Mar. 2013 - Court of Appeal disallows deduction for moulds used by a hangers supplier in China

As such, the moulds are regarded as “excluded fixed assets” for the purpose of section 16G of the Inland Revenue Ordinance (“IRO”) and BFEL is therefore not entitled to claim deduction.

Background

BFEL supplied plastic garment hangers to its parent company in the United Kingdom which onward supplied the same to the ultimate customers.  The hangers were customized and jointly designed by the parent company and its customers.  The hangers were manufactured by unrelated factories in the Mainland China using moulds owned by BFEL.  The moulds were made by the factories under the guidance of BFEL and in accordance with the designs provided by BFEL.  They were used only to manufacture hangers to be supplied to BFEL.  BFEL claimed deduction of the expenditure on the moulds under section 16G.

It was held by the Board of Review that the moulds were the subject of an arrangement under which a right to use the moulds was granted by BFEL to the manufacturers, and thus were the subject of a lease as defined in section 2(1) of the IRO.  They are therefore regarded as “excluded fixed assets” as defined under section 16G(6) and do not qualify for deduction under section 16G. 

The taxpayer appealed directly to the Court of Appeal.

The issue resides in the definition of the word “lease” for the purpose of section 16G:

• Under section 2(1), a lease includes “any arrangement under which a right to use the machinery or plant is granted by the owner of the machinery or plant to another person”.  If this definition applies, the moulds in question should be regarded as the subject of a lease and are therefore “excluded fixed assets” which do not qualify for deduction under section 16G;
• If the ordinary meaning of “lease” instead of the extended definition provided by section 2(1) applies, the moulds should not be regarded as the subject of a lease and should qualify for deduction under section 16G.

Court of Appeal decision

The CoA dismissed the taxpayer’s appeal.

The CoA pointed out that section 2(1) provided that the definitions enacted in it were to apply unless the context otherwise required, it was necessary for BFEL to show that the context in which the term “lease” was used in section 16G(6) required the statutorily defined meaning not to apply.  However, the CoA did not agree with the arguments put forth by the taxpayer.

On the other hand, the CoA agreed with the Revenue that the legislative history of section 16G made it clear that the extended definition of “lease” provided by section 2(1) was intended by the legislature to apply both in the context of section 16G(6) and section 39E.  The definition of “lease” was first introduced in 1986 when section 39E was introduced.  When section 16G was added to the IRO, the definition of “lease” in section 39E(5) was repealed but the same definition was then inserted into section 2(1).  Therefore, the CoA agreed that the only purpose of moving the definition was to ensure that it applied to the word “lease” as used in both section 16G and section 39E.

Latest development

The taxpayer applied for leave to appeal to Court of Final Appeal.  The application is scheduled to be heard on 19 April 2013.

Comments

It is common for a Hong Kong trading company to provide certain moulds for free to its unrelated suppliers for use in the production process in China.  Those moulds are used by the suppliers to manufacture the goods exclusively for the Hong Kong trading company.  The moulds are owned by the Hong Kong company for very good commercial reasons: protection of its intellectual properties or licensed intellectual properties, e.g. design, trademark, licence, patent, etc.

Unless the Court of Final Appeal overrules the CoA’s decision in BFEL’s case by allowing BFEL to deduct the mould cost under section 16G, companies in a similar situation will not be able to claim any relief (either in the form of depreciation allowances or deduction under section 16G) on their genuine business expenditure necessarily incurred to generate their chargeable profits.  Taxpayers facing the same issue should consider modifying their business operations in order to reduce tax cost.