1. Section 61A (and section 61) is not a separate, self-contained charging provision and what it does is to extend the scope of the ordinary charging provisions in the IRO.  There is little distinction between assessments raised under s.61A and those "direct assessments" raised under section 59 or 60.  All these assessments are raised under Part X of the IRO.  It was therefore open to the CIR to proceed the present case relying on the effect of sections 16 and 17 without referring to any tax benefit within the meaning of section 61A even though the original assessments were raised under section 61A.
      
2. The deferred expenditure which the taxpayer sought to deduct formed the sole profit-yielding structure of the taxpayer and was actually a non-recurring or once-and-for-all payment incurred to obtain an income stream.  As such, the deferred expenditure was capital in nature and non-deductible.
      
3. Given the judgment on the above two points, strictly it was not necessary for the CFA to decide whether the taxpayer was liable under section 61A.  However, the CFA made the following important observations regarding the application of section 61A in its obiter dictum:
      
• For any section 61A proceedings, there is a clear need for the IRD to identify with workable clarity at an early stage the tax benefit which it seeks to challenge, the transaction which it says had the effect of conferring that tax benefit on the taxpayer and the person or persons having the relevant dominant purpose.
     
• If the supposed tax benefit would not have been achieved in the absence of section 61A (e.g. where the supposed tax benefit is a deduction but such deduction is not allowable under section 16 or 17), section 61A cannot apply as there is no tax benefit in the statutory sense.
    
• It is therefore incumbent on the CIR to make clear any alternative grounds (other than section 61A) on which he/she may seek to support an assessment.
     
• There are two provisions in section 61A.  Applying section 61A in making an assessment is not straightforward and is best approached by stages.  What the CFA suggested is: (1) in the simplest situations where the taxpayer participates in a free-standing transaction designed to obtain a tax benefit, the appropriate action for the CIR is to apply section 61A(2)(a) and make an assessment wholly disregarding the transaction; (2) in more complicated tax avoidance schemes where new sources of income and new deductions/losses are brought in, the task of counteracting the tax benefit requires the CIR to act under section 61A(2)(b) and make an assessment designed rationally to counteract that tax benefit.
    
• In exercising the power under section 61A(2)(b) and coming up with the "reasonably postulated hypothetical transaction", the CIR must act reasonably and avoid any arbitrary or exorbitant exercise of the statutory power.
     
• While evidence given by taxpayers or their associates as to why they preferred the impugned transaction to simpler and more natural alternatives may be used in determining the "sole or dominant purpose" issue, that evidence would not be of much relevance (and certainly not conclusive) as to the appropriate course to be taken under section 61A(2)(b).

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Tax benefit as a prerequisite for the application of section 61A
   
Although the main thrust of the CFA's judgment in this case is not the application of section 61A, as an obiter dictum, the CFA has addressed the issue which was left open by the CFA in Ngai Lik Electronics v CIR, namely, a tax benefit in the statutory sense is required before section 61A is engaged, and so section 61A can apply only to a transaction which would otherwise avoid tax.
    
The above conclusion, together with the CFA's view expressed in the Ngai Lik case, have set the fundamental rules on the future application of section 61A, namely, a tax benefit that would otherwise be achieved is a prerequisite for applying section 61A and in applying the section, the three interlocking conditions (i.e. transaction, tax benefit and dominant purpose) must be properly aligned and approached with the necessary degree of precision.
   
For details of the CFA's judgement and our observations of the Ngai Lik case, please refer to our Hong Kong Tax News Flash, July 2009 Issue 9.
   
The "reasonable hypothesis" test in applying section 61A
  
As mentioned above, the CFA's comment in this case further confirms that in exercising the power under section 61A(2)(b) to counteract the tax benefit identified, the CIR has to come up with a reasonably postulated hypothetical transaction and "avoid any arbitrary or exorbitant exercise of the statutory power".  Arm's length transaction or market price appear to be acceptable by courts as reasonable benchmark as illustrated in the Ngai Lik case and the Tai Hing Cotton Mill (Development) Limited v CIR case.  Proper transfer pricing documentation will be of assistance in this regard.

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